The US economy is on the mend and headed toward a full recovery.

Although we’re not there yet, that’s clearly where things are going.

However, that clarity and confidence has pushed many stocks toward all-time highs.

That means some stocks have already gone beyond a 100% recovery, even while the economy is not yet at 100% itself.

In this situation, it might make sense to look at stocks that haven’t fully recovered their pre-pandemic highs.

Simply put, it could be a lot more sensible to focus on unloved stocks.

Especially unloved dividend growth stocks.

These are stocks that pay reliable, rising dividends.

Those reliable, rising dividends are funded by reliable, rising profits.

You can find hundreds of examples of these stocks by taking a look at the Dividend Champions, Contenders, and Challengers list.

Jason Fieber's Dividend Growth PortfolioThese stocks pay you to be patient.

While you wait for the love to show up and the stocks to fully recover, you’re paid growing dividend income.

I’ve personally invested in high-quality dividend growth stocks, building my FIRE Fund in the process.

That’s my real-money dividend growth stock portfolio.

And it produces 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 reveal in my Early Retirement Blueprint how that was accomplished.

As great as high-quality dividend growth stocks can be, getting a good deal on the unloved ones supercharges their long-term potential.

Price is only 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. 

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.

Scouring the market for unloved high-quality dividend growth stocks can reward you with exceptional investment results over the long run.

Fortunately, finding this lack of love through a process of valuation isn’t that difficult.

Fellow contributor Dave Van Knapp has made that process much easier with Lesson 11: Valuation.

Part of a large, comprehensive series of “lessons” on dividend growth investing, it offers a valuation guide that can be applied to just about any dividend growth stock.

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…

Sempra Energy (SRE)

Sempra Energy (SRE) is a natural gas and electric utility holding company that serves 36 million customers across parts of Southern California, Texas, and Mexico.

Founded in 1998 through a merger, but with a corporate history dating back to the 1800s, Sempra Energy is now a $41 billion (by market cap) utility giant that employs almost 20,000 people.

The company operates across five segments: SDG&E, 47% of FY 2020 revenue; SoCalGas, 41%; Sempra Mexico, 10%; Sempra LNG, 2%: and Sempra Texas Utilities, 0%.

The bulk of the company’s operations involve providing natural gas and electricity to residents throughout Southern California.

A utility such as this has a very straightforward investment thesis.

Our modern-day society cannot function without the power that utility companies deliver.

They have captive customers who require their services.

Life as we know it would cease to exist without the likes of Sempra Energy, which makes their business model both ubiquitous and necessary in their markets.

This ubiquity and necessity is what drives reliable, rising profits and reliable, rising dividends.

Dividend Growth, Growth Rate, Payout Ratio and Yield

Sempra Energy has already increased its dividend for 18 consecutive years.

The 10-year dividend growth rate is 10.2%, which is actually rather outstanding for a utility business.

Most utility businesses I’ve seen are growing their dividends in a mid-single-digit range.

That said, there has been a slowing of late – the most recent dividend increase came in at under 6%.

Nonetheless, the stock yields 3.25%, which gives you a market-beating yield to go along with that dividend growth.

This yield, by the way, is 25 basis points higher than the stock’s own five-year average yield.

And the dividend looks safe, with a moderate payout ratio of 56.4% (based on midpoint guidance for this year’s adjusted EPS).

I like to see dividend growth stocks in what I call 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

While these dividend metrics are very good, they’re looking at what was.

Investors care more about what will be, as they’re risking today’s capital for tomorrow’s rewards.

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.

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

Blending the proven past with a future forecast in this manner should allow us to develop an educated opinion on where the business is going.

Sempra Energy increased its revenue from $10.036 billion in FY 2011 to $11.370 billion in FY 2020.

That’s a compound annual growth rate of 1.40%.

Not particularly inspiring. But also not terribly surprising for a large utility business.

Meanwhile, earnings per share grew from $5.51 to $8.03 (adjusted) over this time period, which is a CAGR of 4.27%.

That kind of EPS growth is right about what I’d expect from the likes of Sempra Energy, if a bit light.

