US stocks are headed higher over the long run.
How do I know?
The Dow Jones Industrial Average was around 200 points back in 1950.
It’s now coming up on 34,000 points.
The US stock market compounds at an annual rate of nearly 10% over the long term.
It’s almost relentless.
Now, that’s an average – some years are exceptional, while others are poor.
But too much focus on near-term volatility can cause you to miss the forest for the trees.
What’s even more impressive is that some stocks can actually outpace this long-term average.
High-quality dividend growth stocks are such a group.
These stocks represent equity in world-class enterprises that produce reliable, rising profits from providing the world with the products and/or services it demands.
Reliable, rising profits turn into reliable, rising dividends.
You can see that relationship by taking a look at the Dividend Champions, Contenders, and Challengers list.
These are some of the best businesses in the world.
So if the aggregate of all businesses average 10% annually, just imagine what above-average businesses can do.
That’s why I built my FIRE Fund with high-quality dividend growth stocks.
This real-money portfolio produces enough five-figure passive dividend income for me to live off of.
Indeed, this portfolio allowed me to retire in my early 30s.
And my Early Retirement Blueprint shares exactly how I was able to do that.
As great as dividend growth stocks are, valuation is always incredibly important.
Price tells you only what you pay. But 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.
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 dividend growth stocks when they’re undervalued can offer you the chance to outpace the broader market and exponentially grow your wealth and passive income.
The good news is, estimating a stock’s intrinsic value isn’t as difficult as it might seem.
Fellow contributor Dave Van Knapp has made that process much easier after introducing Lesson 11: Valuation.
One of his many instructional “lessons” on the dividend growth investing strategy, it specifically lays out a valuation template that you can apply 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…
Allstate Corp. (ALL)
Allstate Corp. (ALL) is an insurance company that operates as one of the largest property-casualty insurers in the United States.
Founded in 1931, Allstate is now a $38 billion (by market cap) insurance titan that employs more than 42,000 people.
Allstate primarily sells auto and homeowners insurance.
Property-casualty net underwriting premiums accounted for the vast majority of the company’s FY 2020 revenue. Of these premiums, they can be broken down into the following lines: auto insurance, 70%; homeowners, 23%; other personal lines, 5%; and commercial, 2%.
After the announcement that the company will be selling off its Allstate Life Insurance Company in 2021, their primary focus moving forward will be in property-casualty insurance.
Insurance has long been one of my very favorite business models.
It’s the very definition of making money from OPM (“other people’s money”).
Since most people can’t afford to cover catastrophic loss, they buy insurance to mitigate risk. You have built-in demand for something that almost sells itself.
An insurance company collects premiums upfront for shouldering that risk.
These premiums turn into a “float” and can earn significant returns during the time delay between premium collection and claim payout. This float is built entirely upon OPM.
Allstate’s investment portfolio is worth near $100 billion and produced net investment income of nearly $3 billion during 2020.
Moreover, if an insurance company properly prices risk, the underwriting business itself can be very profitable.
So they’re producing profit from the core business model of providing insurance, and then producing more profit from the money it collects by doing so.
This one-two punch is formidable.
It’s also a great recipe for growing profits and dividends.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Allstate has increased its dividend for 11 consecutive years.
The 10-year dividend growth rate is 10.2%, which is solid in and of itself.
But it gets better.
There’s been a marked acceleration in dividend growth of late; their most recent dividend increase, announced in February, came in at 50%!
This growth comes on top of the stock’s market-beating yield of 2.53%.
That yield, by the way, is more than 70 basis points higher than the stock’s own five-year average yield.
And the low payout ratio of 30.5% easily covers the dividend.
I like dividend growth stocks in the “sweet spot” – a yield of between 2.5% and 3.5%, paired with a high-single-digit (or better) dividend growth rate.
This stock is right there.
Revenue and Earnings Growth
As great as these dividend metrics are, though, they’re looking at the rearview mirror.
Investors are risking today’s capital for tomorrow’s returns.
It’s the future growth we care most about.
As such, I’ll now build out a forward-looking growth trajectory for the business, which will later help us to 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.
Then I’ll compare that to a near-term professional prognostication for profit growth.
Melding the proven past with a future forecast like this should allow us to come to reasonably approximate their growth path moving forward.
Allstate grew its revenue from $32.654 billion in FY 2011 to $44.791 billion in FY 2020.
That’s a compound annual growth rate of 3.57%.
