Undervalued Dividend Growth Stock of the Week: Morgan Stanley (MS)

Can you lose money in the stock market?

Of course!

However, investing in high-quality businesses – and staying invested for the long term – will greatly mitigate this risk.

The bigger risk, though, might be the one you’re ignoring.

Your cash is slowly losing value every single day. 

That’s right.

Due to inflation, the value of the dollar is slowly decreasing every day.

Simply put, not investing is the real risk.

Staying in cash will cause you to lose money through a reduction in your purchasing power.

That’s a guarantee.

I’m sure you’ve noticed this happening – virtually everything has become more expensive.

And unlike how it works with the stock market, the long term doesn’t help you with cash.

What’s the solution? 

I’d argue the solution is dividend growth investing.

This strategy espouses investing in world-class businesses paying reliable, rising dividends.

Those reliable, rising dividends are funded by reliable, rising profits.

What’s great is that these dividends are often rising even faster than inflation.

This protects – or even increases – your purchasing power.

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

I’ve used this strategy for myself to great effect.

It helped me to retire in my early 30s.

And I describe in my Early Retirement Blueprint exactly how I accomplished that.

Using the tenets of dividend growth investing, I built my FIRE Fund.

That’s my real-money portfolio, and it produces enough five-figure passive dividend income for me to live off of.

As great as high-quality dividend growth stocks can be, especially in an inflationary environment, valuation at the time of investment remains critical.

Whereas price is what you pay, value is what you get.

An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.

Jason Fieber's Dividend Growth PortfolioThis 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.

Exchanging your value-losing cash for undervalued high-quality dividend growth stocks equips you to fight off inflation over the long run while you grow your wealth and passive income.

The concept of valuation might seem complicated, but it’s really not.

Fellow contributor Dave Van Knapp’s Lesson 11: Valuation makes it even less complicated.

Part of an overarching series of “lessons” on dividend growth investing, it provides a valuation system that can be used to estimate intrinsic value on 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…

Morgan Stanley (MS)

Morgan Stanley (MS) is a multinational investment bank and financial services company.

Founded in 1924, Morgan Stanley is now a $154 billion (by market cap) investment banking powerhouse that employs 75,000 people.

The company has three operating segments: Institutional Securities Group, 50% of FY 2021 revenue; Global Wealth Management Group, 41%; and Investment Management Group, 9%.

Morgan Stanley has become one of the largest diversified capital markets banking institutions in the world.

Under the leadership of CEO James Gorman, Morgan Stanley has made impressive progress over the last decade and built out a powerful one-two punch.

On one hand, they’re one of the leaders in investment banking space.

This includes capital raising activities, financial advisory services, and corporate lending. Morgan Stanley is often involved in major IPOs, mergers, and acquisitions.

On the other hand, they’re a significant player in the wealth management space.

Recent acquisitions of E-Trade and Eaton Vance have scaled this side of the company out even further and increased the fees it can collect. With global asset values rising over the long term, Morgan Stanley should see continued growth here as a natural course of doing business.

For perspective on their scale, Morgan Stanley has $4.9 trillion in client assets under management. That makes them one of the largest asset managers in the world.

In my view, a bet on Morgan Stanley is basically a bet on US-centric capitalism.

That’s been a very correct and profitable bet for more than a century. And I suspect it’ll be a very correct and profitable bet over the next century.

This means higher revenue, more profit, and a bigger dividend over the years to come for the company and its shareholders.

Dividend Growth, Growth Rate, Payout Ratio and Yield

Already, Morgan Stanley has increased its dividend for eight consecutive years.

While that track record isn’t as lengthy as some other vaunted financial institutions, the five-year dividend growth rate of 24.6% shows eagerness to make up for lost time.

In fact, the company’s most recent dividend increase was a jaw-dropping 100%.

The huge dividend increase, combined with some recent weakness in the share price, has caused the yield to rise to 3.2%.

That is more than twice as high as the broader market’s yield.

It’s also a full 100 basis points higher than its own five-year average.

And even after all of that dividend growth, the payout ratio remains a low 34.9%.

I like dividend growth stocks in what I call the “sweet spot” – a yield of between 2.5% and 3.5%, paired with a high-single-digit (or better) dividend growth rate.

The yield is on the higher end of that range, while the dividend growth rate is much higher than what I’m typically looking for.

It’s about as sweet as it gets.

Revenue and Earnings Growth

As sweet as these dividend metrics might be, though, they’re mostly looking backward.

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

It’s future dividend raises and returns that matter most.

Thus, I’ll now build out a forward-looking growth trajectory for the business, which will later help when it comes time to estimate 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.

And then I’ll compare that to a near-term professional prognostication for profit growth.

Weighing up the proven past against a future forecast in this way should give us a pretty good idea as to where the business might be going from here.

Morgan Stanley increased its revenue from $26.1 billion in FY 2012 to $59.8 billion in FY 2021.

That’s a compound annual growth rate of 9.7%.

Really strong top-line growth here.

I usually look for a mid-single-digit top-line growth rate from a mature company like this, but Morgan Stanley easily exceeded my expectations.

Because of no positive GAAP EPS for FY 2012, I’ll advance the EPS comparison by one year to FY 2013.

