The S&P fell by almost 5% during September.
It was the worst month for the broader market since March 2020.
And we all know what happened in March 2020.
While that’s a bummer for those who like to see high stock prices, it’s a gift for those still in accumulation mode.
A lot of stocks have suddenly become much cheaper.
If nothing fundamental has changed for a business, you should be giddy to see lower prices.
That’s perhaps especially true for high-quality dividend growth stocks like those you’ll find on the Dividend Champions, Contenders, and Challengers list.
That’s because those lower prices result in higher yields.
Indeed, this was my goal.
And I achieved that goal at only 33 years old.
In fact, I retired in my early 30s.
I lay it all out in my Early Retirement Blueprint.
The FIRE Fund, which is my real-money portfolio, produces enough five-figure passive dividend income for me to live off of.
That portfolio is chock-full of those aforementioned high-quality dividend growth stocks.
These are some of the very best stocks in the world.
Price is only what you pay. But 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 a great deal on a great dividend growth stock can set you up for outsized dividend income and total return over the long run.
The good news, finding those great deals through the process of valuation isn’t as difficult as it might seem.
Fellow contributor Dave Van Knapp’s Lesson 11: Valuation cuts through the fog and provides an easy-to-understand valuation template that can be applied to almost 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…
Allstate Corp. (ALL) is an insurance company that operates as one of the largest property-casualty insurers in the United States.
Founded in 1931, Allstate is now a $38 billion (by market cap) insurance giant that employs over 42,000 people.
Allstate primarily sells auto and homeowners insurance.
Property-casualty net underwriting premiums accounted for the vast majority of the company’s FY 2020 revenue. Of these premiums, they can be broken down into the following lines: auto insurance, 70%; homeowners, 23%; other personal lines, 5%; and commercial, 2%.
After the sale of its Allstate Life Insurance Company in early 2021, their main focus moving forward will be in property-casualty insurance.
I like this focus. And I like the insurance business generally. In fact, it’s one of my favorite business models.
That’s because of the ingenious way in which insurers make money from other people’s money.
Insurance is a great business model in and of itself. Since most people can’t afford to cover a catastrophic loss, they pay insurance companies to take on that risk for them. Even if they could cover a large loss, insurance is often required for things like cars and homes. This results in premiums.
Insurance companies do their best to run a tight underwriting ship and earn more in premiums than they pay out in claims. This tends to result in a good profit stream.
Whereas you might think that’s where it ends, that’s actually where it begins.
These collected premiums turn into a “float” and can earn significant returns during the time delay between premium collection and claim payout. Other people’s money built this float.
Allstate’s investment portfolio is worth almost $100 billion, and it produced net investment income of nearly $3 billion during 2020.
An insurer takes a great business model and supercharges it with the float.
They produce profit from the core business model of providing insurance, and then produce even more profit from the money collected by doing so.
It’s an incredibly powerful one-two punch.
And it tends to result in a healthy stream of growing dividends back to shareholders.
Dividend Growth, Growth Rate, Payout Ratio and Yield
To be sure, Allstate has increased its dividend for 11 consecutive years.
The 10-year dividend growth rate is 10.2%, which handily beats inflation.
On top of the double-digit dividend growth, the stock’s current yield is 2.5%.
That yield is almost twice as high as what the broader market offers.
It’s also 70 basis points higher than the stock’s own five-year average yield.
The payout ratio is a low 25.9%, easily covering 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 a high-single-digit (or better) dividend growth rate. This stock is right in the sweet spot.
These are great numbers.
Revenue and Earnings Growth
As great as they are, though, they’re looking at what’s already transpired.
But 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 in the valuation process.
I’ll first show you what the last decade has looked like in terms of top-line and bottom-line growth.
I’ll then compare that to a near-term professional prognostication for profit growth.
Comparing the proven past up against a future forecast like this should give us a good idea as to where the company might be going.
Allstate grew its revenue from $32.564 billion in FY 2011 to $44.791 billion in FY 2020.
That’s a compound annual growth rate of 3.57%.
This is a good result from a large, fairly mature insurance business.
Meantime, earnings per share increased from $1.50 to $14.73 (adjusted) over this period, which is a CAGR of 28.89%.