I usually look for a mid-single-digit top-line growth rate from a fairly mature business like this.
Meanwhile, earnings per share moved from $1.50 to $14.73 (adjusted) over this period, which is a CAGR of 28.89%.
I used the lower (and more appropriate) adjusted EPS for FY 2020. Even then, it’s still outstanding.
The first few years of the last decade were great, but the business really started to take off over the last 2-3 years.
Recent quarters have been particularly impressive across the board.
However, an insurance business can see peaks and valleys simply from the variability of catastrophes and the resulting claims. So how an insurance company looks can depend on when you look at it. On the other hand, the float smooths some of that out.
A combination of margin expansion and buybacks also greatly aided their cause and helped to create a lot of excess bottom-line growth.
The outstanding share count is down by almost 40% over the last decade, which is one of the most substantial 10-year reductions I’ve come across.
Looking forward, CFRA is forecasting a 7% CAGR for Allstate’s EPS over the next three years.
That would be a serious drop in growth when compared to the last decade.
But I don’t think it’s unfair.
The last few years have been extraordinary across the board, and I’m not sure how the business can sustain that.
Furthermore, Allstate is working through a GAAP loss from the unloading of Allstate Life Insurance Company. Their near-term GAAP numbers will be lumpy from the unloading of this non-core business.
There’s also the float itself, which could see a performance drag if/when capital markets become less favorable.
That said, Allstate runs a very tight ship. Their property-casualty combined ratio was only 83.3% for Q1 2021.
Even if this lowly 7% EPS growth rate were to materialize over the next few years, by virtue of their low payout ratio, Allstate could still afford to hand out generous low-double-digit dividend raises for the foreseeable future.
Moving over to the balance sheet, the company maintains a rock-solid financial position.
Insurance companies operate conservatively by nature, so this isn’t a surprise.
The long-term debt/equity ratio is 0.26, while the interest coverage ratio is over 22.
These numbers are actually better than they look, as there’s a lot of treasury stock from those big buybacks reducing common equity.
Profitability has been improving recently and is quite robust.
Over the last five years, the firm has averaged annual net margin of 7.34% and annual return on equity of 14.01%.
Again, profitability would look even better without all of that treasury stock.
There really is a lot to like about Allstate if you’re interested in adding an insurance operation to your portfolio.
And they do benefit from durable competitive advantages that include economies of scale, brand recognition, and the float.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
The very business model introduces exposure to natural catastrophes.
Although insurance isn’t cyclical in terms of demand, there’s cyclical economic risk through the investment portfolio.
And interest rates are still low, limiting the returns on the investment portfolio.
With these risks known, I still believe Allstate can be a fantastic long-term investment for dividend growth investors.
That’s especially true with the stock’s valuation being attractive in an otherwise unattractive stock market…
Stock Price Valuation
The stock’s P/E ratio is 11.98.
If we were to factor out the one-time Q1 GAAP loss related to the non-core divestiture, the P/E ratio (using adjusted TTM EPS) is below 6.
Either way, this is considerably lower than the broader market’s earnings multiple.
Both ratios are also off of the stock’s own five-year average P/E ratio of 12.5.
The P/B ratio, at 1.4, is below its five-year average of 1.5.
And the yield, as noted earlier, is significantly 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 8%.
An 8% DGR is at the upper end of what I typically allow for, but Allstate gets the benefit of the doubt.
This DGR is well below the company’s EPS and dividend growth over the last decade.
It’s also not far off from CFRA’s near-term EPS growth forecast for the business.
With the payout ratio being so low, and recent dividend growth actually accelerating, I see this as a very reasonable dividend growth expectation.
The DDM analysis gives me a fair value of $174.96.
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.
This stock looks cheap from where I’m standing.
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 ALL as a 3-star stock, with a fair value estimate of $103.00.
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 ALL as a 5-star “STRONG BUY”, with a 12-month target price of $140.00.
My number is high, but I’d also argue that Morningstar’s number is too low. Averaging the three numbers out gives us a final valuation of $139.32, which would indicate the stock is possibly 9% undervalued.
Bottom line: Allstate Corp. (ALL) is a high-quality property-casualty insurance company with excellent fundamentals and accelerating growth. With a market-beating dividend, double-digit dividend growth, a low payout ratio, more than 10 consecutive years of dividend raises, and the potential that shares are 9% undervalued, this is a stock that should be on every dividend growth investor’s radar.
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 ALL’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 80. 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, ALL’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
This article first appeared on Dividends & Income
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