Earnings per share grew from $1.36 to $8.03 over this nine-year period, which is a CAGR of 21.8%.

It’s now easy to see the direct link from EPS growth to dividend growth here. Both have been growing at 20%+ annually.

Buybacks have helped to power some of the excess bottom-line growth. But a material expansion in net margin has been the real driver of this.

Looking forward, CFRA believes that Morgan Stanley will compound its EPS at an annual rate of 5% over the next three years.

This would be a steep drop in growth compared to what Morgan Stanley has produced over the last decade.

This could prove to be a bit too conservative, but I think it’s appropriate to expect some slowdown relative to the extraordinary results that we’ve seen lately.

There are two issues that will likely act as near-term headwinds for Morgan Stanley.

First, there’s the high likelihood of lower activity around investment banking.

Public listings, corporate activity, and general enthusiasm for the US capital markets went into overdrive over the last two years. The flooding of liquidity through fiscal and monetary policies propelled exuberance.

Second, lower asset values from current volatility, geopolitical events, and any possible recession would reduce AUM and the fees generated.

However, the idea of investing in Morgan Stanley, like all ideas I present and personally put capital to work with, is a long-term one.

I’m quite sure that this company, like most other companies, will see its growth come down quite a bit over the near term.

But the long-term story doesn’t look broken to me. It’s simply a story that won’t be quite as exciting over the next year or two.

Keep in mind, the stock’s price has recently come down dramatically, contracting the valuation. The market has already factored in diminished growth.

Overall, I think Morgan Stanley is easily positioned to hand out high-single-digit dividend raises for the foreseeable future, even with ~5% EPS growth, by virtue of the low payout ratio.

Stacking that kind of dividend growth on top of a starting yield of over 3% presents a compelling combination.

Financial Position

Moving over to the balance sheet, the company has a solid financial position.

Total assets of $1.2 trillion match up against $1.1 trillion in total liabilities.

Investment-grade credit ratings for the parent company’s long-term debt are as follows: BBB+, Standard & Poor’s; A, Fitch; A1, Moody’s.

Profitability is robust.

Over the last five years, the firm has averaged annual net margin of 21.1% and annual return on equity of 11.5%.

Regarding the material expansion in net margin that I touched on earlier, the company was printing single-digit annual net margin 10 years ago. It’s hard to overstate the improvement here.

There’s very little to dislike about Morgan Stanley.

It’s a world-class institution that has melded together two fantastic business models in investment banking and wealth management.

And with global scale, a network effect, switching costs, brand power, and industry know-how, the company does benefit from durable competitive advantages.

Of course, there are risks to consider.

Regulation, litigation, and competition are omnipresent risks in every industry.

The financial industry is highly competitive, although Morgan Stanley’s scale limits this somewhat.

On the other hand, regulation is a major, ongoing issue that only becomes more problematic at scale.

The company is heavily reliant on corporate action. Any economic slowdown would likely result in a reduction of this kind of activity.

There is substantial exposure to global capital markets here. Negative world events, including geopolitical flareups and/or recessions, can reduce asset values and the fees that Morgan Stanley can collect.

Executional risks are present. Recent acquisitions of Eaton Vance and E-Trade must be properly integrated and utilized.

The last decade’s expansion in margin is highly unlikely to repeat itself.

It’s good to be mindful of the risks, but I still think Morgan Stanley’s overall caliber outweighs them.

And with the stock down 20% from its 52-week high, the valuation has become attractive…

Stock Price Valuation

The stock is trading hands for a P/E ratio of 10.9.

That’s about half that of the broader market’s earnings multiple.

It’s also lower than the stock’s own five-year average P/E ratio of 11.6.

And the yield, as noted earlier, is much 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 7%.

That dividend growth rate is not as aggressive as I can go.

And when you look at what Morgan Stanley has demonstrated in terms of EPS and dividend growth over the last decade, this might look conservative.

But I think some caution is warranted.

Morgan Stanley has had an amazing decade. Highly impressive across the board. But the road ahead becomes more difficult, with less liquidity, hot geopolitics, and rising recession risks all looming.

Still, even with CFRA’s EPS growth slowdown factored in, the overall quality of the business, along with the low payout ratio, gives the company leeway on future dividend raises.

I see this as a fair assessment of their long-term dividend growth potential.

The DDM analysis gives me a fair value of $99.87.

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 putting it through a sensible valuation model, 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 MS as a 3-star stock, with a fair value estimate of $89.00.

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 MS as a 4-star “BUY”, with a 12-month target price of $115.00.

I came out in the middle this time around. Averaging the three numbers out gives us a final valuation of $101.29, which would indicate the stock is possibly 16% undervalued.

Bottom line: Morgan Stanley (MS) is a high-quality company that has put two excellent business models under one roof. It’s now a world-class financial institution with few rivals, which bodes extremely well for their future prospects. With a 3%+ yield, double-digit dividend growth, a low payout ratio, eight consecutive years of dividend increases, and the potential that shares are 16% undervalued, long-term dividend growth investors would be wise to consider buying this stock on the big dip.

— 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 MS’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 55. 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, MS’s dividend appears Borderline Safe with a moderate risk of being cut. Learn more about Dividend Safety Scores here.

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Source: DividendsAndIncome.com