When you’re truly investing for the long term, there’s one thing you must have.
You must have confidence in the business model and its long-term viability and prospects.
How do you gain this confidence?
Investing in a world-class business that provides critical products and/or services is a great start.
Without this confidence, it’s almost impossible to successfully invest.
I’ve built up a large investment portfolio myself over the years – a portfolio that I refer to as the FIRE Fund.
This real-money portfolio produces enough five-figure passive dividend income for me to live off of.
Indeed, I do actually live off of dividends.
I actually retired in my 30s by living off of dividends rather than a paycheck.
My Early Retirement Blueprint explains exactly how I was able to achieve this feat.
A pillar of this Blueprint is, of course, the investment strategy I’ve been using over the years.
That strategy is dividend growth investing.
This brings me back to my original point on confidence.
See, dividend growth investing is all about investing in world-class businesses that pay reliable, rising dividends to shareholders.
Well, reliable, rising profits come about by providing the world with critical products and/or services.
This all rings a bell, right?
You can find hundreds of US-listed stocks that have raised dividends each year for at least the last five consecutive years by perusing the Dividend Champions, Contenders, and Challengers list.
Because of the way dividend growth investing is structured, you’re almost automatically filtered right into world-class businesses that are easy to have confidence in for the long term.
But successful long-term investing involves more than just confidence.
Valuation at the time of investment is another very important aspect.
While price is what you pay, 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.
Investing in world-class businesses that pay reliable, rising dividends, and doing so when they’re undervalued, should provide you with plenty of investment confidence and success over the long term.
Now, spotting undervaluation would require one to first understand valuation.
Fortunately, it’s not that difficult.
Fellow contributor Dave Van Knapp has made it even easier through the introduction of Lesson 11: Valuation.
One of his “lessons” on dividend growth investing, it describes a valuation process that can be used to estimate the fair value of just about 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…
United Parcel Service, Inc. (UPS) is a multinational shipping & receiving and supply chain management company.
Founded in 1907, UPS is now a $150 billion (by market cap) shipping juggernaut that employs 400,000 people.
The company reports results across three segments: U.S. Domestic, 62% of FY 2021 revenue; International, 20%; and Supply Chain Solutions, 18%.
This is the world’s largest package delivery company. UPS uses nearly 600 planes and more than 100,000 vehicles to deliver millions of packages to residences and businesses worldwide every single day.
UPS operates a simple-to-understand business model with a very straightforward long-term investment thesis, and this thesis involves a high degree of confidence.
The world is full of consumers.
Naturally, they consume a lot of stuff.
Well, UPS is there to logistically make sure that stuff gets properly transported so that it can be consumed.
It’s as simple as that.
However, the simplicity makes it no less attractive.
If anything, it’s the opposite.
This is a fantastic business. And it’s becoming more fantastic by the day.
That’s because UPS has two powerful and enduring tailwinds blowing their way.
First, global consumption is growing.
This is the result of a huge global population – nearly 8 billion people – that is increasing in size while simultaneously becoming wealthier.
Second, more goods are being shipped directly to consumers after online purchases.
Because of the meteoric rise of e-commerce over the last decade, demand for point-to-point shipping has also dramatically risen.
As the world’s largest package delivery company, that plays right into the company’s hands.
That should lead to UPS being able to continue growing its revenue, profit, and dividend for decades into the future.
Dividend Growth, Growth Rate, Payout Ratio and Yield
UPS has already increased its dividend for 13 consecutive years.
The 10-year dividend growth rate is 7%.
That’s not bad, especially considering the stock’s market-smashing yield of 3.5%.
That yield, by the way, is 70 basis points higher than its own five-year average.
There’s nothing wrong with that combination of yield and growth.
However, it’s actually better than it looks.
That’s because recent dividend growth has accelerated, with the most recent dividend increase coming in at a jaw-dropping 49%.
Even after that big move with the dividend, the payout ratio is still 49.7%.
That’s nearly a “perfect” payout ratio, harmoniously balancing retaining earnings for internal growth against returning cash to shareholders.
I like dividend growth stocks in what I refer to as the “sweet spot” – a yield of between 2.5% and 3.5%, paired with a high-single-digit (or better) dividend growth rate.
UPS ticks both the yield and growth boxes here, making it very sweet.
Revenue and Earnings Growth
As sweet as it might be, these dividend metrics are admittedly looking backward.
But investors are risking today’s capital for tomorrow’s rewards.
It’s future business growth and dividend growth that matters most.
As such, 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 produced in terms of top-line and bottom-line growth over the last decade.
And then I’ll uncover a near-term professional prognostication for profit growth.
Amalgamating the proven past with a future forecast should allow us to develop a reasonable idea as to where the business might be going from here.
UPS advanced its revenue from $54.1 billion in FY 2012 to $97.3 billion in FY 2021.
That’s a compound annual growth rate of 6.7%.
Strong top-line growth here.
I usually look for a mid-single-digit top-line growth rate from a large, mature business like this. UPS more than delivered.
