The US stock market continues to scream higher.
Investors looking for good deals on quality stocks could become frustrated by this.
But you should keep two things in mind.
First, the US stock market is almost certainly headed higher in the long run, making current prices look cheap in the future.
Second, there are deals in every market.
I’m sure there was a time, many years ago, when the Dow Jones Industrial Average was at 5,000 points, where investors were complaining about expensive stocks.
Yet how much would you love to see stocks so lowly priced now?
But we can’t travel back in time.
So it’s more worthwhile to focus on where businesses are going over the long run.
This is something I’ve always tried to keep in mind as an investor.
This focus helped me to build my FIRE Fund.
That’s my real-money stock portfolio, and it generates the five-figure passive dividend income I live off of.
I built this portfolio using the tenets of dividend growth investing.
That’s an investing strategy that advocates buying and holding shares in world-class enterprises paying reliable, rising dividends.
You can find hundreds of examples by perusing the Dividend Champions, Contenders, and Challengers list.
This strategy is powerful, especially if you’re looking to achieve financial freedom at a young age.
I used this strategy for exactly that purpose – and I retired in my early 30s, as I lay out in my Early Retirement Blueprint.
However, as powerful as this strategy is, it can become much more powerful if you’re prudent about cost.
Price is only 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.
Getting a good deal on a high-quality dividend growth stock can supercharge both your wealth and passive income over the long term.
Fortunately, the process of valuation isn’t as difficult as you might think.
Fellow contributor Dave Van Knapp has made it easier than ever with the introduction of Lesson 11: Valuation.
Part of a more comprehensive series of “lessons” on dividend growth investing, it provides a valuation guide that you can apply to just about 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…
Enbridge Inc. (ENB)
Enbridge Inc. (ENB) is an energy distribution and transportation company that owns and operates crude and natural gas pipelines across the United States and Canada. It also operates a gas utility business. Additionally, the company has considerable exposure to renewable energy through a diversified portfolio of renewable energy projects.
Founded in 1949, Enbridge is now a $78 billion (by market cap) energy powerhouse that employs more than 11,000 people.
The company has five business segments: Energy Services, 47% of FY 2020 revenue; Liquids Pipelines, 27%; Gas Transmission and Midstream, 13%; Gas Distribution, 12%; and Renewable Power Distribution, 2%.
After merging with Spectra Energy Corp. in 2017, Enbridge has become the largest energy infrastructure company in North America. Enbridge operates the world’s longest and most complex crude oil and liquids transportation system.
To give you some perspective, their pipeline network stretches from Norman Wells, Canada to Brownsville, Texas.
They operate over 17,000 miles of active crude pipeline across North America, split almost evenly between the US and Canada.
The company transports 25% of the crude oil produced in North America, and they also transport 20% of all natural gas consumed in the US.
This is a massive and indispensable energy infrastructure company.
In addition to this energy infrastructure, Enbridge is Canada’s largest natural gas utility. The company serves approximately 3.8 million retail customers in Ontario and Quebec.
To cap it all off, they’re working hard to future-proof the business. Enbridge aims to have net zero emissions by 2050.
They’ve committed almost $8 billion to renewable energy and power transmission projects that are currently in operation or under construction. Some of their low-carbon opportunities include renewable natural gas and hydrogen power-to-gas.
While the world is starting to wean itself off of hydrocarbons, our modern-day society currently cannot function without these energy products.
And there’s no immediate future in which that reality is all that different.
Moreover, Enbridge has impressively insulated itself from volatile commodity pricing.
The company estimates that ~98% of its cash flow is predictable through regulated operations, take or pay contracts, or fixed fees.
Put all of this together and it’s not hard to see how Enbridge has managed to consistently keep their profit and dividend flowing and growing.
Dividend Growth, Growth Rate, Payout Ratio and Yield
As it stands, Enbridge has increased its dividend for 25 consecutive years.
If that’s not impressive enough, the 10-year dividend growth rate is 11.3%.
But wait. There’s more.
That rather high dividend growth rate comes on top of the stock’s current yield of 7.27%.
This yield is more than four times higher than the broader market’s yield.
It’s also more than 150 basis points higher than the stock’s own five-year average yield.
It’s not often that you find a yield this high paired with a double-digit dividend growth rate.
Now, I wouldn’t expect that kind of dividend growth to continue indefinitely. But an investor doesn’t need a high growth rate when the yield is over 7%.
Nonetheless, the dividend appears to be safe and in a position to grow in line with the business.
That’s evidenced by the elevated but unhazardous 68.9% payout ratio.
Revenue and Earnings Growth
As impressive as these dividend metrics are, though, they’re looking at what’s already transpired.
It’s future dividends and growth that today’s investors are most interested in.
Investors risk today’s capital for tomorrow’s rewards.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will later help to estimate the stock’s intrinsic value.
I’ll first show you what the company has done in terms of long-term top-line and bottom-line growth.
Then I’ll compare that to a near-term professional prognostication for profit growth.
Amalgamating the proven past with a future forecast in this way should allow us to reasonably extrapolate where the company is going from here.
Enbridge grew its revenue from CAD $19.402 billion in FY 2011 to CAD $39.087 billion in FY 2020.
That’s a compound annual growth rate of 8.09%.
Great revenue growth.
While that vastly exceeds my expectations for a pipeline company, it’s important to keep in mind that much of the top-line growth was fueled by Enbridge’s 2017 acquisition of Spectra Energy.
