What should an investor look for when they’re trying to find high-quality companies?
Well, lot of qualities come to mind pretty quickly.
But one quality, in particular, has to be near the top of the list.
If a company has shown an ability to endure for a century or more, that’s a great indication that it has the ability to endure for another century or more.
And if you’re a long-term investor, that’s exactly the kind of assurance you want.
I mean, who wants to go to bed wondering whether or not their investments will still be around in the morning?
Plus, durable businesses tend to consistently increase their sales and profits.
Because if they couldn’t do that, they wouldn’t last.
And this lays the groundwork for consistently increasing dividends.
This straightforward logic speaks on the basic premise of dividend growth investing.
You can find hundreds of these enterprises by perusing the Dividend Champions, Contenders, and Challengers list.
I’ve personally used this strategy for more than a decade now.
I built the FIRE Fund in the process.
That’s my real-money portfolio, and it produces enough five-figure passive dividend income for me to live off of.
Indeed, I do live off of dividends.
I actually quit my job and retired in my early 30s.
My Early Retirement Blueprint details how I was able to accomplish that.
A pillar of the Blueprint is, of course, dividend growth investing.
That said, dividend growth investing isn’t only about investing in the right businesses but also doing so at the right valuations.
Price is simply 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.
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.
Investing in high-quality businesses with extraordinary durability, and doing so when they’re undervalued, sets your wealth and passive income up for extraordinary durability.
Now, that endeavor does require one to understand valuation in the first place.
But it’s really not that difficult.
Fellow contributor Dave Van Knapp’s Lesson 11: Valuation has made it much easier to understand.
Part of an overarching series of “lessons” designed to teach investors the ins and outs of dividend growth investing, this lesson lays out a simple-to-follow valuation template that can be used to estimate the fair value of just about 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…
Bank of New York Mellon Corp. (BK) is a global financial services company.
Founded in 1784, Bank of New York Mellon is now a $34 billion (by market cap) financial giant that employs nearly 50,000 people.
Bank of New York Mellon provides a range of investment management and financial services in more than 100 markets across 35 countries.
The bank has three business segments: Securities Services, 45% of FY 2021 revenue; Market and Wealth Services, 30%; and Investment and Wealth Management, 25%.
Bank of New York Mellon is the largest global custody bank in the world, with over $46 trillion in assets under custody and administration. They also have approximately $2.3 trillion in assets under management.
If these numbers haven’t already clued you in, this is a powerhouse bank that provides critical services behind the global banking infrastructure. This is basically on the opposite end of the spectrum from an S&L bank.
In particular, Bank of New York Mellon specializes in institutional services, which includes trade execution, custody, securities lending, and clearance and settlement.
A broad array of accounting and administrative services are also available.
Through industry consolidation and advancements toward sticky custody assets, Bank of New York Mellon has built an enviable business model focused on scalable, fee-based securities servicing and fiduciary businesses.
Indeed, fee revenue accounted for roughly 80% of total FY 2021 revenue.
Because of the scale, stickiness of assets, and fee-based business model, the path of least resistance for the company is to slowly, but surely, grow larger.
And that bodes very well for their ability to continue growing their dividend.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Already, the bank has increased its dividend for 11 consecutive years.
Their 10-year dividend growth rate is 10.5%, which is very solid.
That said, there was some deceleration in the dividend growth over the last few years or so.
But I see that as a consequence of the financial environment, not as a result of some structural issue with the business.
The pandemic, in particular, hampered dividend growth.
However, with the environment perking up somewhat, the bank’s most recent dividend increase of 9.7% was right on the mark.
In addition, the stock offers an appealing 3.2% yield here.
That market-beating yield is 90 basis points higher than its own five-year average.
A flip of sorts has occurred here.
The dividend growth hasn’t been consistently high over the last five years, but the yield has also risen rather dramatically in the interim.
So the stock has essentially turned into more of a current income vehicle.
And I don’t think that’s the worst thing in the world, especially if the dividend growth returns to its former state.
With the payout ratio at only 32.9%, the bank has plenty of room to raise the dividend over the years to come.
I like dividend growth stocks in what I call the “sweet spot” – a yield of between 2.5% and 3.5%, paired with high-single-digit (or better) dividend growth.
We’re definitely in the sweet spot here.
Revenue and Earnings Growth
As sweet as these dividend metrics are, they’re looking backward.
But investors risk today’s capital for tomorrow’s rewards.
As such, I’ll now built out a forward-looking growth trajectory for the business, which will later be very helpful 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 then I’ll unveil a professional prognostication for near-term profit growth.
Blending the proven past with a future forecast should give us some idea as to what the business’s future growth path might look like.
Bank of New York Mellon increased its revenue from $14.1 billion in FY 2012 to $15.9 billion in FY 2021.
That’s a compound annual growth rate of 1.3%.
Not exactly inspiring.
However, this period has been about as challenging as it possibly gets for the bank.
