There is no alternative.
This acronym often comes up when the mainstream media attempts to explain the S&P 500’s high valuation.
Investors supposedly have nowhere else to turn when it comes time to put capital to work.
But I’d argue there is an alternative.
While the broader market on its own might have an elevated valuation, many individual stocks do not have this problem.
It’s less a stock market than it is a market of stocks.
When speaking on individual stocks, I propose sticking to high-quality dividend growth stocks.
These stocks represent equity in world-class enterprises paying reliable, rising dividends.
They’re some of the very best stocks you can own.
You can find hundreds of examples of these stocks on the Dividend Champions, Contenders, and Challengers list.
I’ve personally invested in these stocks as I’ve gone about building my FIRE Fund.
This portfolio – and the dividend income it produces – allowed me to retire in my early 30s.
My Early Retirement Blueprint describes exactly how I was able to accomplish that feat.
Suffice it to say, as I’ve already foreshadowed, sticking to high-quality dividend growth stocks was a pillar of my success.
However, there’s more to it than just that.
Valuation at the time of investment is crucial, even with high-quality dividend growth stocks.
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 at attractive valuations, in lieu of the expensive S&P 500, could deliver outsized gains in wealth and passive income for investors over the long run.
Of course, spotting an attractive valuation requires one to actually have an idea of intrinsic value.
Fortunately, this isn’t as difficult as it might seem.
Fellow contributor Dave Van Knapp put together Lesson 11: Valuation in order to make the valuation process much easier.
It’s part of a series of “lessons” on dividend growth investing, and it provides a ton of insight on how to go about estimating fair value.
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…
Enbridge Inc. (ENB) is an energy distribution and transportation company that owns and operates crude and natural gas pipelines across the United States and Canada. It also operates a gas utility business. Additionally, the company has considerable exposure to renewable energy through a diversified portfolio of renewable energy projects.
Founded in 1949, Enbridge is now an $83 billion (by market cap) energy juggernaut that employs more than 11,000 people.
The company has five business segments: Energy Services, 47% of FY 2020 revenue; Liquids Pipelines, 27%; Gas Transmission and Midstream, 13%; Gas Distribution, 12%; and Renewable Power Distribution, 2%.
By merging with Spectra Energy Corp. in 2017, Enbridge became the largest energy infrastructure company in North America. Enbridge operates the world’s longest and most complex crude oil and liquids transportation system.
To give you some perspective on that system, their pipeline network stretches from Norman Wells, Canada to Brownsville, Texas.
They operate over 17,000 miles of active crude pipeline across North America, split nearly evenly between the US and Canada.
The company transports 25% of the crude oil produced in North America, and they also transport 20% of all natural gas consumed in the US.
Simply put, this company owns and manages vital energy infrastructure.
In addition to this energy infrastructure, Enbridge is Canada’s largest natural gas utility. The company serves approximately 3.8 million retail customers in Ontario and Quebec.
Not content to rest on their laurels, Enbridge is working hard to cement their place in the future of energy.
Enbridge cleverly calls this “Bridge to the Energy Future”.
The company is aiming to have net zero emissions by 2050.
Toward that end, Enbridge has committed almost $8 billion to renewable energy and power transmission projects that are currently in operation or under construction. This category includes significant onshore and offshore wind developments in North America and Europe.
Some of their low-carbon opportunities include renewable natural gas, hydrogen power-to-gas, and carbon capture.
Now, the world is trying to wean itself off of hydrocarbons. But the uncomfortable truth is that our modern-day society currently cannot function without these traditional energy products.
Recent energy shortages throughout Europe are a glimpse into what can happen if you ignore reality and try to meet current power demands with insufficient future energy supplies.
Circling back around to the core business model, Enbridge has impressively insulated itself from volatile commodity pricing.
The company estimates that ~98% of its cash flow is predictable through regulated operations, take or pay contracts, or fixed fees.
With the business deftly balancing current power needs with future energy preparedness, they’re positioned to continue pipelining increasing dividends straight to their shareholders.
Dividend Growth, Growth Rate, Payout Ratio and Yield
The company has increased its dividend for 25 consecutive years.
A great look made even greater by the 10-year dividend growth rate of 11.3%.
I always love to see a double-digit long-term dividend growth rate.
But I especially love it when the yield is this high.
The stock yields 6.6%.
That’s five times higher than the broader market’s yield.
It’s also 90 basis points higher than the stock’s own five-year average yield.
You will almost never see a yield this high paired with a growth rate this high.
And the dividend is secured by a payout ratio of 68.9%, based on midpoint guidance for this fiscal year’s DCF/share.
These dividend metrics are out of this world.
Revenue and Earnings Growth
As great as the numbers are, though, they’re largely looking backward.
But investors are risking 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 when it comes time to estimate the stock’s intrinsic value.
I’ll first show you this company has done in terms of growing its top line and bottom line over the long term.
Then I’ll compare that to a near-term professional prognostication for profit growth.
Pitting the proven past up against a future forecast in this way should give us a very good idea as to where the business might be going from here.
Enbridge increased its revenue from CAD $19.4 billion in FY 2011 to CAD $39.1 billion in FY 2020.
That’s a compound annual growth rate of 8.1%.
Great revenue growth.
However, it’s important to keep in mind that much of the top-line growth was fueled by Enbridge’s 2017 acquisition of Spectra Energy.
I usually show ten years’ worth of top-line and bottom-line growth in my analyses. That’s a fairly long period of time, which tends to smooth out short-term fluctuations and provide a long-term lens through which to look at a business.
But since the Spectra Energy acquisition fundamentally changed the business, I’ll be showing bottom-line growth from FY 2017 onward.
