I want to share one of my favorite Warren Buffett quotes.
“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
You almost can’t lose by investing in wonderful businesses for the long run. On the other hand, you almost can’t win by loading up a portfolio with junky businesses. This logic is at the heart of dividend growth investing.
This investment strategy advocates buying and holding shares in businesses that pay reliable, rising dividends to their shareholders.
Dividend growth investing basically funnels you right into wonderful businesses… automatically. That’s because it generally requires a business to be wonderful in the first place in order to produce the reliable, rising profit necessary to support reliable, rising dividends.
See what I mean by perusing the Dividend Champions, Contenders, and Challengers list. That list contains invaluable information on over 700 US-listed stocks that have raised their dividends each year for at least the last five consecutive years. As you can see, it’s often the household names – the wonderful businesses – that can do this.
I’ve been personally using this strategy for more than a decade now, using it to build my FIRE Fund.
That’s my real-money portfolio.
And it produces enough five-figure passive dividend income for me to live off of.
In fact, I do live off of dividends.
I’ve been doing so for years.
I actually quit my day job and retired in my early 30s.
I explain in my Early Retirement Blueprint exactly how I was able to accomplish this.
What I will quickly say here is, you can supercharge Buffett’s idea by investing in wonderful businesses when the valuation is also attractive.
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.
Using Buffett’s wisdom to invest only in wonderful businesses, but supercharging the idea by doing so when undervaluation is present, sets you up to generate immense wealth and passive income over the course of your life.
Of course, taking this action means you first understand valuation.
Fellow contributor Dave Van Knapp’s Lesson 11: Valuation, which is part of an overarching series of “lessons” on dividend growth investing, will help you.
This lesson teaches the basics of valuation and presents a valuation template that can be easily applied toward 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…
U.S. Bancorp (USB) is a bank holding company that offers a diversified mix of financial services, including traditional retail banking, wealth management, commercial banking, and payment services.
Founded in 1863, U.S. Bancorp is now a $68 billion (by market cap) banking giant that employs 69,000 people.
Operating as the fifth-largest American bank by deposits, U.S. Bancorp has over 3,000 branches spread out across 25 different states (primarily in the Midwest and West).
The bank ranks first in deposit share in four states, while it has a top-five position in 17 states.
The company reports results across five business segments: Consumer & Business Banking, 38% of FY 2021 revenue; Payment Services, 26%; Corporate & Commercial Banking, 17%; Wealth Management & Investment Services, 14%; and Treasury and Corporate Support, 5%.
What better business to be in to make money than in the business of money itself?
The core banking business model is one of the best out there, due to the “float”.
Access to large sums of low-cost and low-risk capital – deposits – can be used to fund loans and other ventures that generate attractive returns.
Because of this, the banking business model is one of my favorite business models.
But don’t take just my word for it.
Warren Buffett also loves the banking business model – he’s invested heavily into a number of banks, including having approximately $5.5 billion invested in U.S. Bancorp.
Banking is one of the oldest business models in civilization, dating back to antiquity.
Why is it so enduring?
Society’s ongoing prosperity has been, and continues to be, dependent on banking and the flow of capital.
Without banking, our way of life essentially collapses.
This leads me to strongly believe that banking will endure for many centuries to come, which bodes well for U.S Bancorp to keep growing its revenue, profit, and dividend well into the future.
Dividend Growth, Growth Rate, Payout Ratio and Yield
As things stand, the company has increased its dividend for 12 consecutive years.
If not for the Great Recession, the bank would have a much more impressive dividend growth track record.
Still, the 10-year dividend growth rate of 11.1% shows that U.S. Bancorp has been making up for lost time.
And you’re able to pair that double-digit dividend growth rate with the stock’s current yield of 4.1%.
That yield blows away what the broader market offers.
It’s also 100 basis points higher than its own five-year average.
This is a super compelling mix of yield and growth.
With a payout ratio of only 39.7%, this is a healthy dividend poised for many more sizable increases in the years ahead.
Terrific dividend metrics right across the board here.
Revenue and Earnings Growth
As terrific as these metrics might be, they’re largely looking backward.
However, investors are risking today’s capital for the rewards of tomorrow.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will later be of great aid when it comes time to estimate the stock’s intrinsic value.
I’ll first show you what this company has done over the last decade in terms of its top-line and bottom-line growth.
And then I’ll uncover a near-term professional prognostication for profit growth.
Amalgamating the proven past with a future forecast in this way should allow us to develop a model about where the business might be going from here.
U.S. Bancorp advanced its revenue from $20.3 billion in FY 2012 to $22.8 billion in FY 2021.
That’s a compound annual growth rate of 1.3%.
I would like to see a higher top-line growth rate, but the last decade has been unusually challenging for banks.
Scars from the GFC have lingered, including historically low interest rates, additional regulation, and general caution around growth.
And then we threw a global pandemic in there.
All that said, the bottom line has fared better.
The bank grew its earnings per share from $2.84 to $5.10 over this period, which is a CAGR of 6.7%.
That’s a bit more like it.
I think this is actually a pretty good result when considering how difficult the last decade has been.
