As we begin 2022, I’m excited.

It’s a new year, filled with opportunities to learn, invest, and grow.

On the other hand, I’m also somewhat frustrated.

And that’s because the huge run that stocks went on in 2021 has arguably left slim pickings.

But I still see some great stocks out there worthy of attention, if not capital.

Of course, I’m not using the adjective “great” loosely or vaguely.

I’m referring specifically to high-quality dividend growth stocks.

These are some of the best stocks in the world.

After all, these stocks represent equity in world-class enterprises that pay reliable, rising dividends.

They can afford to do that because they’re producing reliable, rising profits by providing the world with what it demands.

You can find hundreds of these stocks on the Dividend Champions, Contenders, and Challengers list.

Jason Fieber's Dividend Growth PortfolioI’ve routinely put my hard-earned capital to work with these stocks, building my FIRE Fund in the process.

That’s my real-money dividend growth stock portfolio.

This portfolio generates enough five-figure passive dividend income for me to live off of.

In fact, I’ve been able to live off of dividends for years.

I actually retired in my early 30s.

And I share in my Early Retirement Blueprint exactly how I did that.

As great as high-quality dividend growth stocks are, what you buy and when you buy it will have a major say in how well you do as an investor.

That’s due to valuation.

A stock’s price only tells you what you’ll pay. But it’s value that tells you what you 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.

Buying a high-quality dividend growth stock when it’s undervalued means you’re investing in a world-class business at an advantageous point in time, which positions you to do incredibly well over the long run.

Now, spotting the advantageous valuation requires one to actually understand valuation.

Fortunately, it’s not that difficult.

Fellow contributor Dave Van Knapp put together a series of “lessons” on dividend growth investing, of which one is Lesson 11: Valuation.

This lesson lays out 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…

Pinnacle West Capital Corporation (PNW)

Pinnacle West Capital Corporation (PNW) is a utility holding company that principally serves as the parent of Arizona Public Service, Arizona’s largest and longest-serving electric utility.

With corporate roots dating back to over 125 years ago, Pinnacle West is now an $8 billion (by market cap) utility titan that employs 6,000 people.

Pinnacle West serves more than 1 million customers.

The company’s one reportable segment is their regulated electricity segment, which consists of traditional regulated retail and wholesale electricity businesses engaged in electricity generation, transmission, and distribution.

Residential customers accounted for 50% of FY 2020 electric revenue, while industrial and commercial customers accounted for 49%. Other revenue occurred through wholesale, transmission for others, and miscellaneous customers.

APS is vertically integrated, providing retail or wholesale electric service to almost the entire state of Arizona. Their service area excludes the metro Tucson area and about half of the metro Phoenix area.

Fuel sources for APS for 2020 were as follows: gas, 28%; nuclear, 23%; demand-side management, 16%; coal, 14%; renewables, 11%; and purchased power, 8%.

A significant portion of the company’s energy mix comes from clean resources. Moreover, management has announced a plan for the utility to deliver 100% clean, carbon-free electricity by 2050.

The utility business model, and the investment thesis behind it, is very simple.

Our modern-day society cannot function without reliable power.

By providing a basic need, a utility company naturally has a floor under the business.

However, I think Pinnacle West has a rising floor.

And that’s because of its geographic advantage.

Utilities are typically bound to a geographical area.

In Pinnacle West’s case, that’s actually a good thing – of the top-10 largest US cities, Phoenix grew the fastest (in percentage terms) between 2010 and 2020, according to the most recent information from the US Census Bureau.

This means more captive customers coming to consume the energy that Pinnacle West provides.

And that should result in the company being able to consistently grow its revenue, earnings, and dividend over the coming years.

Dividend Growth, Growth Rate, Payout Ratio and Yield

Pinnacle West has already increased its dividend for 11 consecutive years.

The 10-year dividend growth rate is 4.2%, which is solid.

Then there’s the market-smashing 4.8% yield.

This yield isn’t just more than three times higher than what the broader market offers; it’s also 110 basis points higher than the stock’s own five-year average yield.

The moderate payout ratio of 67.5% covers the dividend handily.

There aren’t many stocks out there offering a yield near 5% right now, even in the utility space.

For income-oriented dividend growth investors, this yield is notable and appealing.

Revenue and Earnings Growth

As appealing as it might be, though, these dividend metrics are largely looking backward.

However, investors are always risking today’s capital for tomorrow’s rewards.

As such, I’ll now build out a forward-looking growth trajectory for the business, which will later guide us during 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.

And I’ll then reveal a near-term professional prognostication for profit growth.

Comparing the proven past up against a future forecast in this way should allow us to reasonably extrapolate where the business might be going from here.

Pinnacle West grew its revenue from $3.2 billion in FY 2011 to $3.6 billion in FY 2020.

That’s a compound annual growth rate of 1.1%.

Meanwhile, earnings per share moved from $3.09 to $4.87 over this period, which is a CAGR of 5.2%.

Considering that this is a utility business, these numbers are good. Not excellent. But certainly not poor.

However, because of the noted demographic trends playing out in Arizona, the next 10 years could be even better.

Looking forward, CFRA currently has no three-year growth projection for Pinnacle West’s EPS.

