The US stock market has come roaring back from its March lows.
And many stocks are now sitting at all-time highs.
However, a stock can be sitting at an all-time high and still be cheap.
An investor has to compare the price to intrinsic value.
And if the former is below the latter, you might have a good deal on your hands – even after a big recovery.
This level-headed approach helped me to build out my FIRE Fund.
That’s my real-money stock portfolio.
It generates enough five-figure passive dividend income for me to live off of.
In fact, this portfolio allowed me to retire in my early 30s.
I lay out in my Early Retirement Blueprint exactly how that transpired.
Suffice to say, it involved a lot of saving and investing.
But not just any kind of investing.
This investment strategy advocates buying and holding shares in world-class enterprises that pay reliable, rising dividends.
The Dividend Champions, Contenders, and Challengers list has invaluable data on hundreds of US-listed dividend growth stocks.
However, even a great investment strategy still requires a certain thoughtfulness about valuation.
While price is what you pay, it’s value that you actually get.
An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.
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.
Sticking to high-quality businesses while remaining thoughtful about valuation should lead to fantastic long-term investment results.
And this thoughtfulness isn’t that difficult to muster.
Fellow contributor Dave Van Knapp’s Lesson 11: Valuation has made the valuation process much easier.
Part of a larger series of “lessons” on dividend growth investing, this lesson describes a simple series of steps that one can follow to estimate intrinsic value.
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…
Fifth Third Bancorp (FITB) is a diversified regional bank holding company that offers a range of financial services and products, such as deposits, lending, transaction processing, and advisory solutions.
Founded in 1858, Fifth Third Bancorp is now a $23 billion (by market cap) major regional institution that employs almost 20,000 people.
Headquartered in Cincinnati, Ohio, the bank is primarily focused on its core Midwestern market that includes the states of Ohio, Michigan, Illinois, and Indiana.
As of December 31, 2019, they had $169 billion in assets, making them one of the top-20 largest banks in the United States. For perspective on that, there are over 5,000 commercial banks and savings institutions in the US.
The bank operates four main businesses: Commercial Banking, 57% of FY 2019 net income; Branch Banking, 34%; Wealth and Asset Management, 4%; and Consumer Lending, 4%.
There’s no doubt whatsoever that the last few years have been difficult for banks.
Between persistently low interest rates, a long recovery from the Great Recession, and now a global pandemic, banks seemingly can’t win.
Because of their unpopularity, bank stocks were practically ignored by investors. And this pushed down valuations to levels that implied they’d never grow again.
Yet banks are growing. Healthily.
And now bank stocks are popular – Fifth Third’s stock is up almost 60% over the last six months.
However, even after this sudden resurgence, the stock still looks attractive. It was pushed down so far, for so long, that there’s a lot of coiled spring to unwind here.
And while that spring unwinds, investors can look forward to collecting a market-beating dividend that’s growing like clockwork.
Dividend Growth, Growth Rate, Payout Ratio and Yield
The company has already increased its dividend for 10 consecutive years.
Their five-year dividend growth rate is 15.1%, which handily beats any kind of inflation.
That growth comes on top of the stock’s yield of 3.22%.
This yield, by the way, is more than twice as high as what the broader market offers.
It’s also more than 40 basis points higher than the stock’s own five-year average yield.
With a payout ratio of 59%, the dividend is easily covered. That’s after using depressed GAAP EPS.
Once the bank moves past the pandemic, reserves will be released and the payout ratio will drop as a result of rising EPS.
I love dividend growth stocks in the “sweet spot”.
The sweet spot is a yield of between 2.5% and 3.5%, paired with a high-single-digit dividend growth rate.
This stock is clearly right there.
Revenue and Earnings Growth
As great as these dividend metrics are, they’re looking backward.
Investors are risking their capital today for tomorrow’s rewards.
As such, I’ll now put together a forward-looking growth trajectory for the bank, which will later guide us toward an estimate of 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.
Then I will compare that to a near-term professional prognostication of profit growth.
Blending the proven past with this future forecast should give us great insight into where the business will likely go.
Fifth Third has grown its revenue from $6.333 billion in FY 2010 to $7.253 billion in FY 2019.
That’s a compound annual growth rate of 1.52%.
Notably, I’m using FY 2019 as the most recent fiscal year. That’s because the full-year revenue numbers are not yet available for FY 2020.
There have been minor reshufflings and sales of various business units over the last decade, which caused some volatility in top-line results. There was also the acquisition of MB Financial, Inc. for $4.7 billion in 2018.
The overall revenue trend is positive.
Meanwhile, earnings per share increased from $0.63 to $3.33 over this period, which is a CAGR of 20.32%.