Much of this excess bottom-line growth was driven by share buybacks, with the outstanding share count down by 21% over the last decade.
Looking forward, CFRA believes that U.S. Bancorp will compound its EPS at an annual rate of 6% over the next three years.
CFRA sees “strength in NII [net interest income], a continued rebound in payment services revenue, and weakness in mortgage banking revenue.”
So you have some strengths offsetting some weaknesses.
CFRA adds further color and conviction: “Over the next twelve months, we expect benefits from USB’s digital transformation to result in positive operating leverage. Although we see higher growth rates in other regional banks, we are encouraged by USB’s conservative risk profile as recessionary fears continue to mount.”
I think that sums up U.S. Bancorp perfectly.
It’s a conservatively-run regional bank that benefits from diversification.
It also illustrates what’s so great about modern banks.
Banks have taken a business model that’s already incredibly enduring and lucrative, as I touched on earlier, and bolted on modern-day fee-based opportunities such as credit cards, processing services, investment management, trust services, and various investment products.
Indeed, the bank’s Payment Services business segment comprises more than 1/4 annual revenue.
This is why U.S. Bancorp was able to grow its EPS at a respectable rate during a very tough decade.
However, the next decade could be a lot better for the company.
We’re getting further and further away from the GFC, the pandemic is mostly behind us, and rising rates benefit the large float.
If we take CFRA’s forecast as our base case for near-term EPS growth, that still sets up shareholders for at least high-single-digit dividend growth over the foreseeable future – a low payout ratio allows for this.
When you’re looking at a 4%+ yield to start with, I think there’s a lot to like about that picture.
Moving over to the balance sheet, the bank has a great financial position.
Total assets of $573 billion line up well against $518 billion in total liabilities.
Their senior unsecured debt has the following credit ratings: A2, Moody’s; A+, S&P; A+, Fitch.
These ratings are well into investment-grade territory.
Profitability for the bank is among the best in the industry.
Over the last five years, the firm has averaged annual net margin of 27.9% and annual return on equity of 13.9%. Net interest margin came in at 2.5% last year.
This is a terrific financial institution, which is probably why Buffett has given his seal of approval.
And the bank does have durable competitive advantages that include economies of scale, “sticky” deposits, switching costs, established relationships, and an entrenched float.
Of course, there are risks to consider.
Competition, regulation, and litigation are omnipresent risks in every industry.
Banks are highly exposed to economic cycles; a recession could hurt the bank through reduced deposits and loan demand on the income statement, as well as higher credit losses on the balance sheet.
If there are lasting economic scars from the pandemic, like there were from the GFC, this could create long-term growth headwinds for the company.
Interest rates have been persistently low over the last decade, limiting growth, but rates are finally on the rise.
U.S. Bancorp has announced that it’s acquiring MUFG Union Bank for approximately $8 billion through cash and stock, which adds near-term questions around execution and capital use.
I see these risks as pretty standard for a bank, but the valuation could be quite special.
After dropping nearly 30% from its 52-week high, the valuation now looks very appealing…
Stock Price Valuation
The stock is trading hands for a P/E ratio of 10.6.
That’s almost half of where the broader market’s P/E ratio is at.
It’s also well off of the stock’s own five-year average P/E ratio of 12.9.
This stock typically has a pretty undemanding earnings multiple, but it appears to be especially undemanding right now.
We can also see that the P/B ratio of 1.6 is lower than its own five-year average of 1.7.
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 not as high, nor as low, as I can go.
I think a down-the-middle approach works here.
This is quite a bit lower than the demonstrated dividend growth rate over the last decade.
On the other hand, it is fairly close to the bank’s 10-year EPS CAGR.
And it’s not far off from CFRA’s near-term projection for EPS growth.
With the payout ratio at a modest level, I believe this is a reasonable, if conservative, judgment of the bank’s dividend growth capability over the foreseeable future.
The DDM analysis gives me a fair value of $65.63.
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 put forth a rational valuation model, yet the stock comes out looking extremely 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 USB as a 4-star stock, with a fair value estimate of $59.00.
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 USB as a 3-star “HOLD”, with a 12-month target price of $48.00.
There’s a range here, and I came out on the high end, but we all view the current pricing as favorable. Averaging the three numbers out gives us a final valuation of $57.54, which would indicate the stock is possibly 25% undervalued.
Bottom line: U.S. Bancorp (USB) is a large, high-quality financial institution that operates one of the world’s most enduring and powerful business models. It’s been able to buffer operational volatility through consistent fees, even while it should benefit from rising rates. With a market-beating yield, a double-digit dividend growth rate, a modest payout ratio, more than 10 consecutive years of dividend increases, and the potential that shares are 25% undervalued, long-term dividend growth investors should consider investing in this company alongside Warren Buffett.
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 D&I: How safe is USB’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, USB’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
Start Collecting Daily Dividend Checks [sponsor]
After researching income stocks for over 30 years, I've come up with a one of a kind dividend portfolio. With the right 20-30 stocks, you can collect a dividend check every single day the market is open. That's over 260 dividend checks per year. Click here for the names of these 20+ stocks.
Source: Dividends & Income