The world is one of haves and have-nots.
And so is the stock market.
While some stocks had a blistering 2020, others floundered.
As Benjamin Graham said, the market is a voting machine over the short term and a weighing machine over the long term.
Certain stocks are very popular right now. Perhaps too popular.
Others, even high-quality stocks, are unpopular.
And if you wait until these unpopular stocks become popular, you’ll be paying up for that popularity.
I prefer to go against the crowd and buy high-quality stocks when they’re unpopular.
That’s because I know, over the long run, the business will eventually be weighed out and the stock will be valued based on that weight.
I have done this repeatedly over the years as I’ve built out my FIRE Fund.
This real-money portfolio produces enough five-figure passive dividend income for me to live off of.
In fact, this portfolio allowed me to retire in my early 30s.
And that happened even though I grew up poor, don’t have a college degree, and never had a high-paying job.
I lay out in my Early Retirement Blueprint exactly how that transpired.
Long story short, I’ve lived below my means and invested my capital into high-quality dividend growth stocks.
Stocks like those you can find on the Dividend Champions, Contenders, and Challengers list.
I’ve invested in these stocks because they have the proven ability to grow profit year in and year out.
And they pay out reliable, rising cash dividends – which I can use to pay my bills at a young age.
But it’s more than just buying the right stocks.
There’s also valuation to be aware of.
Whereas price tells you what you pay, value tells you what you get.
An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.
This is relative to what the same stock might otherwise provide if it were fairly valued or overvalued.
Price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.
That higher yield correlates to greater long-term total return potential.
This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.
Prospective investment income is boosted by the higher yield.
But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.
And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.
These dynamics should reduce risk.
Undervaluation introduces a margin of safety.
This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value.
It’s protection against the possible downside.
Buying high-quality stocks when they’re unpopular can lead to tremendous wealth and passive income over the long term.
Taking advantage of undervaluation requires one to first understand valuation.
Fortunately, it’s easier than ever to do that.
Fellow contributor Dave Van Knapp even provided an easy-to-follow valuation template, via Lesson 11: Valuation.
One of his “lessons” on dividend growth investing, this valuation template can be applied to almost any dividend growth stock out there.
With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…
American Electric Power Company Inc. (AEP)
American Electric Power Company Inc. (AEP) is an American electric utility holding company that, through subsidiaries, provides electricity generation, transmission, and distribution to more than five million retail customers across 11 different states.
Founded in 1906, American Electric Power Company is now a $39 billion (by market cap) regulated utility monster that employs more than 17,000 people.
The company reports results across four primary segments: Vertically Integrated Utilities, 56% of FY 2019 revenue; Transmission and Distribution Utilities, 27%; Generation & Marketing, 11%; and AEP Transmission Holdco, 6%. A Corporate & Other segment has insignificant revenue.
FY 2019 utility retail revenue can be broken down by customer type: residential, 48%; commercial, 28%; industrial, 22%; and other, 2%.
The company primarily relies on coal for energy generation. Coal accounts for 45% of their generating capacity, while natural gas represents 28%. Most of the remainder comes from renewable sources such as wind and hydro.
The investment thesis for a power utility business is extremely straightforward.
Simply put, our modern society cannot function without dependable access to electricity.
Utilities that provide this service naturally profit from their role.
And investors who own shares in high-quality utilities profit, too.
Investors can also usually count on some of the most reliable growing dividends out there, due to the innate need for power.
Dividend Growth, Growth Rate, Payout Ratio and Yield
As it stands, American Electric Power Company has increased its dividend for 11 consecutive years.
The 10-year dividend growth rate is 5.2% and this growth rate has been remarkably consistent over the last decade.
For example, the most recent dividend raise was 5.7%.
This growth rate certainly isn’t stratospheric.
But it is rather strong when pairing it with the stock’s starting yield 3.80%.
That yield is more than twice as high as what the market offers.
It’s also 50 basis points higher than the stock’s own five-year average yield.
And with a payout ratio of 76.7%, the dividend remains easily supported by earnings.
Great dividend metrics here. We have a fairly large dividend growing at a mid-single-digit pace. One can do much, much worse than this.
Revenue and Earnings Growth
However, this is looking at what the utility has already done.
But it’s really what the utility will do that matters to investors.
We invest our capital for future returns. It’s today’s risk for tomorrow’s reward.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will later help us estimate the stock’s intrinsic value.
I’ll first show you what the company has done over the last decade in terms of top-line and bottom-line growth, before comparing that to a near-term professional prognostication for profit growth.
Blending the proven past with a future forecast in this way should allow us to come to a reasonable estimation regarding the company’s long-term growth path.
The company grew its revenue from $14.427 billion in FY 2010 to $15.561 billion in FY 2019.
That’s a compound annual growth rate of 0.84%.
Meanwhile, earnings per share moved from $2.53 to $3.88 over this period, which is a CAGR of 4.87%.
This is fairly typical growth for a large, regulated utility business.