And since this acquisition fundamentally changed the business, I’ll be showing bottom-line growth from FY 2017 onward.
However, in this case, I won’t be looking at earnings per share. Being an infrastructure business with a large midstream presence, it translates its profits like an MLP would (as distributable cash flow per share) instead of EPS like a normal corporation.
Enbridge’s DCF/share grew from CAD $3.68 in FY 2017 to CAD $4.67 in FY 2020, which is a CAGR of 8.27%.
This is a very strong result, and that’s even after factoring in the turmoil that the pandemic brought to energy markets during 2020.
I think this shows just how resilient the business model is.
Looking forward, CFRA projects that Enbridge will compound its EPS/share at a 15% annual rate over the next three years.
I’m not sure if CFRA is translating the profit reporting from EPS to DCF here, but I do see that as an awfully aggressive near-term profit growth forecast.
With energy under the regulatory microscope, the pandemic still not over, and Enbridge embroiled in a protracted legal battle over its Line 5, 15% annual growth is a high mark to reach.
However, I think shareholders would gladly settle for something more in line with the bottom-line CAGR the company has produced since taking over Spectra in 2017.
For further perspective on this, Enbridge is guiding for CAD $4.85 in DCF/share at the midpoint for FY 2021.
While that shows a safe dividend, it would represent only 3.9% YOY growth in DCF/share.
I tend to err on the side of caution. And I think Enbridge is capable of doing mid-single-digit bottom-line growth over the near term, which would allow for like dividend growth.
In my view, that’s more than acceptable when shareholders are also lapping up a 7%+ yield.
Moving over to the balance sheet, the company is in a good financial position.
The long-term debt/equity ratio is 1.02.
Enbridge has lowered its consolidated debt/EBITDA ratio from approximately 6 in 2016 to within a range of between 4.5 and 5.
Their credit ratings are in investment-grade territory: Standard & Poor’s rates their senior unsecured debt BBB+; Moody’s, Baa2; Fitch, BBB+.
Profitability is difficult to gauge. That’s because of the way profit is translated. GAAP numbers can be misleading or even meaningless.
With that said, over the last five years, the firm has averaged annual net margin of 6.53% and annual return on equity 6.99%.
Within the energy space, this is one of my favorite names. It has the kind of operational resiliency and dividend reliability that I love to see.
And with a pipeline system that has incredible scale and integration, which would be nigh impossible to replicate by a competitor, especially with regulation making it increasingly difficult to build new pipelines, the company does benefit from durable competitive advantages.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
Whereas Enbridge does not have many formidable competitors, regulation and litigation are huge issues in their industry.
Their current dispute with Michigan over their Line 5 is a prime example of that.
In addition, it’s becoming increasingly difficult for companies to get permits to build new pipelines, making the existing infrastructure that much more valuable.
While scale is a key advantage, it also works against them in some ways. There’s less growth potential with a mature business such as this.
Even though the company is largely insulated from volatile commodity pricing, they remain sensitive to energy over the long run via demand and counterparty risk.
There’s long-term business model risk, as society is starting to move away from hydrocarbons. Enbridge has invested in renewables, but the core business model remains based on hydrocarbon consumption.
Their balance sheet is good, but plenty of debt is on the balance sheet. Any increase in costs as it relates to raising capital (via equity or debt) would harm the company’s growth plans.
Overall, I view Enbridge as a great idea for dividend growth investors who are looking for yield and okay with the risks.
This view is amplified by the fact that the stock has not yet recovered its pre-pandemic highs, leading to an attractive valuation…
Stock Price Valuation
The stock is available for a forward P/DCF ratio of 9.49, based on the midpoint guidance for this year.
With this being analogous to P/E ratio on a normal stock, it’s obscenely cheap when compared to the broader market.
However, this is a stock that’s always cheap.
I think the market has taken a prudent approach, considering the risks. And that’s fair.
Looking at it from another angle, the P/CF ratio of 9.7 is not far off from its own five-year average.
On the other hand, the yield, as noted earlier, is substantially 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 an 8% discount rate (to account for the high yield) and a long-term dividend growth rate of 3%.
That DGR looks downright disappointing when you compare it to the 10-year DGR. In addition, the recent per-share cash flow growth has been stellar.
However, again, I’d rather err on the side of caution.
The payout ratio is elevated. And the midpoint guidance for this fiscal year shows less than 4% YOY growth in per-share cash flow.
In addition, the regulatory and legal risks are high.
The DDM analysis gives me a fair value of $56.86.
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 with a conservative take on the valuation, the stock looks very 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 ENB as a 4-star stock, with a fair value estimate of $46.00.
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 ENB as a 4-star “BUY”, with a 12-month target price of $45.00.
I came out high, surprisingly. Averaging the three numbers out gives us a final valuation of $49.29, which would indicate the stock is possibly 30% undervalued.
Bottom line: Enbridge Inc. (ENB) is a world-class infrastructure company. They have little exposure to volatile commodity pricing, and they’ve operated through the pandemic admirably. With a market-smashing 7%+ yield, double-digit dividend growth, 25 consecutive years of dividend raises, and the potential that shares are 30% undervalued, this is a great high-yield opportunity for long-term dividend growth investors willing to accept the risks.
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 ENB’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 57. 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, ENB’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 & Income
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