March 16, 2020 has now become known as Black Monday II.
Precipitated by the fear of an oncoming pandemic, the S&P 500 suffered a 12.93% drop that day.
That’s one of its largest single-day drops ever – and it came after a series of other very large daily drops.
Here we are a year later, and we can now see that things weren’t nearly as bad as forecasted.
Yet there are a number of stocks out there still feeling the sting from last March.
Even where certain businesses have mostly recovered, their shares have not.
This is the kind of opportunity I’ve repeatedly taken advantage of on my way to building out my FIRE Fund.
That’s my personal six-figure dividend growth stock portfolio.
It produces enough five-figure passive dividend income for me to live off of.
In fact, this portfolio and the dividend income it produces allowed me to retire in my early 30s.
My Early Retirement Blueprint describes exactly how I was able to retire so early in life.
The investment strategy I used was critical to my success.
It involves buying and holding shares in world-class enterprises that pay reliable, rising cash dividends.
Hundreds of examples of these stocks can be found on the Dividend Champions, Contenders, and Challengers list.
This strategy is so great because it compels you to stick to investing in truly great businesses, as evidenced by their growing cash dividends.
And those growing cash dividends can serve as the passive income lifeblood of an early retirement.
But dividend growth investing is more than just picking the right stocks.
There’s also valuation to contend with.
Price is what you pay, but value is 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.
Taking advantage of a disconnect between business performance and stock performance by buying high-quality dividend growth stocks when they’re undervalued can put you on the fast track to financial freedom.
The good news is, estimating a stock’s intrinsic value is a pretty straightforward process.
Fellow contributor Dave Van Knapp has made that process even easier by way of Lesson 11: Valuation.
Part of an overarching series of “lessons” on dividend growth investing, it lays out a simple valuation template that you can apply to most dividend growth stocks.
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…
Realty Income Corp. (O) is a real estate investment trust that leases freestanding, single tenant, triple-net-leased retail properties.
Founded in 1969, it’s now a $22 billion (by market cap) real estate giant that employs more than 200 people.
Their portfolio of over 6,500 properties spreads out across 49 US states, Puerto Rico, and the United Kingdom. They have approximately 600 clients operating across more than 50 industries.
While the S&P 500 has been making new all-time highs, this stock has been languishing as if it’s permanently and deeply scarred by the pandemic.
I think some investors see that it’s a retail real estate company and immediately run for the hills.
But that’s where there’s an opportunity for more enterprising investors who know how to look beyond a stock name and actually delve into real business numbers.
Realty Income ended FY 2019 with 98.6% portfolio occupancy. The company ended FY 2020 with 97.9% portfolio occupancy.
Sure, 98.6% is better than 97.9%.
But let’s be clear.
This business has most certainly not fallen off a cliff in the manner that its stock performance would have you believe.
While the stock is still well below its pre-pandemic price of over $80/share, it’s easy to see why the business has actually held up pretty well.
They own quality properties in great locations, and they sign well-capitalized tenants to long-term triple-net-lease contracts.
These tenants are often some of the biggest and best businesses in the world – and many of these businesses have been barely affected by the pandemic.
Some of Realty Income’s top tenants include Home Depot Inc. (HD) and FedEx Corporation (FDX).
A pandemic doesn’t mean these tenants suddenly go bust. Nor do leases suddenly become null and void.
Owning Realty Income’s stock has always given you the chance to effectively act as a “landlord” and collect “rent checks” without doing any of the associated hard work.
But the pandemic has proven out the value of their large, diversified portfolio of commercial properties. Compare that to many mom-and-pop rental property landlords who have been hurt by non-payments.
Realty Income’s dividend was reliably paid – and increased – straight through the crisis.
By the way, Realty Income sends shareholders monthly dividends – just as if you owned these properties directly and were collecting rent every month.
The company prides itself on this fact so much that it has branded itself The Monthly Dividend Company®.
Realty Income’s diversified portfolio and strong tenant mix serves them and their shareholders well.
And it should allow them to continue paying out their large, growing, monthly dividend.
Dividend Growth, Growth Rate, Payout Ratio and Yield
That monthly dividend has now grown for 28 consecutive years, which dates back to their initial IPO.
The 10-year dividend growth rate is 4.9%.
That’s an impressive level of growth when paired with the stock’s current yield of 4.58%.
This yield, by the way, is almost 40 basis points higher than its own five-year average.
The payout ratio is 85.0%.
Their payout ratio might look high at first glance, but REITs typically operate with high payout ratios. A REIT is legally obligated to return at least 90% of taxable income to shareholders in the form of dividends.
This is a large, monthly dividend growing at a mid-single-digit rate, and it’s been one of the surest dividends right through the crisis.
A lot to like about that.
Revenue and Earnings Growth
However, these dividend metrics are looking at what’s already transpired.
Investors are risking today’s capital for tomorrow’s dividends and returns.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will later help us to estimate intrinsic value for the stock.
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’ll compare those results to a near-term professional prognostication for profit growth.
Blending the proven past with a future forecast like this should tell us quite a bit about what the company’s growth path looks like.
Realty Income grew its revenue from $421 million in FY 2011 to $1.652 billion in FY 2020.
That’s a compound annual growth rate of 16.40%.
But we have to remember that REITs like this one typically fund growth by issuing equity and debt. That’s because they’re returning most of their cash flow to shareholders.