Notably, I did use adjusted EPS for the most recent fiscal year – the business recognized a large gain on its South American businesses in 2020 that isn’t indicative of ongoing earnings power.

If we were to use GAAP EPS for FY 2020, the 10-year EPS CAGR would improve significantly. But I don’t think that’d be accurate.

Looking forward, CFRA forecasts that Sempra Energy will compound its EPS at an annual rate of 5% over the next three years.

I see this as a reasonable forecast.

This is basically right in line with what kind of bottom-line growth the business has produced over the last decade. And I don’t see anything that would meaningfully change that dynamic.

CFRA believes that Sempra Energy will benefit from an increase in both customers and rates.

There’s also the company’s Cameron LNG export facility. It should reach full capacity by the end of 2021. This could bolster the company’s near-term prospects.

On the other hand, the exit of the South American businesses further concentrates them on their local markets, and this will weigh on near-term results.

CFRA’s growth forecast would permit Sempra Energy to increase its dividend at a similar or better rate. The latter could actually be more likely.

Sempra Energy has been slowly expanding its payout ratio over the last decade (which is why you see the long-term DGR exceeding the 10-year EPS CAGR). They can continue to do to this, and may very well continue to do it, as many utilities operate with a much higher payout ratio.

Financial Position

Moving over to the balance sheet, the company has a good financial position.

The long-term debt/equity ratio is 0.93, while the interest coverage ratio is over 2.

These numbers are not out of line with what you’d typically see from a large utility business.

Profitability is impressive in comparison to many other utilities.

Over the last five years, the firm has averaged annual net margin of 15.08% and annual return on equity of 10.66%.

This is a pretty straightforward investment.

It’s primarily a Southern California utility business, which comes with all of the good and bad associated with something like that.

With economies of scale, a geographic monopoly, and a unique regulatory structure that practically guarantees a profit, the company does benefit from durable competitive advantages.

Of course, there are risks to consider.

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

Utilities don’t necessarily have “competition” in the traditional sense.

However, their market’s abundant sunshine could lead to customers adopting more power generation at the source, becoming competitors in the future.

Moreover, regulation in their main market is heightened, arguably to the point of being oppressive and counterproductive. This could be their largest risk.

Their main market also has climate concerns (such as regular wildfires) that pose large risks.

And California has political risk. A continued push toward greener energy initiatives introduces a near-term growth driver at the cost of long-term uncertainty.

Overall, this is a premium utility business with a higher growth rate than a lot of other utilities out there.

Yet the valuation doesn’t seem to be all that premium – the stock is still well below its pre-pandemic highs of over $160/share…

Stock Price Valuation

The stock’s P/E ratio (using midpoint EPS guidance for this year) is 17.37.

That’s discounted relative to a lot of other quality utility stocks.

It’s much lower than the broader market’s earnings multiple.

It’s also well off of the stock’s own five-year average P/E ratio of 36.4.

And the stock’s yield, as noted earlier, is 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%.

This DGR isn’t terribly high. But it is higher than what I normally ascribe to utility stocks.

That’s because Sempra has typically grown faster than a lot of other utility businesses, benefiting from higher rates and better profitability.

Also, their payout ratio is fairly low by utility standards, leaving them some room for further expansion.

I basically split the difference here between their demonstrated 10-year DGR and 10-year EPS growth rate, which I think is a reasonable compromise.

The DDM analysis gives me a fair value of $156.93.

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.

I don’t think my analysis was aggressive, yet 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 SRE as a 3-star stock, with a fair value estimate of $132.00.

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 SRE as a 4-star “BUY”, with a 12-month target price of $158.00.

I came out just below where CFRA is at. Averaging the three numbers out gives us a final valuation of $148.98, which would indicate the stock is possibly 10% undervalued.

Bottom line: Sempra Energy (SRE) is a high-quality utility business benefiting from built-in demand for its necessary services. With a market-beating dividend, double-digit long-term dividend growth, a moderate payout ratio, almost 20 straight years of dividend increases, and the potential that shares are 10% undervalued, this is a compelling long-term idea that should be on any dividend growth investor’s list.

-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 SRE’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 79. 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, SRE’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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