If you can’t beat them, join them.
That’s one of my favorite proverbs.
It can apply to many situations in life, but I think the stock market is perhaps one of the best applications for it.
Whereas many people seem frustrated by the wealth that’s been built by investors, that strikes me as defeatist.
The stock market has democratized wealth building in a way that allows almost anyone to join in.
Take me, for example.
I grew up on welfare in Detroit, have no college education, and was poor for most of my life.
I wasn’t exactly what you might picture as the “ideal candidate” for stock investing.
Yet I decided to “join them” in my late 20s anyway, living well below my means and regularly investing my savings into high-quality dividend growth stocks like those you’ll find on the Dividend Champions, Contenders, and Challengers list.
Well, it allowed me to retire in my early 30s.
From welfare to financial freedom at 33 years old.
I share that journey in my Early Retirement Blueprint.
See, I didn’t let the envy of others’ wealth beat me.
Instead, I joined in and took advantage of the stock market’s incredible power to build wealth for just about anyone out there.
And I now own and control a six-figure dividend growth stock portfolio, which I refer to as the FIRE Fund.
This portfolio produces enough five-figure passive dividend income for me to live off of.
Price is only what you pay. Value is what you actually get for your money.
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.
Joining in and investing in high-quality dividend growth stocks at attractive valuations is practically a surefire way to “beat” the negative naysayers out there and grow your wealth and passive income to stratospheric heights.
Despite the concept of valuation seeming to be complicated, it’s actually not.
Fellow contributor Dave Van Knapp put together Lesson 11: Valuation, part of an overarching series of “lessons” on dividend growth investing, to demystify valuation and provide a transparent template that can be used to estimate the intrinsic value of 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…
Fifth Third Bancorp (FITB) is a diversified regional bank holding company that offers a range of financial services and products, such as deposits, lending, transaction processing, and advisory solutions.
Founded in 1858, Fifth Third Bancorp is now a $25 billion (by market cap) major regional institution that employs nearly 20,000 people.
Headquartered in Cincinnati, Ohio, the bank is mostly focused on its core Midwestern market that includes the states of Ohio, Michigan, Illinois, and Indiana.
With total assets of approximately $200 billion, they are in the top-20 largest banks in the United States. For perspective on this scale, there are over 5,000 commercial banks and savings institutions in the US.
The bank operates four main businesses: Commercial Banking, 42% of FY 2020 revenue; Branch Banking, 32%; Wealth and Asset Management, 9%; and Consumer Lending, 9%. General Corporate and Other accounts for the other 8%.
The banking business model is one of the best around, which is why it’s one of the oldest around.
Take in capital at one rate. Lend at a higher rate. Earn on the massive, low-cost float.
And the near term is looking particularly good for the business model.
Banks like Fifth Third should benefit from one of the best setups you could possibly imagine.
There’s a ton of liquidity in the American financial system, greatly reducing risk for banks.
Meanwhile, the economy is running red hot. This will likely result in more loan demand.
In addition, the Federal Reserve is projecting an environment in which rates are rising even faster than expected.
All of this plays right into the hands of Fifth Third, which bodes well for their ability to grow their profit and their dividend.
Dividend Growth, Growth Rate, Payout Ratio and Yield
As things stand, the bank has increased its dividend for 10 consecutive years.
But that’s about to become 11 consecutive years, because the bank has already stated that they plan to raise the dividend by 11.1%, to $0.30/share per quarter.
This double-digit dividend growth is par for the course – the company’s 10-year DGR is 22.7%.
That incredible dividend growth comes on top of the stock’s yield of 3.30% (after factoring in the new quarterly dividend).
I see this as a very compelling combination of yield and growth.
This yield, by the way, is more than twice as high as what the broader market offers.
It’s also 50 basis points higher than the stock’s own five-year average yield.
The low payout ratio of 44.1% easily covers the dividend.
I like dividend growth stocks in what I refer to as the “sweet spot” – a yield of between 2.5% and 3.5%, paired with high-single-digit (or better) dividend growth.
This stock is in a spot that’s about as sweet as it gets.
Revenue and Earnings Growth
As great as these dividend metrics are, they’re looking at what was.
But investors are more concerned with what will be.
We risk today’s capital for tomorrow’s rewards.
As such, I’ll now put together a forward-looking growth trajectory for the business, which will later help with the estimation of 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.
Blending the proven past with a future forecast in this manner should allow us to come to some reasonable conclusions about where the business might be going from here.
Fifth Third grew its revenue from $6.030 billion in FY 2011 to $7.625 billion in FY 2020.
That’s a compound annual growth rate of 2.64%.
