Did you see that?
If you missed it, you’re too busy paying attention to the entire stock market.
The S&P 500 itself is still cruising along near all-time highs.
However, many individual stocks within the market have already entered correction territory.
With some of these stocks down 10% or more in a matter of only weeks, good deals have presented themselves.
This mindset – seeing it as a market of stocks, not a stock market – has helped me to build my FIRE Fund.
That’s my real-money dividend growth stock portfolio that produces enough five-figure passive dividend income for me to live off of.
Indeed, I was able to retire in my early 30s.
And I lay out in my Early Retirement Blueprint how I accomplished that.
A major aspect of the Blueprint is the investment strategy I used, which is dividend growth investing.
This strategy advocates buying and holding shares in world-class enterprises that pay reliable, rising dividends.
You can find hundreds of examples of these enterprises on the Dividend Champions, Contenders, and Challengers list.
As true as that may be, though, what you pay for an asset – no matter how great the asset is – always matters.
Price only tells you 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.
Getting good deals on great stocks could help you to build an outsized amount of wealth and passive income over the long term.
Fortunately, finding these good deals isn’t as hard as it might seem.
Fellow contributor Dave Van Knapp put together Lesson 11: Valuation in order to help investors master the valuation process.
One of his many “lessons” on dividend growth investing, it’s an easy-to-follow 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…
Huntington Bancshares Incorporated (HBAN) is a regional bank holding company that offers a range of traditional banking services, such as deposits, auto financing, mortgages, and insurance products.
Founded in 1866, Huntington is now a $19 billion (by market cap) major Midwest player that employs almost 16,000 people.
Huntington operates over 800 branches which are located in the American Midwest region.
Their core market is Ohio. They rank third in deposit share in Ohio, holding 15% of the state’s deposits.
The pandemic has made the last year difficult for almost all people and all businesses, and banks are no exception.
However, US banks came out of the pandemic in better condition than expected.
And there’s much to look forward to for US banks. A global economic recovery and the possibility of rising interest rates rank high on that list.
That’s speaking about US banks generally.
In regard to Huntington specifically, they just closed on an exciting merger with fellow Midwestern bank TCF Financial Corp. This move provides instant scale and creates a formidable competitor.
The new regional powerhouse has over $135 billion in total deposits. It’s now a top-25 bank in the United States.
Due to an overlapping footprint in the Midwestern region, Huntington sees room for significant synergies – approximately 37% of TCF’s noninterest expense.
While it’ll take time to work everything out, this merger could end up being a tremendous win for the combined organization. For instance, Huntington has stated that it expects the transaction to be 18% accretive to 2022 EPS.
That kind of substantial accretive growth translates to higher profits, and it gives the bank the ability to pay out even bigger dividends.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Already, Huntington has increased its dividend for 10 consecutive years.
The five-year dividend growth rate is 20.1%.
That’s an incredible growth rate on its own, but it’s especially incredible when you see that the stock also yields 4.39%.
This market-smashing yield is almost 90 basis points higher than the stock’s own five-year average yield.
In my view, it’s a very compelling combination of yield and growth.
However, more recent dividend increases have been in the mid-single-digit range.
And dividend growth is currently on pause as the bank waits for the Federal Reserve to allow them to increase capital returns to shareholders.
But with a payout ratio of only 52.6%, the bank is positioned to hand out a sizable dividend increase once they’re given the go-ahead.
Revenue and Earnings Growth
These dividend metrics are great.
As great as they are, though, they’re looking at what’s already transpired.
However, investors are risking today’s capital for tomorrow’s growth and rewards.
It’s the future dividend raises that matter most.
Thus, I’ll now put together 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 bank 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.
Blending the proven past with a future forecast like this should allow us to extrapolate out a reasonable approximation of the bank’s future growth path.
Huntington increased its revenue from $2.616 billion in FY 2011 to $4.815 billion in FY 2020.
That’s a compound annual growth rate of 7.01%.
Very strong top-line growth.
Meanwhile, earnings per share grew from $0.59 to $0.69 over this period, which is a CAGR of 1.75%.
This looks rather poor on its face.
However, it’s poor largely because of the pandemic’s impact on the bank’s FY 2020 EPS.
Huntington, like pretty much every other US bank, had to secure protective loan loss provisions throughout 2020.
These reserves are now being released throughout 2021, which is causing EPS to spring back to normal.