This is one of those rare times in which CFRA doesn’t have that forecast.

On one hand, CFRA speaks on the favorable service area: “Positive economic development in Phoenix continues to attract new businesses to the area, which should support an expanding revenue base for PNW as business influxes typically pair with higher residential growth.”

On the other hand, Pinnacle West’s regulatory environment has deteriorated. During their most recent rate case this past October, the regulatory body (ACC) decided to cut the company’s allowed return on equity from 10% to 8.7%.

CFRA estimates a $0.90 hit to this year’s EPS from this decision.

Utilities run local monopolies and provide necessary power to captive customers. It’s easy to see how that could get out of control, so they’re heavily regulated.

This regulation can act like a pendulum, depending on a variety of factors. Sometimes it’s relaxed. Sometimes not. It’s a case of the latter right now.

In this case, I see a tailwind (demographics) running up against a headwind (regulation).

Pinnacle West will almost certainly continue to grow its base. But the rates they can charge the base will be lower for the foreseeable future.

It is possible that the pendulum will swing back the other way in the future. Either way, the base will likely expand in the meantime.

Putting it all together, I think the utility is positioned to grow the dividend at a mid-single-digit rate over the long run, which would be in line with the last decade.

And with such a high starting yield, that’s a compelling setup for income-oriented dividend growth investors.

The big caveat here is that this is a long-term projection.

The near-term dividend growth could be relatively light, while the company adjusts to new ROE paradigm. After that shakes out and the demographic tailwind kicks in even harder, dividend growth should pick up.

Financial Position

Moving over to the balance sheet, the financial position is good. It’s what I’d expect from a utility business.

The long-term debt/equity ratio is 1.1, while the interest coverage ratio is near 4.

Profitability is robust, with margins impressing.

Over the last five years, the firm has averaged annual net margin of 14.6% and annual return on equity of 10%.

We already know where ROE is headed, though.

I think there’s a lot to like about Pinnacle West, especially if you have an orientation toward income and could use more utility exposure in your portfolio.

And the company does benefit from durable competitive advantages, including economies of scale, a geographic monopoly, and a regulatory structure that nearly guarantees some level of profit.

Of course, there are risks to consider.

Litigation, regulation, and competition are omnipresent risks in every industry.

Regulation is a double-edged sword.

Regulators allow for utilities to make a reasonable profit, factoring in things like CapEx. Profit tends to scale with costs. This puts a profit floor in place.

On the flip side, there’s a ceiling. Because power is necessary and there’s often only one power provider in any one geographic area, regulators limit the rates a utility can charge.

We have recently seen the ceiling become more prominent than the floor.

Since a geographic monopoly is often in place, competition in the traditional sense is usually nil.

However, customers could become competition in the future through the generation of power at the site of consumption.

There’s geographic risk here. Utilities don’t have the ability to expand their coverage areas very much, so they largely rely on the underlying population growth of those areas. Fortunately, Pinnacle West has a geographic advantage.

I also see pricing risk. The company purchases some of their power. This leaves them vulnerable to swings in natural gas prices.

Lastly, there’s nuclear risk. Pinnacle West has an interest in the Palo Verde nuclear plant, the largest nuclear plant in the US.

Many of these risks are pretty standard for a utility, and I think this name can make a lot of sense for long-term dividend growth investors.

The rate case was a setback. But this was a $100+ stock in early 2020. And the revenue base has surely grown since then.

A miserable 2021 has left the stock with a very undemanding valuation, making it even more appealing as a long-term investment…

Stock Price Valuation

The stock is trading hands for a P/E ratio of 13.8.

That’s well below where the broader market is at and where utilities in general are at.

It’s also way off of the stock’s own five-year average P/E ratio of 18.1.

And 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 a 9% discount rate (due to the high yield) and a long-term dividend growth rate of 4.5%.

That rate is lower than the EPS growth rate over the last decade. And it’s nearly mirroring the 10-year proven dividend growth rate.

I see the demographic tailwind essentially canceling out much of the regulatory headwind over the coming years, which should result in something akin to the status quo.

Now, I think the near term could be shaky in terms of dividend growth. Indeed, the company elected to increase the dividend by only 2.4% in November.

But I think this will smooth out over the long run. A mid-single-digit long-term dividend growth rate is not a high hurdle for a utility to clear.

The DDM analysis gives me a fair value of $78.96.

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 conservative valuation, 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 PNW as a 4-star stock, with a fair value estimate of $78.00.

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 PNW as a 3-star “HOLD”, with a 12-month target price of $71.00.

I landed almost exactly in the same spot as Morningstar on this one. Averaging the three numbers out gives us a final valuation of $75.99, which would indicate the stock is possibly 9% undervalued.

Bottom line: Pinnacle West Capital Corporation (PNW) is a utility that’s located in a very advantageous geographic area, with much of its service territory benefiting from domestic migration patterns. This is causing a lot of growth in its revenue base. With a market-smashing yield near 5%, mid-single-digit dividend growth, 11 consecutive years of dividend increases, and the potential that shares are 9% undervalued, this is a compelling long-term idea for income-oriented dividend growth investors.

-Jason Fieber

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 PNW’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 70. 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, PNW’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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