Stock market bubbles.

It can be fun if you’re inside one while it’s expanding.

Not so much when it bursts.

I’ve never experienced a bubble bursting, because I’ve never participated in a bubble.

I instead go after high-quality dividend growth stocks when they’re undervalued.

You might think that’s boring.

Jason Fieber's Dividend Growth PortfolioIf you want excitement, skydiving or riding roller coasters might fit the bill.

But when it comes to successful long-term investing, boring is so beautiful.

I’ve been at this for a decade now, building my real-money FIRE Fund in the process.

This six-figure portfolio chock-full of high-quality dividend growth stocks produces the five-figure dividend income I live off of.

In fact, this portfolio allowed me to retire in my early 30s – as I describe in my Early Retirement Blueprint.

I’ve seen bubbles expand and burst, businesses come and go, investors rise and fall.

I’m still here and doing so well a decade later largely thanks to the dividend growth investing strategy I follow and recommend, which has focused my capital into world-class enterprises that can take a licking and keep on ticking.

I’m talking about world-class enterprises like you can find on the Dividend Champions, Contenders, and Challengers list.

But successful long-term investing involves a lot more than following the right strategy or investing in the right businesses.

Valuation at the time of investment is also extremely important.

While price is what you pay, it’s value that 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.

Investing in boring but beautiful businesses when they’re undervalued can allow you to sidestep bubbles and prosper over the long term.

Undervaluation, by the way, is easier to spot than you might think.

Fellow contributor Dave Van Knapp has made sure of that with Lesson 11: Valuation.

Part of a more comprehensive series of “lessons” on dividend growth investing, it provides a valuation template that can be used to estimate the value on 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…

Digital Realty Trust, Inc. (DLR)

Digital Realty Trust, Inc. (DLR) is a global real estate investment trust that owns and operates data centers.

Founded in 2004, Digital Realty Trust is now a $38 billion (by market cap) data center juggernaut that employs over 1,500 people.

Their real estate portfolio of over 280 data centers is spread out across more than 20 countries worldwide. These purpose-built properties are strategically located for their networking capabilities.

They work with over 4,000 customers, with some of their largest customers being the likes of IBM, Facebook, Oracle, and LinkedIn.

The digitization of many aspects of life has been playing out over the last decade.

Life has changed immensely over this period. And it continues to change immensely.

The Internet is now a vital part of most people’s lives. And with the Internet-of-Things spreading everywhere from smart appliances to self-driving cars, our future is going to be more digital than it’s ever been.

AI. Data. Cloud. IoT. This is our future.

Some companies will benefit from digitization. Some will be at a disadvantage.

Digital Realty Trust is most certainly in the former camp.

Digitization directly works to the advantage of companies that own and operate data centers, as these centers act as critical infrastructure to the global flow of information through interconnected networks. Digitization doesn’t happen without data centers.

The company was in a great position before 2020. They’re in an even better position now.

That’s because the pandemic has accelerated digitization.

For example, the pandemic has resulted in more companies adopting a work-from-home model for their employees.

This was probably an eventuality, but there’s been a forced move in this direction over the last year. And Digital Realty Trust is in the position to benefit more than ever from the accelerating evolution in the way people live, work, and play.

That bodes well for the company’s ability to increase its profit and pay out a rising dividend to shareholders.

Dividend Growth, Growth Rate, Payout Ratio and Yield

Already, Digital Realty Trust has increased its dividend for 16 consecutive years.

The 10-year dividend growth rate is 8.6%.

That’s a very strong dividend growth rate when paired with the stock’s current yield of 3.18%.

This yield blows away what the broader market offers.

It’s also not far off from the stock’s own five-year average yield.

And with a payout ratio of 73.1% (using the midpoint of FY 2020 core FFO/share guidance), the dividend is quite secure.

This stock offers a safe, market-beating dividend that’s growing at a high-single-digit rate. This is what I consider the “sweet spot” for dividend growth investors.

Revenue and Earnings Growth

However, this is looking at the past.

Investors are putting today’s capital at risk for tomorrow’s rewards.

It’s really those future dividends that we care most about.

Thus, I’ll now build out a forward-looking growth trajectory for the business, which will later help us estimate the intrinsic value of the stock.

I’ll first show you what Digital Realty Trust has done over the last decade in terms of top-line and bottom-line growth.

Then I’ll compare that to a near-term professional prognostication for profit growth.

Blending the proven past with a future forecast like this should allow us to model out a reasonable expectation for future growth.

Digital Realty Trust has increased its revenue from $865 million in FY 2010 to $3.209 billion in FY 2019.

That’s a compound annual growth rate of 15.68%.

Obviously, that’s extremely impressive.

However, we have to keep in mind that top-line growth from a REIT can be somewhat misleading. A REIT often funds absolute growth via debt and equity.

The dilutive effective from equity issuances can lead to a pretty large divergence between top-line and bottom-line growth.

Indeed, Digital Realty Trust’s outstanding share count has more than doubled over the last decade.

As you might suspect, it’s far more insightful to look at profit growth on a per-share basis when dealing with a REIT.

And when looking at per-share profit growth for a REIT, you want to look at funds from operations instead of normal earnings.