Meantime, earnings per share increased from $1.18 to $1.83 over this period, which is a CAGR of 5.0%.
While I wouldn’t call 5% long-term annual EPS growth fantastic, it’s important to keep in mind that FY 2020 was an absolute disaster for banks in general.
That’s because of the response to the pandemic, which involved setting aside massive loan loss reserves.
If we were to back up the time horizon just one year, the nine-year CAGR for EPS was nearly 14%.
Still, even with a terrible FY 2020 factored in, the bank actually performed pretty well.
Looking forward, CFRA is forecasting that Fifth Third will compound its EPS at an annual rate of 19% over the next three years.
This would be a stunning result, and it’d be well ahead of what the bank has historically been able to typically produce.
CFRA rightly points out the differentiated business model here.
That differentiation relates to recurring fees.
CFRA says this: “FITB’s diversified earnings stream is supported by the sizeable level of fee income (35-38% of net revenue vs. 28% industry avg.).”
This heavy fee structure takes away some of the usual concerns about a bank’s exposure to economic cycles and interest rates.
Also, I think it’s important to highlight Fifth Third’s geographic footprint.
While the bank has long relied on its Midwestern roots, it has been aggressively expanding into Florida – a state that is seeing a massive influx of new residents.
This business model differentiation, along with this unique geographic mix, makes the bank rather unique and appealing.
I don’t necessarily see them putting up the kind of numbers that CFRA is expecting, but they don’t have to.
The payout ratio is low enough to support double-digit dividend growth for years to come, even if the bank only produces high-single-digit EPS growth.
On the other hand, if CFRA is accurate, this could be a phenomenal performer in terms of both dividend growth and total return.
Moving over to the balance sheet, the bank has a solid financial position.
They have total assets of $194.2 billion against $171.7 billion in total liabilities.
Credit ratings for their senior debt are as follows: BBB+, S&P; Baa1, Moody’s; and A-, Fitch.
Their profitability is robust.
Over the last five years, the firm has averaged annual net margin of 29.89% and annual return on equity of 11.63%. Net interest margin came in at 2.78% for FY 2020.
Fifth Third has operated at a high level for many years. Yet they could do even better from here.
And with economies of scale, a large float, switching costs, and built-up relationships, the company does benefit from durable competitive advantages.
Of course, there are risks to consider.
Competition, regulation, and litigation are omnipresent risks in every industry.
Low interest rates continue to challenge banks, although this challenge may start to lighten up next year as rates rise.
There is direct exposure to economic cycles. The current cycle is one of the most unpredictable cycles we’ll ever see.
Lingering effects from the pandemic and economic shutdowns could leave a lasting scar on the bank.
If the pandemic were to lead to a more long-term recession, this would hurt the bank in two ways. Less economic activity limits loan and deposit growth, and loan losses harm the balance sheet.
Overall, even with these risks known, I think this bank could be a great long-term investment.
And with the stock recently correcting and well off of its 52-week high of $43.06/share, I see the valuation as making it even more appealing…
Stock Price Valuation
The P/E ratio is 10.61.
That’s less than half of what the broader market commands.
It’s also lower than the stock’s own five-year average P/E ratio of 10.9.
The P/B ratio is only 1.2.
Most US banks, depending on size and quality, sport a P/B ratio of between 1 and 2. This stock is on the low end of that spectrum.
And the yield, as noted earlier, is significantly higher than is 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 is somewhat on the high end of what I usually allow for when valuing a bank.
But Fifth Third’s long-term operational excellence warrants it.
This DGR is below the company’s demonstrated long-term EPS growth and dividend growth. It’s also way lower than CFRA’s near-term EPS growth projection.
And the upcoming dividend increase will be over 11%.
With the payout ratio being so low, and EPS growth expectations being so high, Fifth Third is in a good position to outperform this 7% mark.
The DDM analysis gives me a fair value of $42.80.
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 after a pretty conservative valuation, the stock looks quite 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 FITB as a 3-star stock, with a fair value estimate of $37.00.
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 FITB as a 4-star “BUY”, with a 12-month target price of $46.00.
I’m basically right in the middle this time around. Averaging the three numbers out gives us a final valuation of $41.93, which would indicate the stock is possibly 15% undervalued.
Bottom line: Fifth Third Bancorp (FITB) is a high-quality regional bank that should benefit from rising rates, an increase in loan demand, and its geographic footprint expansion. With a market-beating yield, double-digit dividend growth, a low payout ratio, and the potential that shares are 15% undervalued, this is a stock that dividend growth investors should be able to bank on.
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 FITB’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, FITB’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 & IncomeWe’re Putting $2,000 / Month into These Stocks
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