The broader market has been incredibly resilient all year long.
The S&P 500 is currently within a few percentage points of its all-time high.
However, there’s an undercurrent at play.
Below the surface, volatility reigns.
Despite the broader market’s strength, plenty of individual stocks have recently strongly corrected.
It’s a market of stocks, not just a stock market.
Many, many stocks are down 10%+ over the last few months.
And I see this short-term volatility as a long-term opportunity.
It’s helped me to build out my FIRE Fund.
That’s my real-money stock portfolio.
This portfolio produces enough five-figure passive dividend income for me to live off of.
That’s because this portfolio is chock-full of high-quality dividend growth stocks.
I’m talking about stocks that pay reliable, rising dividends to shareholders,
These reliable, rising dividends are funded by reliable, rising profits.
You can find hundreds of these stocks on the Dividend Champions, Contenders, and Challengers list.
I’ve been following the dividend growth investing strategy for 10+ years.
Well, it allowed me to retire in my early 30s.
And my Early Retirement Blueprint spills the beans on how I did that.
As great as the dividend growth investing strategy is, though, valuation at the time of investment is always very important.
Price is simply what you pay. But value is what 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.
Taking advantage of the market’s undercurrent of volatility, and buying a high-quality dividend growth stock when it’s undervalued, can be a tremendous boon to your wealth and passive income over the long haul.
If you think undervaluation is difficult to spot, fear not.
Fellow contributor Dave Van Knapp has demystified the valuation process, making it fairly straightforward to value just about any dividend growth stock.
His Lesson 11: Valuation, which is part of a comprehensive series on dividend growth investing, lays out a valuation template that you can use as a guide.
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…
Digital Realty Trust, Inc. (DLR) is a global real estate investment trust that owns and operates data centers.
Founded in 2004, Digital Realty Trust is now a $41 billion (by market cap) data center behemoth that employs nearly 3,000 people.
Their real estate portfolio of over 290 data centers is spread out across 24 countries on six continents. These purpose-built properties are strategically located for their networking capabilities.
Their global platform has over 4,000 customers. Some of their largest customers include: IBM, JPMorgan Chase, Uber, and LinkedIn.
When investors typically think of a REIT, their minds might initially conjure up images of shopping malls and office space.
Well, this REIT is nothing of the sort. Its differentiation positions it squarely in the middle of the ongoing technology evolution, which involves almost every facet of our lives.
See, everyday life is becoming increasingly digitized.
The Internet is now an essential part of most people’s day-to-day lives. We practically cannot function without it.
And with the Internet-of-Things expanding into everything from smart homes to self-driving cars, our future is going to be more digital than it’s ever been.
AI. Data. Cloud. IoT.
That’s where society is going.
And that works to the advantage of companies that own and operate data centers. These data centers act as critical infrastructure, allowing the global flow of information through interconnected networks. Digitization doesn’t happen without data centers.
The company was in a great position before 2020. They’re in an even better position now.
That’s because the pandemic has only accelerated digitization.
I’ll give you a quick example of this.
More companies are starting to offer flexible work-from-home schedules for their employees. This was probably inevitable, but there’s been a forced move in this direction over the last year.
Well, remote work will require people to rely even more on digital tools than they were before.
And Digital Realty Trust stands to benefit from the accelerating evolution in the way people live, work, and play.
All of this bodes extremely well for the company’s long-term ability to grow its profit and dividend.
Dividend Growth, Growth Rate, Payout Ratio and Yield
As it sits, Digital Realty Trust has increased its dividend for 17 consecutive years.
The 10-year dividend growth rate is 8.6%.
The stock’s current yield is 3.2%.
I think that’s a very nice combination of yield and growth.
By the way, this yield is more than twice as high as the broader market’s yield.
It’s also within 30 basis points of the stock’s own five-year average yield.
And the payout ratio is a reasonable 71.6%. That’s based on midpoint guidance for this fiscal year’s FFO/share.
I like dividend growth stocks in what I refer to as the “sweet spot” – that’s a yield of between 2.5% and 3.5%, paired with a high-single-digit (or better) dividend growth rate.
This stock is definitely in that spot.
Revenue and Earnings Growth
As great as these dividend metrics are, though, they’re looking at the past.
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 aid in the valuation process.
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 way should give us a very good idea as to where the company might be going.
Digital Realty Trust grew its revenue from $1.063 billion in FY 2011 to $3.904 billion in FY 2020.
That’s a compound annual growth rate of 15.6%.
Highly impressive sales growth here.
However, REITs often fund growth through equity and debt. The former means share offerings (or dilution). That’s why per-share profit growth is much more insightful when looking at a REIT.
Furthermore, when looking at profit growth for a REIT, you should look at funds from operations instead of normal earnings.
FFO measures cash generated by a REIT. It adds depreciation and amortization expenses back to earnings.
The company increased FFO/share from $4.06 to $5.11 over this 10-year period, which is a CAGR of 2.59%.
We can now see a material difference between absolute top-line growth and relative bottom-line growth.
Dilution accounts for much of the difference. The outstanding share count has more than doubled over the last decade.