What’s incredible about this is that it happened during one of the most difficult periods you could imagine for a bank.
A combination of buybacks and large improvements across the board helped to propel this excess bottom-line growth.
While extremely impressive, this EPS growth rate is a bit misleading. The starting year (FY 2010) had an abnormally low EPS result.
However, even if we look at a more recent five-year stretch, EPS compounded at an annual rate of 13.45% between FY 2015 and FY 2019.
Looking forward, CFRA is anticipating that Fifth Third will compound its EPS at an annual rate of 7% over the next three years.
This would be a deceleration in growth compared to what the bank has historically enjoyed.
On one hand, CFRA is concerned about limited loan growth and a compression in net interest margin. Low interest rates are a weight on banks.
On the other hand, CFRA sees strong corporate banking revenue, higher investment advisory fees, and a recovery in service charges on deposits.
CFRA likes Fifth Third’s improving profitability outlook and diversified product set that generates a lot of fee income.
One unique aspect about this bank, relative to Midwestern competitors, is their deepening exposure to the Southeast. Fifth Third expanded into Florida years ago, which is a market the bank is doubling down on. With Florida being a very popular state to move to, Fifth Third should benefit.
Rates are low. But they have almost nowhere to go but up.
The wildcard here is obviously the pandemic. Without that, CFRA’s forecast looks very conservative. But with so much near-term uncertainty, I like the caution.
Even if this lower EPS growth rate were to manifest itself, the bank could still grow its dividend at a high-single-digit rate. And that’s certainly appealing with the 3%+ starting yield.
Moving over to the balance sheet, the bank has a solid financial position.
They have total assets of $169.4 billion against $143.9 billion in total liabilities.
Credit ratings for their senior debt are as follows: BBB+, S&P; Baa1, Moody’s; and A-, Fitch.
The bank’s profitability is strong.
Over the last five years, the firm has averaged annual net margin of 30.30% and annual return on equity of 11.92%. Net interest margin came in at 3.31% for FY 2019.
There really is a lot to like about this bank as a long-term investment.
Banks are one of the oldest and most attractive business models of all. A large float is a competitive advantage for an entrenched bank that operates at scale. And the “sticky” nature of deposits means this competitive advantage is not easily lost once gained.
Of course, there are risks to consider.
Competition, regulation, and litigation are omnipresent risks in every industry.
Pervasively and persistently low interest rates continue to challenge banks.
Any lingering effects from the pandemic and economic shutdowns could leave a lasting scar on the bank.
If the pandemic were to lead to a more long-term recession, this would hurt the bank in two ways. Less economic activity limits loan and deposit growth, and loan losses harm the balance sheet.
With these risks out in the open, I still feel that this business has excellent long-term prospects.
And while the valuation isn’t as incredible as it was six months ago, the stock still looks at least moderately undervalued here…
Stock Price Valuation
The stock’s P/E ratio is 18.29.
That’s based on FY 2020 GAAP EPS – a number that has been pressured by reserves.
Once we move past the pandemic, GAAP EPS should rebound sharply. And this P/E ratio will shrink in short order.
Even with depressed EPS, this P/E ratio is still lower than the broader market’s earnings multiple.
In addition, the stock’s P/CF ratio, at 7.1, is materially lower than its three-year average of 9.8.
And the yield, as noted earlier, is markedly 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 7%.
In my view, this is a reasonable, if conservative, growth assumption.
This is right in line with CFRA’s near-term EPS growth forecast. It’s also quite a bit lower than the bank’s demonstrated long-term dividend growth rate and EPS growth rate.
With so much uncertainty, I’d rather err on the side of caution.
The DDM analysis gives me a fair value of $38.52.
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 run, the stock still looks undervalued.
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 FITB as a 4-star stock, with a fair value estimate of $35.00.
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 FITB as a 4-star “BUY”, with a 12-month target price of $36.00.
I came out slightly high this time around. Averaging the three numbers out gives us a final valuation of $36.51, which would indicate the stock is possibly 9% undervalued.
Bottom line: Fifth Third Bancorp (FITB) is a quality regional bank that has shown an exceptional ability to grow in a challenging environment. And deepening exposure to one of the fastest-growing areas of the United States gives them a bright future. With a market-beating yield, double-digit dividend growth, a moderate payout ratio, and the potential that shares are 9% undervalued, this dividend growth stock is still on sale.
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 FITB’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 50. 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, FITB’s dividend appears Borderline Safe with a moderate risk of being cut. Learn more about Dividend Safety Scores here.
This article first appeared on Dividends & IncomeWe’re Putting $2,000 / Month into These Stocks
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