Being an infrastructure business with a large midstream presence, it translates its profits like an MLP would (as distributable cash flow per share) instead of earnings per share like a normal corporation. So that’s what we’ll look at.
Enbridge’s DCF/share grew from CAD $3.68 in FY 2017 to CAD $4.67 in FY 2020, which is a CAGR of 8.3%.
This is a very strong result. And that’s even after factoring in the turmoil that the pandemic brought to energy markets during 2020.
I think this shows how resilient the business model is, which speaks on the point I made earlier regarding predictable cash flow.
Looking forward, CFRA is forecasting that Enbridge will compound its EPS at an annual rate of 15% over the next three years.
I believe that’s CFRA’s way of looking at cash flow growth.
This would mark a significant acceleration in Enbridge’s growth.
Now, I’m not sure I see a convincing case for Enbridge to nearly double its bottom-line growth rate over the next few years.
On the other hand, I see no reason why one would expect any kind of material slowdown in growth.
For further perspective, Enbridge itself is guiding for CAD $5.00 in DCF/share at the high end for FY 2021. That would represent 7.1% YOY growth, if they hit that number.
I expect Enbridge, due to its consistent and predictable cash flow, to continue with the status quo as it relates to its bottom-line growth. And that should translate to like dividend growth.
When combining high-single-digit dividend growth with a starting yield of 6.6%, that’s more than enough to make this a compelling long-term idea.
Moving over to the balance sheet, the company is in a good financial position.
The long-term debt/equity ratio is 1.0.
Notably, Enbridge has lowered its consolidated debt/EBITDA ratio from approximately 6 in 2016 to 4.6.
Their credit ratings are in investment-grade territory: Standard & Poor’s rates their senior unsecured debt BBB+; Moody’s, Baa2; Fitch, BBB+. Furthermore, Enbridge states that 95% of its customers are investment grade.
Profitability is difficult to gauge. That’s because of the way profit is translated. GAAP numbers can be misleading or even downright meaningless.
With that said, over the last five years, the firm has averaged annual net margin of 7.4% and annual return on equity 6.8%.
Within the energy space, this is one of my favorite long-term investments. It has the kind of operational resiliency and dividend reliability that I love to see.
And the company does have durable competitive advantages that include massive scale and extremely high barriers to entry. Simply put, it would be almost impossible to build a competing pipeline network from scratch today.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
While Enbridge doesn’t have many direct competitors, regulation and litigation are big risks in their industry.
Their current dispute with Michigan over their Line 5 is a prime example of that.
Regulation can sometimes work to their advantage, though. It’s becoming increasingly difficult for companies to get permits to build new pipelines, making the existing infrastructure that much more valuable.
While scale is a key advantage, it also works against them in some ways. There’s less growth potential with a mature, scaled-up business like this.
Even though the company is largely insulated from volatile commodity pricing, they remain sensitive to energy over the long run through demand and counterparty risk.
There’s long-term risk in the very business model, with society starting to move away from hydrocarbons. Enbridge has invested in renewables, but the core business model remains based around hydrocarbons. It is possible, though, that the network could be repurposed in the future for the storage and transportation of hydrogen as the energy transition plays out.
Their balance sheet is good, and better than it used to be, but it remains encumbered. Any increase in costs as it relates to raising capital (via equity or debt) would harm the company’s growth plans.
Overall, I see Enbridge as a prime candidate for long-term dividend growth investors looking for yield at the expense of higher risk.
With the stock still priced below its pre-pandemic high, the valuation makes this idea even more appealing right now…
Stock Price Valuation
The stock is trading hands for a forward P/DCF ratio 8.3, based on midpoint guidance for this fiscal year.
With that being roughly analogous to P/E ratio on a normal stock, it’s obscenely cheap when compared to almost anything else out there.
However, this is a stock that’s always cheap.
I think the market has considered the risks and decided to approach this name prudently. That’s fair.
The five-year average P/CF ratio for the stock is only 9.4, which is very low. And the current P/CF ratio of 11.1, also very low, is actually running ahead of that average.
But the yield, as noted earlier, is substantially 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 an 8% discount rate (to account for the high yield) and a long-term dividend growth rate of 3%.
This looks ultra conservative when you compare that to the long-term demonstrated DGR, the long-term DCF/share growth, and the near-term forecast for bottom-line growth.
Well, it looks ultra conservative because it is. I think it’s wise to be careful with the expectations here. And one has to respect the risks.
Keep in mind, the most recent dividend increase, announced last December, was only 3.1%.
And the company’s own midpoint guidance for this fiscal year would put YOY DCF/share growth at 3.9%.
I’d rather err on the side of caution, although I acknowledge there could be a lot of possible upside as it relates to future dividend increases.
The DDM analysis gives me a fair value of $55.21.
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 believe I was shrewd with my valuation, yet the stock still looks exceptionally 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 ENB as a 3-star stock, with a fair value estimate of $44.00.
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 ENB as a 3-star “HOLD”, with a 12-month target price of $44.00.
I came out high, which surprises me. Averaging the three numbers out gives us a final valuation of $47.74, which would indicate the stock is possibly 18% undervalued.
Bottom line: Enbridge Inc. (ENB) is the largest energy infrastructure company in North America. Its operational resiliency and dividend reliability are rare in this industry. With a 6.6% yield, 25 consecutive years of dividend increases, a reasonable payout ratio, double-digit long-term dividend growth, and the potential that shares are 18% undervalued, this is a compelling long-term idea for yield-seeking 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 ENB’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 57. 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, ENB’s dividend appears Borderline Safe with a moderate risk of being cut. Learn more about Dividend Safety Scores here.
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.