FFO measures cash generated by a REIT. It adds depreciation and amortization expenses back to earnings.

The company has increased its FFO/share from $3.39 to $6.66 over this 10-year period, which is a CAGR of 7.79%.

Still rather strong, but we do see that drop from revenue growth.

Looking forward, CFRA currently has no three-year FFO/share growth projection.

That’s unfortunate, as I like to compare that projection against a historical baseline for these analyses.

However, there’s a specific note from CFRA that accurately sums up the investment thesis and near-term growth outlook for Digital Realty Trust: “DLR will likely continue to benefit from high occupancy levels and its diverse customer base. We see modest rate increases as demand growth continues to outpace capacity growth in a number of markets.”

In my view, investors should expect future growth that’s at least in line with what’s occurred over the last decade.

I say that because Digital Realty Trust is now larger, and arguably better, than it was 10 years ago.

They’ve scaled up in a big way in recent years – and scale in this arena matters very much.

Significant acquisitions have included DuPont Fabros Technology for $7.6 billion in 2017, Ascenty for $1.8 billion in 2018, and Interxion for $8.4 billion in 2019.

Plus, there’s the fact that the digitization of most aspects of our lives has been accelerated, which is a natural tailwind for Digital Realty Trust.

Whereas dividend growth has slightly outpaced FFO/share growth over the last decade, I believe the two will more closely match over the next decade and converge to meet in the middle.

That kind of high-single-digit dividend growth, when paired with a 3%+ yield, is quite appealing.

Financial Position

Moving over to the balance sheet, I’ve already foreshadowed the swelling of debt.

That said, the company has acquired some valuable assets in exchange for more leverage.

They have $12.4 billion in total liabilities against $23.1 billion in total assets.

The company’s investment-grade credit ratings are as follows: BBB, S&P Global; Baa2, Moody’s; BBB, Fitch.

Moreover, many of their top tenants are world-class institutions with their own investment-grade ratings.

When investors think of a REIT, their minds might initially conjure up images of shopping malls and office space.

Well, this REIT is nothing of the sort. It’s differentiation positions it squarely in the middle of the ongoing technology evolution, which involves almost every facet of our everyday lives.

Investors buying this stock now could be “future-proofing” their portfolios, without paying the nosebleed prices that one will often find among other tech plays.

And with global scale, switching costs, sticky assets, strategically-placed properties that are purpose-built, and technological know-how, the company does benefit from competitive advantages.

Of course, there are risks to consider.

Litigation, regulation, and competition are omnipresent risks in every industry.

As a company that participates in and benefits from the evolution in technology, any unforeseen changes in technology, which can happen rapidly, could be disadvantageous to Digital Realty Trust.

The balance sheet has ballooned in recent years in an attempt to compete at scale, which leaves the company more vulnerable to interest rates and less flexible.

This business model is capital intensive.

Real estate is highly cyclical. This real estate is differentiated, but there is still an element of cyclicality to contend with.

There’s also a scarcity of competitive advantages in real estate, although Digital Realty Trust’s unique real estate portfolio gives it advantages that I don’t usually see in real estate.

With these risks known, I still believe this stock should make for an excellent long-term investment.

And with the stock still 15% off of its 52-week high, the valuation looks attractive right now…

Stock Price Valuation

The stock is trading hands for a P/FFO ratio of 22.97 (using the midpoint of FY 2020 core FFO/share guidance).

This would be analogous to a P/E ratio for a regular stock.

That might look slightly high at first glance, but I think it’s more than reasonable for a business growing at the listed rate.

I also consider the valuation on a relative basis. Almost any other high-quality technology stock you’ll find is trading at a much higher multiple than this.

The P/CF ratio of 21.8 is a bit higher than its own three-year average 19.0, but the company now has additional assets and tailwinds it didn’t have before.

And the yield, as noted earlier, is pretty much in line with its 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 7%.

This DGR is near the higher end of what I normally allow for, especially for a REIT, but I’m of the opinion that this business does deserve it.

Both the long-term dividend growth and FFO/share growth have exceeded this mark; in the case of the former, the excess adds up to more than 150 basis points on an annualized basis.

If anything, with the great possibility of an acceleration in growth, my factored DGR could prove to be conservative.

However, I’d always rather err on the side of caution.

The DDM analysis gives me a fair value of $159.79.

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.

Even after a pretty careful valuation, the stock still looks cheap.

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 DLR as a 3-star stock, with a fair value estimate of $125.00.

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 DLR as a 3-star “HOLD”, with a 12-month target price of $170.00.

I came out somewhere in the middle. Averaging the three numbers out gives us a final valuation of $151.60, which would indicate the stock is possibly 8% undervalued.

Bottom line: Digital Realty Trust, Inc. (DLR) is a high-quality, differentiated REIT that has positioned itself squarely in the middle of a tech evolution that will increasingly digitize our lives. While the stock has done nothing but move up since I started putting together this analysis, reducing the level of undervaluation, I see this as one of the cheapest tech plays left. With a safe yield that’s more than twice as high as the market, big dividend growth, almost two decades of dividend raises, and the potential that shares are 8% undervalued, this could be one of the best technology investments available to dividend growth investors in this market.

-Jason Fieber

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 DLR’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 94. 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, DLR’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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