I began investing in early 2010.
And right from the start, I’ve heard people complain about the US stock market being “too expensive”.
Yet here we near all-time highs, with the S&P 500 more than three times higher than it was in early 2010.
Many people have lost out on a lot of money by sitting on the sidelines.
I would advise you to avoid that same mistake by focusing on the long term.
Moreover, and more to the point, I’d advise to stop worrying about the broader market and get busy looking at individual stocks.
Every stock represents equity in a real business.
Some are doing better than others.
And some offer better opportunities than others.
In my view, and in my experience, the best long-term opportunities are high-quality dividend growth stocks.
These are stocks that have increased their dividends each year for at least the last five consecutive years.
You can find hundreds of examples of these stocks on the Dividend Champions, Contenders, and Challengers list.
The reason these stocks are often fantastic as long-term investments is because they’re often such fantastic businesses.
And their fantastic nature is borne out through these lengthy track records of growing dividends.
After all, it would be nigh impossible for a business to be lousy while simultaneously paying out ever-larger cash dividends to shareholders.
Lousy businesses are too busy just trying to make a profit and stay in business to do that.
This is a big reason why I’ve invested in high-quality dividend growth stocks myself, building out my FIRE Fund in the process.
That’s my real-money dividend growth stock portfolio.
It produces the five-figure passive dividend income I live off of.
Indeed, investing in these stocks and living off of dividends allowed me to retire in my early 30s.
I lay out exactly how I accomplished that in my Early Retirement Blueprint.
As great as these stocks can be, though, undervaluation can catapult them into truly spectacular long-term investments.
Price is only what you pay for a stock. But 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.
Buying high-quality dividend growth stocks when they’re undervalued leaves you with almost no chance to do anything but build significant wealth and growing passive income over the long run.
Finding undervalued stocks might seem easier said than done, but that’s actually not true.
Fellow contributor Dave Van Knapp put together Lesson 11: Valuation as an excellent valuation guide that can help you to estimate the value of just about any dividend growth stock out there.
Armed with that guide, finding undervaluation isn’t difficult at all.
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…
Edison International (EIX)
Edison International (EIX) is a utility holding company for Southern California Edison, an electric utility business that provides electricity to 5 million customers across Southern, Central, and Coastal California.
Founded in 1886, Edison International is now a $21 billion (by market cap) utility giant that employs more than 13,000 people.
SCE is their main operating segment.
Investing in a utility business such as Edison International is always a pretty straightforward affair with a simple investment thesis.
The thesis is that modern-day society cannot function without reliable access to power.
We basically can’t live without electricity. There is a captive consumer base in place because of this.
Thus, utility companies that can meet this inherent and unflinching demand for power tend to prosper.
And since there is often only one major utility provider in any single geographic area, these businesses further benefit from their monopolistic characteristics.
All of this is true for Edison International, giving their business model a powerful one-two punch.
And this bodes well for their ability to continue increasing their profit and their dividend over the long run.
Dividend Growth, Growth Rate, Payout Ratio and Yield
As it stands, they’ve increased their dividend for 18 consecutive years.
Their 10-year dividend growth rate of 7.3% is uncommonly high for a utility business, which is impressive.
However, more recent dividend raises have been in the 4%-5% range.
Still, that’s plenty of dividend growth when you pair that with the stock’s current yield of 4.67%.
That yield is more than three times higher than what the broader market offers.
It’s also more than 100 basis points higher than the stock’s own five-year average yield.
And with a payout ratio of 57.0% (based on core EPS), the dividend is easily manageable.
This is a rather compelling combination of yield and growth – especially in this yield-starved, low-rate environment.
Revenue and Earnings Growth
As great as these dividend metrics might be, they’re largely looking at what’s already transpired.
Investors risk today’s capital for tomorrow’s returns.
It’s those future dividends and dividend raises that we care most about.
Thus, 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 reveal the company’s 10-year top-line and bottom-line growth.
Then I’ll compare that to a near-term professional prognostication for profit growth.
Blending the proven past with a future forecast like this should give us enough information to come to a reasonable conclusion regarding where the business is likely to go from here.