That said, I don’t see this result as accurately indicative of the company’s true growth profile.
FY 2020 was an aberration for many reasons, but Q1 2020 in particular threw their whole year off.
In addition to the uncertainty that the pandemic-induced shutdowns caused in early 2020, Digital Realty Trust closed on its $8.4 billion combination with Interxion in the first quarter of 2020 and reported a skewed Q1. The timing was unfortunate, but the tie-up with Interxion gave Digital Realty Trust much-needed scale in Europe.
The truth of the matter is that we can’t make money on yesterday’s results. We’re always investing for future growth. And I maintain my view that Digital Realty Trust’s future is as bright as it’s ever been.
Looking forward, CFRA currently has no three-year FFO/share growth projection.
That’s regrettable. I like to compare that projection against a historical baseline for these analyses. That allows a bigger picture and future trajectory to more easily be fleshed out.
However, CFRA does include its forecast for both FY 2021 and FY 2022 FFO/share. They are $6.50 and $7.01, respectively.
That FY 2021 number would represent a 27.2% YOY increase compared to FY 2020 FFO/share. And the FY 2022 number would represent a 7.8% YOY increase compared to the FY 2021 projection.
It’s that latter number – 7.8% – that I see as a pretty rational expectation for long-term bottom-line growth.
If we look at normalized, pre-pandemic FFO/share growth that isn’t skewed by a significant acquisition, the CAGR was near 8%.
With Interxion and its 50+ European data centers on board, along with post-pandemic tailwinds blowing at its back, Digital Realty Trust should be able to do at least this well over the coming years.
And that sets them up for like dividend growth.
Moving over to the balance sheet, the financial position is good.
I will note that the balance sheet has swelled over the last few years, with Digital Realty Trust scaling up through acquisitions. The aforementioned InterXion combination is one example of that. The $7.6 billion acquisition of DuPont Fabros Technology 2017, and $1.8 billion acquisition of Ascenty in 2018, are two more examples.
The company has $18.4 billion in total liabilities against $36.1 billion in total assets.
The company’s investment-grade credit ratings are as follows: BBB, S&P Global; Baa2, Moody’s; BBB, Fitch.
Moreover, many of their top tenants are world-class institutions with their own investment-grade ratings.
Investing in Digital Realty Trust could offer you a chance to make your portfolio “future proof”.
And the company does benefit from durable competitive advantages that include: global scale, switching costs, sticky assets, strategically-placed properties that are purpose-built, and technological know-how.
Of course, there are risks to consider.
Litigation, regulation, and competition are omnipresent risks in every industry.
The company is much more involved in technology than a typical real estate investment trust. As such, they’re directly exposed to the risk that technology changes faster than they keep up with.
The increase in debt over the last few years leaves the company more vulnerable to interest rates and less flexible.
This business model is capital intensive.
Real estate is highly cyclical by nature. This real estate is differentiated, but there is still an element of cyclicality to contend with.
There’s often a scarcity of durable competitive advantages in real estate, although this company’s unique real estate portfolio gives it advantages that I don’t usually see in real estate.
The differentiated real estate is in and of itself somewhat of a risk, just in the sense that it’s difficult to repurpose these properties.
Even with these risks out in the open, I still believe that this can be a great long-term investment for dividend growth investors.
With the stock 16% off of its 52-week high, the attractive valuation only makes the investment case that much more clear…
Stock Price Valuation
The stock is trading hands for a P/FFO ratio of 21.9, based on midpoint guidance for this fiscal year’s FFO/share.
For an exciting tech business, that is not a high multiple.
Many of the more “traditional” REITs are trading for similar multiples, despite not having this kind of tech exposure.
Most basic valuation metrics are close to their recent historical averages, even though the company is arguably positioned better than ever before.
For instance, the P/CF ratio of 21.5 is very close to its five-year average of 19.5.
And the yield, as noted earlier, is close to 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 is higher than I generally allow for when valuing a REIT, but I think this REIT’s specialization and differentiation warrants it.
It is lower than the long-term demonstrated dividend growth. It’s also lower than their normalized FFO/share growth. And it’s lower than the FFO/share growth that CFRA is forecasting over the next two years.
With the payout ratio at a moderate level, I view the company as being capable of this kind of dividend growth for the foreseeable future.
The DDM analysis gives me a fair value of $165.49.
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 valuation was too aggressive, yet the stock 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 DLR as a 3-star stock, with a fair value estimate of $130.00.
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 DLR as a 3-star “HOLD”, with a 12-month target price of $170.00.
I came out slightly below where CFRA is at. Averaging the three numbers out gives us a final valuation of $155.16, which would indicate the stock is possibly 9% undervalued.
Bottom line: Digital Realty Trust, Inc. (DLR) is an atypical REIT that has exciting exposure to the future of technology and society through its strategically-located, purpose-built data centers. With a market-beating yield, high-single-digit dividend growth, a reasonable payout ratio, more than 15 consecutive years of dividend increases, and the potential that shares are 9% undervalued, this stock is worth consideration by 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 DLR’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 94. 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, DLR’s dividend appears Very Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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