Looking forward, CFRA believes that American Electric Power Company will compound its EPS at an annual rate of 6% over the next three years.
That would be an acceleration in EPS growth relative to what the utility has recorded over the last decade.
CFRA cites customer growth, higher rates, and higher transmission volumes as tailwinds. The WFH theme should positively impact residential numbers.
Notably, the utility is executing a substantial spending plan ($35 billion from 2020 through 2024), which should result in higher rates, revenue, profit, and dividends as costs are passed on to customers.
This is a utility that will have to spend in the future, as the large reliance on coal for generation capacity has to be reduced. Whereas you could look at the current coal exposure as a negative, the move toward an energy mix improvement is a growth opportunity for them.
American Electric Power Company has already stated that it expects 24% of its generation capacity to come from coal in 2030. Simultaneously, they expect renewable energy capacity to jump to 39% by 2030.
I think CFRA’s near-term EPS growth projection is reasonable. And that would translate to like dividend growth over the foreseeable future, which is more than enough when paired with a near-4% yield.
Moving over to the balance sheet, the company’s financial position is okay.
It’s not out of line for a utility; however, I do think there’s room for improvement in this area of the business.
The long-term debt/equity ratio is 1.28. The interest coverage ratio is just over 2.5.
Over the last five years, the firm has averaged annual net margin of 10.68% and annual return on equity of 9.10%.
This is about as bulletproof as a business model gets, due to the innate need for the electricity it provides to millions of customers.
And with scale, a unique regulatory structure that almost guarantees profit, and the ability to operate as a local monopoly within its service territory, the company does benefit from competitive advantages.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
Competition is essentially nullified by a geographic monopoly.
On the other hand, governments heavily regulate electric utilities.
In exchange for being able to pass on costs and offer a necessary service to a captive customer base, a utility business must accept a limit on how much profit they can actually make.
In addition, new future competition could arrive in the way of customers becoming competitors. This would happen if power is able to be easily and cheaply generated and stored at the consumption site. Technology advancements in solar cells and batteries are a big risk to electric utilities.
There’s also geographic risk. A utility company cannot expand its coverage area very much, so underlying growth within its established service territory is very important.
I also see some reputation risk in the form of coal exposure. While the company continues to move away from coal, its heavy reliance on coal for energy generation could lead to some customer dissatisfaction.
Overall, even with these risks known, I think this regulated utility business is highly attractive for income-oriented investors.
And the stock’s low valuation makes it particularly attractive right now…
Stock Price Valuation
The stock has a P/E ratio of 20.22.
While that might actually look high, keep a couple things in mind.
First, it’s lower than both the broader market and the stock’s own five-year average P/E ratio of 28.0.
Second, impairments largely related to plant closures have reduced TTM GAAP EPS. This has had the effect of skewing the P/E ratio higher.
Meantime, the P/S ratio is right in line with its five-year average.
And the yield, as noted earlier, is notably higher than its own recent historical average.
So the stock looks cheap when looking at basic valuation metrics. But how cheap might it be? What would a rational estimate of intrinsic value look like?
I valued shares using a dividend discount model analysis.
I factored in a 10% discount rate and a long-term dividend growth rate of 6%.
This is on the low end of what I tend to allow for in a DDM analysis.
However, it’s also within a range of what I normally ascribe to a regulated utility such as this.
These are slower-growing, higher-yielding stocks that are perfect for investors looking for income or aiming to raise the overall income profile of their portfolio.
I think this is a warranted DGR.
It’s very close to where the most recent dividend increase came in at. And CFRA is calling for near-term EPS growth to come in at this exact level.
Looking at the overall growth profile of the business, this seems like a very reasonable expectation.
The DDM analysis gives me a fair value of $78.44.
The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.
The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.
It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.
I find it to be a fairly accurate way to value dividend growth stocks.
I came up with a valuation that indicates this stock is roughly fairly valued.
But we’ll now compare that valuation with where two professional stock analysis firms have come out at.
This adds balance, depth, and perspective to our conclusion.
Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.
1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.
Morningstar rates AEP as a 4-star stock, with a fair value estimate of $89.00.
CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.
They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.
CFRA rates AEP as a 3-star “HOLD”, with a 12-month target price of $98.00.
I came out on the low end this time around. Averaging the three numbers out gives us a final valuation of $88.48, which would indicate the stock is possibly 13% undervalued.
Bottom line: American Electric Power Company Inc. (AEP) is a high-quality regulated utility that provides a necessary service to millions of people. With a secure yield near 4%, more than a decade of consistent dividend raises, and healthy dividend growth, this near-bulletproof dividend growth stock is a compelling idea for income-oriented investors.
P.S. If you’d like access to my entire six-figure dividend growth stock portfolio, as well as stock trades I make with my own money, I’ve made all of that available exclusively through Patreon.
Note from DTA: How safe is AEP’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 81. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, AEP’s dividend appears Very Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
This article first appeared on Dividends & Income
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