If we were to back things up one year to FY 2019, the nine-year EPS CAGR would be slightly over 10%.
An investor needs to look past the recent chaos and skate to where the puck is going.
In that sense, with the release of reserves and an accretive merger now closed, Huntington is in a great spot for bottom-line growth.
Looking forward, CFRA is projecting that Huntington will compound its EPS at an annual rate of 5% over the next three years.
I usually agree with CFRA’s EPS forecasts.
In this case, though, I think they’re being awfully conservative.
CFRA notes the high possibility of additional reserve releases throughout 2021. And they also acknowledge that the merger will likely improve the bank “from competitive, geographic, and product standpoints”.
If Huntington was typically able to grow its bottom line at a low-double-digit annual rate prior to the merger, and if this merger truly is accretive, I’m not sure why they’d suddenly be able to only manage half the growth they were able to manage before.
But even if we were to take CFRA’s forecast as the base case, Huntington would still be able to hand out high-single-digit dividend increases for the foreseeable future.
The modest payout ratio gives them that kind of flexibility.
And if CFRA’s forecast ends up being too conservative, future dividend raises could be quite large.
Moving over to the balance sheet, the bank has a rock-solid financial position.
They have total assets of $123 billion against $105 billion in total liabilities.
Credit ratings for The Huntington National Bank’s senior unsecured notes are all well into investment-grade territory and are as follows: A-, S&P; A3, Moody’s; and A-, Fitch.
Over the last five years, the firm has averaged annual net margin of 23.54% and annual return on equity of 10.73%. Net interest margin is at 2.99% for the last fiscal year.
Huntington offers investors an appealing case for investment.
It’s a high-quality regional bank that just closed an accretive merger and is actively releasing reserves. They’re scaling up just in time for an economic recovery. Plus, rates might rise faster than anticipated.
And they do have a durable competitive advantages that include scale, switching costs, and a large deposit base.
Of course, there are risks to consider.
Litigation, regulation, and competition are omnipresent risks in every industry.
A “lower-for-longer” paradigm around interest rates is a major headwind for all banks, although the Federal Reserve has seemed to shift its narrative toward raising rates faster than originally scheduled.
Banks are highly exposed to economic cycles, and the current cycle is fraught with uncertainty. Any residual effects from the economic shutdowns related to the pandemic could leave a lasting scar on the economy and the bank.
If a long-term recession were to occur, this would hurt the bank twice over. Less economic activity limits growth, while loan losses stress the balance sheet.
There’s also near-term execution risk with the TCF merger.
With these risks known, this is still an intriguing long-term investment.
The current valuation, after a recent correction, only serves to make it more intriguing…
Stock Price Valuation
The P/E ratio is 11.93 right now.
That’s well below the broader market’s earnings multiple.
It’s also below the stock’s own five-year average P/E ratio of 14.2.
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 and a long-term dividend growth rate of 5.5%.
This is arguably a super cautious take on the long-term dividend growth picture.
The bank’s long-term EPS growth greatly exceeds this level (once throwing out the anomalous FY 2020), as does the dividend growth over the last five and ten years.
And with a moderate payout ratio and accretive growth underway, it would seem likely that the bank greatly outdoes this mark.
On the other hand, CFRA is projecting only 5% EPS growth over the next three years, there is merger execution risk at play, and the economic recovery is still underway.
I’d rather err on the side of caution, all things considered.
The DDM analysis gives me a fair value of $18.09.
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.
After my cautious valuation model, the stock still looks notably 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 HBAN as a 4-star stock, with a fair value estimate of $18.00.
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 HBAN as a 3-star “HOLD”, with a 12-month target price of $16.00.
I came out within pennies of where Morningstar is at. Averaging the three numbers out gives us a final valuation of $17.36, which would indicate the stock is possibly 27% undervalued.
Bottom line: Huntington Bancshares Incorporated (HBAN) is a high-quality regional bank that just closed on an accretive merger that gives them additional scale precisely when additional scale is helpful to benefit from an economic recovery. With a market-smashing yield of 4.4%, 10 consecutive years of dividend raises, double-digit dividend growth, a moderate payout ratio, and the potential that shares are 27% undervalued, dividend growth investors should strongly consider depositing some of these shares into their portfolios.
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 HBAN’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 50. 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, HBAN’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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