As such, it’s particularly important to look at a REIT’s profit growth on a per-share basis, rather than in absolute terms.
And when looking at per-share growth for a REIT, you want to look at funds from operations instead of normal earnings.
This is a measure of cash generated by a REIT, which adds depreciation and amortization expenses back to earnings.
The company increased its FFO/share from $1.98 to $3.31 over this 10-year period, which is a CAGR of 5.88%.
That’s a more accurate look at the true growth profile of Realty Income, which is still very solid.
Looking forward, CFRA currently has no near-term FFO/share growth forecast for Realty Income.
The last time I looked at CFRA’s growth forecast for Realty Income, which was back in May 2020, they were forecasting 5% FFO/share growth for the REIT over the next three years.
I don’t see any deterioration in Realty Income’s business model since May 2020. If anything, things look much better and more certain in March 2021 than they did in May 2020. We have a bright light at the end of this tunnel, and that light is getting closer.
In the end, I view a 5% three-year FFO/share growth forecast as reasonable. And that’s what I’ll continue to work off of.
This level of growth would be a drop from what the company has produced over the last decade, but the pandemic won’t leave them completely unscathed. Modeling in a slight drop in growth over the near term strikes me as prudent.
I will highlight a portion of CFRA’s note on Realty Income that I think is useful: “We see robust demand continuing for freestanding retail space, driven by a favorable supply/demand environment. While the Covid19 pandemic has certainly affected O, we forecast the company will fare relatively better than peers given its top tenants are concentrated in industries deemed essential – such as convenience, drug, and grocery stores.”
A 5% near-term FFO/share growth rate would imply a similar dividend growth rate, which would basically translate to a continuation of the long-term status quo. And I like that.
Moving over to the balance sheet, Realty Income sports a strong financial position.
They have $9.7 billion in liabilities against $20.7 billion in assets.
Their credit ratings are well into investment-grade territory: A3, Moody’s; A-, S&P Global.
Furthermore, many of the company’s top tenants have excellent financial positions of their own.
Realty Income is perfect for an investor who wants exposure to real estate but doesn’t want to do the hard work.
You get that monthly “rent check” without having to worry about scouting properties, securing loans, finding tenants, managing properties, and arranging for maintenance and repairs.
Buying a stock is a lot easier than buying properties, especially on the commercial side. Then you can just sit back and collect a monthly dividend check that’s growing.
And while competitive advantages are difficult to secure in real estate, I believe the company’s deep expertise, long-term contracts, and massive scale do give it competitive advantages.
Of course, there are risks to consider.
Litigation, regulation, and competition are omnipresent risks in every industry.
The long-term effects from the pandemic are still unknown, although the company’s financials have held up remarkably well.
Real estate is cyclical. Demand for its properties and the health of its tenants can oscillate.
As a REIT, its capital structure relies on external funding for growth. This exposes the company to volatile capital markets and interest rates.
Higher interest rates are a risk. Debt becomes more expensive. And the stock can look less appealing in comparison.
Any kind of recession would hurt the REIT twice over. There’s the reduction in demand for real estate. And equity issuances after a drop in the stock price would come at a higher cost.
Their diversification is working to their benefit, but large-scale changes in physical retail could hamper long-term growth.
With these risks out in the open, I still believe this business can make for an excellent long-term investment.
That belief is partly predicated on the fact that it’s been an excellent long-term investment.
The stock has provided a compound annual rate of return of 15.3% between its 1994 IPO and the end of 2020.
But with the stock down about 20% over the last year, I think it’s attractively valued here…
Stock Price Valuation
Shares trade hands for a P/FFO ratio of 18.12.
This would be comparable to a P/E ratio on a normal stock.
Compared to the broader market, this is a relatively low multiple.
But I think it’s even better than it looks. That’s because FFO is being slightly depressed by the pandemic.
There’s also the cash flow multiple to look at.
The P/CF ratio of 19.0 is lower than the stock’s own three-year average P/CF ratio of 19.5.
And the yield, as noted earlier, is measurably 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 9% discount rate and a long-term dividend growth rate of 4.5%.
This DGR is lower than both the company’s demonstrated long-term dividend growth rate and long-term FFO/share growth.
It’s also lower than the 5% near-term FFO/share growth forecast I referenced earlier.
I view this as a pretty cautious expectation. And I fully believe that Realty Income can at least meet this expectation. It wouldn’t surprise me at all to see them exceed it.
The DDM analysis gives me a fair value of $65.25.
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 cautious 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 O as a 3-star stock, with a fair value estimate of $66.00.
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 O as a 4-star “BUY”, with a 12-month target price of $66.00.
We have an extremely tight consensus here. Averaging the three numbers out gives us a final valuation of $65.75, which would indicate the stock is possibly 7% undervalued.
Bottom line: Realty Income Corp. (O) is a high-quality real estate investment trust that offers shareholders the opportunity to garner instant scale in commercial real estate. This stock pays out a monthly “rent check” dividend while the shareholder “landlords” do none of the hard work. With a market-smashing 4.6% yield, more than 25 consecutive years of dividend increases, inflation-beating dividend growth, a reliable monthly dividend, and the potential that shares are 7% undervalued, this stock should absolutely be on your radar if you’re looking for a safe, large, monthly dividend.
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 O’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 70. 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, O’s dividend appears Safe with an unlikely 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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