Edison International grew its revenue from $12.760 billion in FY 2011 to $13.578 billion in FY 2020.
That’s a compound annual growth rate of 0.69%.
It’s nothing awe-inspiring. But it’s also not out of line for a mature Southern California utility.
Earnings per share advanced from $3.22 to $4.52 over this period, which is a CAGR of 3.84%.
Notably, I used the company’s core EPS. This is a non-GAAP number that factors out discrete items which give a more meaningful look into earnings power.
This growth is neither excellent nor poor for a utility business, in my view.
I’d expect annual EPS growth to be in the range of around 4% from a utility business such as this, and they’re pretty close to that.
Looking forward, CFRA does not provide an EPS growth forecast for Edison International.
However, CFRA does note that it projects “revenue growth of 4.3% in 2021 and 3.6% in 2022”. They see the company benefiting from “customer growth and higher rates and higher commercial and industrial volumes”.
That kind of top-line growth would be a significant bump up from what Edison International has produced over the last decade.
And it would lay the foundation for similar, if not better, EPS growth.
With that kind of EPS growth likely to materialize, Edison International should be capable of generating mid-single-digit dividend growth for the foreseeable future and beyond.
Financial Position
Moving over to the balance sheet, their financial position is slightly weaker than I’d like to see for a mature utility business like this.
The long-term debt/equity ratio is 1.40, while the interest coverage ratio is a bit under 2.
Profitability could also be improved somewhat, although FY 2018’s GAAP loss unfavorably skews the averages.
Over the last five years, the firm has averaged annual net margin of 5.48% and annual return on equity of 5.49%.
Again, this is a straightforward investment.
There’s nothing complicated about the idea of investing in a utility.
This company won’t knock you dead with growth, but it’s typically been a great income producer that has a solid growth kicker attached to it.
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, regulation, and competition are omnipresent risks in every industry.
While a utility doesn’t usually have “competition” in the traditional sense, there’s always a risk that its customers become competitors in the future through more power generation at the point of consumption.
And their main market has a heightened amount of regulation that can unnecessarily weigh on the business.
There’s substantial wildfire risk here. California’s AB 1054 legislation provides some prudent financial management as it pertains to smoothing out the burdens of an outsized one-time event, but there are ongoing costs to this protection.
California also introduces political risk. A continued push toward greener energy initiatives introduces a near-term growth driver at the cost of long-term uncertainty.
Overall, I see this as a solid utility that’s made to be more attractive by virtue of its low valuation…
Stock Price Valuation
The stock’s P/E ratio is only 12.21.
Now, that’s based on core EPS.
Still, that’s about half of where the broader market is at on a GAAP basis.
We can also look at cash flow for more clarity.
The P/CF ratio of 21.0 is well below the stock’s own five-year average of 28.2.
And the yield, as noted earlier, is materially 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 (due to the elevated yield) and a long-term dividend growth rate of 4.5%.
This DGR is on the lower end of what I usually allow for when looking at a utility.
However, I think this is a realistic take on the business.
Recent dividend raises have been in this range. The long-term EPS growth rate is around 4%. And based on CFRA’s near-term revenue growth projections, EPS should continue to grow in the mid-single-digit range.
With the payout ratio being moderate, I see this as a reasonable expectation for future dividend growth.
The DDM analysis gives me a fair value of $61.54.
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 view my valuation as aggressive at all, 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 EIX as a 4-star stock, with a fair value estimate of $70.00.
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 EIX as a 3-star “HOLD”, with a 12-month target price of $63.00.
I came out on the low end. Averaging the three numbers out gives us a final valuation of $64.85, which would indicate the stock is possibly 14% undervalued.
Bottom line: Edison International (EIX) is an easy-to-understand utility business offering a necessary service to millions of captive customers. With a market-smashing 4.7% yield, nearly 20 consecutive years of dividend raises, a moderate payout ratio, inflation-beating growth, and the potential that shares are 14% undervalued, this is an under-the-radar stock for dividend growth investors to take a serious look at.
-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 EIX’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 60. 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, EIX’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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