Meanwhile, earnings per share moved up from $0.83 to $12.13 (adjusted) over this period, which is a CAGR of 34.7%.
Huge EPS growth.
Three quick caveats.
One, FY 2012 EPS was abnormally low. This lower starting base skews the growth rate higher than it ought to be.
Two, I used adjusted EPS for FY 2021. This is actually lower than GAAP EPS, as UPS recognized an MTM pension gain on a GAAP basis for FY 2021. Using GAAP EPS would have led to an even higher 10-year CAGR, but that would have been less accurate.
Three, the pandemic undoubtedly helped the company. Growth went into overdrive over the last two years.
No matter how you slice it, though, UPS has put up some great results.
Helping to propel a lot of this excess bottom-line growth has been a combination of slight margin expansion and share buybacks. Regarding the latter, the outstanding share count is down by approximately 9% over the last 10 years.
Looking forward, CFRA believes that UPS will compound its EPS at an annual rate of 8% over the next three years.
This would represent a major drop from the 34%+ CAGR UPS put up over the last 10 years.
However, I don’t see it as off-base at all.
As I just pointed out, we have to look at the 10-year EPS CAGR with caveats.
The difference between top-line and bottom-line growth in this case is very stark, and I explained why.
On the other hand, it’s unlikely for such a large delta to persist.
If we assume that revenue growth will remain in that high-single-digit range, it would be reasonable to expect EPS growth to come in pretty close to where CFRA is at here.
Buybacks alone could get you there.
And further margin expansion, aided by increasing automation at facilities, could also help.
UPS would then be able to grow the dividend at a like rate for the foreseeable future.
And pairing that ~8% dividend growth with a starting yield of 3.5% is a rather compelling combination of yield and growth, in my view.
Moving over to the balance sheet, UPS has a rock-solid financial position.
The long-term debt/equity ratio is 1.4, while the interest coverage ratio is approximately 25.
It’s due to low common equity, not an inordinate amount of debt, that the D/E ratio looks somewhat high.
Profitability is fairly robust.
Over the last five years, the firm has averaged annual net margin of 6.8% and annual return on equity of 192.2%.
ROE is obviously so high because of the low common equity I just touched on.
Net margin, however, could be higher. Signs of improvement have shown up over the last few years, and I think increasing automation will boost this metric further.
UPS has a terrific business that is positioned to benefit and profit from rising global consumerism.
And the company does have durable competitive advantages that include massive economies of scale, an established global network, cost efficiency, and high barriers to entry.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
Competition is heating up, with Amazon.com, Inc. (AMZN) building out a delivery network and insourcing logistics. This could hurt UPS doubly so, as Amazon is a large customer for UPS (accounting for more than 10% of annual revenue).
It’s possible that a recession is on the horizon. Such an event would temporarily reduce demand for goods and shipping, which would impact UPS.
The global supply chain is currently in a state of flux.
Soaring fuel costs are an issue. However, UPS does effectively hedge fuel price fluctuations with fuel surcharges.
Escalating labor costs are another risk.
I believe investors should carefully consider these risks, but I also think UPS can, and should, make for an excellent long-term investment.
With the stock down 25% from its recent high, creating what looks like an attractive valuation, I believe it could be a particularly excellent long-term investment right now…
Stock Price Valuation
The stock is trading hands for a P/E ratio of 14.2.
That’s well below the broader market’s earnings multiple.
It’s also way off of the stock’s own five-year average P/E ratio of 26.7.
But lumpy GAAP EPS skews this.
If we look at the cash flow multiple, which has been less lumpy, it’s currently at 10.2.
That’s much lower than its own five-year average of 15.4.
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%.
This number is far below both the long-term demonstrated EPS growth rate and near-term EPS growth forecast.
It’s also right in line with the proven 10-year DGR.
And with the payout ratio remaining almost perfectly balanced, I expect future dividend growth to roughly mirror EPS growth.
I don’t think this is a high hurdle for UPS to clear when we look out over the long run.
If anything, there’s a nice margin of safety here.
The DDM analysis gives me a fair value of $216.85.
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 put together a very fair valuation model, yet the stock looks materially undervalued to me.
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 UPS as a 3-star stock with a fair value estimate of $186.00.
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 UPS as a 4-star “BUY”, with a 12-month target price of $240.00.
I came out almost exactly in the middle. Averaging the three numbers out gives us a final valuation of $214.28, which would indicate the stock is possibly 23% undervalued.
Bottom line: United Parcel Service, Inc. (UPS) is a high-quality business that’s advantageously positioned in a world with rising consumption and point-to-point delivery. Logistics are only becoming more important to everyday life. With a market-smashing yield, 13 consecutive years of dividend increases, a recent dividend raise of nearly 50%, a balanced payout ratio, and the potential that shares are 23% undervalued, long-term dividend growth investors would be wise to consider shipping this stock into their portfolios.
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 UPS’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 69. 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, UPS’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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