Rates have been persistently low, global growth has been muted, and then a pandemic hit.
Meanwhile, EPS grew from $1.73 to $4.14 over this period, which is a CAGR of 10.2%.
What we can see here is, even with very little revenue growth, the bank can still put up strong EPS growth.
Just imagine what they could do with better top-line growth.
A combination of profitability improvement and extensive share buybacks helped to propel a lot of this excess bottom-line growth.
Regarding the latter, the outstanding share count is down by 27% over the last 10 years.
Looking forward, CFRA believes that Bank of New York Mellon will compound its EPS at an annual rate of 12% over the next three years.
That would represent a mild acceleration in EPS growth relative to what the bank has done over the last decade.
Is it unreasonable to expect that?
I don’t think so.
One of the big anchors weighing this enterprise down has been low rates. Their asset base is constrained.
But the US Federal Reserve is almost guaranteed to raise rates aggressively over the course of this year.
As such, Bank of New York Mellon (and its ilk) will benefit.
Like I stated only moments ago, the bank was able to put up a 10%+ CAGR in its EPS during a very challenging period with low rates and limited top-line growth.
If you lighten the weight of that rate anchor, the bank’s ability to head skyward increases.
Meantime, a big reason why Bank of New York Mellon has done so well over the last decade, despite low rates, is because of its scalable, fee-based business model.
Since the company has a substantial asset management business, it should continue to prosper alongside the global capital markets.
It’s built to succeed without high rates. But if rates rise, all the better.
With the payout ratio being so low, anything close to CFRA’s EPS growth forecast easily sets the company up to deliver high-single-digit or low-double-digit dividend raises for the foreseeable future.
And when you’re already starting off with a 3.2% yield, that’s compelling.
Moving over to the balance sheet, the company has a solid financial position.
The bank has $444.4 billion in total assets against $401.0 billion in total liabilities.
The Bank of New York Mellon’s long-term senior debt has credit ratings that are well into investment-grade territory: S&P, AA-; Moody’s, Aa2; and Fitch, AA.
I also think it’s now appropriate to point out that Warren Buffett has given his seal of approval to the bank.
Berkshire Hathaway Inc. (BRK.B) has a longtime investment in Bank of New York Mellon that is worth over $3 billion.
Profitability is robust, with nice margin expansion over the last decade.
Over the last five years, the firm has averaged annual net margin of 24.5% and annual return on equity of 10.1%.
This company has been doing business for nearly 250 years. One of the bank’s founders was Alexander Hamilton – you know, one of the Founding Fathers of the United States of America. It’s an incredible story.
Helping the bank to endure are durable competitive advantages that include massive scale, secure positioning in banking infrastructure, entrenched relationships built around sticky assets, and industry know-how around regulatory matters.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
Ongoing downward pressure in fees across banking, in general, could limit the company’s long-term growth trajectory.
The bank’s asset management business faces pressures of its own from the rise of low-cost, passive alternatives.
Also, the economic fallout from the pandemic remains unknown. Any lasting economic scars could negatively affect the bank.
And while rates are rising, they’re still historically low.
These are risks to seriously consider, but I still think this bank could be a great long-term investment.
That’s especially true with the stock 31% off of its 52-week and looking very undervalued…
Stock Price Valuation
The stock’s P/E ratio is 11.1.
That’s much lower than the broader market’s earnings multiple.
It’s also lower than its own five-year average of 12.3.
Also, the P/B ratio of 0.9 is notably lower than its own five-year average of 1.2.
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 7%.
That dividend growth rate is lower than the bank’s demonstrated dividend growth and EPS growth over the last decade. It’s also quite a bit lower than the near-term EPS growth expectation from CFRA.
The most recent dividend increase came in much higher than this.
And the payout ratio is low.
Overall, you could say that I’m being very conservative here.
I think caution is appropriate.
The global economy is currently in a precarious position. As a consequence, banks are, arguably, in a precarious position.
I think it’s very possible, if not likely, that the company exceeds this growth rate over the long run. But I would rather err on the side of caution.
The DDM analysis gives me a fair value of $48.51.
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 think I was careful with the valuation, yet the stock still 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 BK as a 4-star stock, with a fair value estimate of $55.00.
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 BK as a 3-star “HOLD”, with a 12-month target price of $50.00.
I came out low this time around. Averaging the three numbers out gives us a final valuation of $51.17, which would indicate the stock is possibly 14% undervalued.
Bottom line: Bank of New York Mellon Corp. (BK) operates a great business that has shown an incredible level of durability for more than two centuries. Its founding can be traced back to the founding of the USA. With a market-beating yield, double-digit long-term dividend growth, a low payout ratio, more than 10 consecutive years of dividend increases, and the potential that shares are 14% undervalued, this could be your opportunity to buy a Buffett-approved dividend growth stock while it looks cheap.
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 BK’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, BK’s dividend appears Borderline Safe with a moderate risk of being cut. Learn more about Dividend Safety Scores here.
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