I used adjusted EPS for FY 2020, which actually came in lower than the GAAP EPS. Even then, it’s still outstanding.
Allstate, unlike a lot of other businesses, benefited from 2020. That’s because they had less auto claims to deal with, as people were driving less during the pandemic and shutdowns.
However, this isn’t smoke and mirrors. The business really started to take off over the last few years – well before the pandemic. 2020 simply gave them extra wind in their sails.
A combination of margin expansion and share repurchases fueled a lot of excess bottom-line growth.
The outstanding share count is down by almost 40% over the last decade, which is one of the most substantial 10-year reductions I’ve ever seen.
Looking forward, CFRA believes that Allstate will compound its EPS at an annual rate of 7% over the next three years.
That would represent a material growth slowdown.
But I don’t think it’s totally unreasonable to expect this.
The last few years have been exceptional, and 2020 was particularly (and somewhat artificially) great.
Unloading the Allstate Life Insurance Company, which is resulting in near-term GAAP EPS lumpiness, and the normalization of claims will likely cool things off over the short term.
There’s also the investment portfolio, which could see a performance drag if/when capital markets become less favorable.
On the other hand, Allstate is a disciplined underwriter. Their underlying property-casualty combined ratio was only 85.7% for Q2 2021.
Now, CFRA’s EPS growth forecast could prove to be too low.
But even if this is what Allstate produces over the next few years, the setup is still for high-single-digit dividend growth for the foreseeable future. That’s because the payout ratio is so low. With the 2.5% yield, that’s compelling.
Moving over to the balance sheet, Allstate has a rock-solid financial position.
This isn’t a surprise. Insurance companies are usually conservatively run.
The long-term debt/equity ratio is 0.26, while the interest coverage ratio is over 22.
The former number looks worse than it really is – there’s a lot of treasury stock from those big buybacks reducing common equity.
Profitability is robust and improving.
Over the last five years, the firm has averaged annual net margin of 7.66% and annual return on equity of 14.72%.
There’s a lot to like here about Allstate.
And economies of scale, brand recognition, and the float are durable competitive advantages that protect the business.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
The business model features direct exposure to catastrophic risk.
Although demand for insurance isn’t cyclical, the investment portfolio has exposure to economic cycles.
Low interest rates limit the returns on the investment portfolio.
Business line concentration is also a risk.
With these risks out in the open, I still think Allstate can be a fantastic long-term investment for dividend growth investors.
The current valuation only makes me more enthusiastic…
Stock Price Valuation
The P/E ratio is 10.2.
That’s extremely low in a market where the S&P 500 has a P/E ratio of over 30.
It’s also well off of the stock’s own five-year average P/E ratio of 11.6.
And the yield, as noted earlier, is significantly 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 8%.
That DGR is on the high end of what I ordinarily allow for.
But I think the fundamentals support it.
The payout ratio is very low. The demonstrated long-term dividend growth is nearly in the double digits. And the most recent dividend increase, which was announced earlier this year, was 50%.
Moreover, the business has been producing very strong bottom-line growth.
With the forecast for near-term EPS growth being only slightly below this number, I view the low payout ratio as something that affords the company some discretion and flexibility in terms of growing the dividend at a modestly higher rate.
The DDM analysis gives me a fair value of $174.96.
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 careful valuation, the stock still 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 ALL as a 2-star stock, with a fair value estimate of $114.00.
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 ALL as a 5-star “STRONG BUY”, with a 12-month target price of $160.00.
I came out slightly high, but I’d also argue that Morningstar’s number is too low. Averaging the three numbers out gives us a final valuation of $149.65, which would indicate the stock is possibly 17% undervalued.
Bottom line: Allstate Corp. (ALL) is a high-quality insurance company that benefits from a powerful one-two punch. Recent results have been outstanding, and the business is positioned well. With a market-beating yield, more than a decade straight of dividend increases, double-digit dividend growth, a very low payout ratio, and the potential that shares are 17% undervalued, this looks like a clear long-term opportunity for dividend growth investors.
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 ALL’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 80. 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, ALL’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
We’re Putting $2,000 / Month into These Stocks
The goal? To build a reliable, growing income stream by making regular investments in high-quality dividend-paying companies. Click here to access our Income Builder Portfolio and see what we’re buying this month.