The stock market is very different from most other markets.

It’s the only market where people seem to wish for higher prices.

This is seemingly irrational, especially if you’re an active buyer of what the market offers.

However, regardless of the market or merchandise, you should always wish to pay less.

Warren Buffett puts it like this: “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”

I couldn’t agree more.

And when speaking about quality merchandise (stocks, not socks), I immediately think of high-quality dividend growth stocks.

Why?

It’s simple.

These stocks represent equity in some of the best businesses in the world.

The Dividend Champions, Contenders, and Challengers list says it all.

This list contains invaluable information on hundreds of US-listed stocks that have raised dividends each year for at least the last five consecutive years.

Jason Fieber's Dividend Growth PortfolioIf you peruse that list, you’ll see countless household names.

After all, it takes a special kind of business to be able to routinely grow profit in such a way that the dividend can also routinely grow.

I’ve been buying high-quality dividend growth stocks for years, building out my FIRE Fund in that process.

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

I’ve actually been living off of dividends for years.

I chose to quit my job and retire in my early 30s.

And I share in my Early Retirement Blueprint how I was able to make this happen.

Now, quality merchandise is very important.

However, Buffett also pointed out the importance of seeking markdowns.

This comes down to valuation.

Whereas price is what you pay, it’s value that 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.

Using Buffett’s sage advice to buy quality merchandise when it’s marked down, and focusing those efforts into undervalued high-quality dividend growth stocks, sets an investor up for life-changing amounts of wealth and passive income over the long run.

Of course, this would first require one to fully understand the concept of valuation.

Fear not.

My colleague Dave Van Knapp’s Lesson 11: Valuation is here to help.

Part of an overarching series of “lessons” on dividend growth investing, it teaches the ins and outs of valuation and puts forth a valuation template that can be applied toward 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…

Essex Property Trust Inc. (ESS)

Essex Property Trust Inc. (ESS) is a real estate investment trust that owns and operates a portfolio of US West Coast multifamily properties.

Founded in 1971, the company is now a $15 billion (by market cap) real estate mammoth that employs nearly 2,000 people.

Essex Property Trust focuses on three different supply-constrained markets: Southern California, 44% of revenue; Northern California, 38%; and Seattle Metro, 19%.

The company’s property portfolio consists of approximately 62,000 apartment homes across 253 apartment communities.

While many REITs own discretionary types of real estate (shopping centers, for example), Essex Property Trust concentrates on the non-discretionary need that is shelter.

Built-in, never-ending demand is what gives this company so much staying power.

There is almost no risk of obsolescence.

No matter what happens with technology or trends, people will always need somewhere to live.

Now, the company’s West Coast concentration could be argued to be both the company’s greatest strength and greatest weakness.

On one hand, a combination of unique geography and gratuitous amounts of red tape conspire to limit supply.

This works to the company’s advantage.

Entrenched supply is that much more valuable.

And these issues also apply to houses, which serves to make rent more affordable by comparison.

In addition, the West Coast has been a fabulous creator of high-paying jobs, and the location is naturally desirable for climate and nature reasons.

On the other hand, a very high COL, a homelessness crisis, and rising crime along the I-5 corridor temper demand.

In addition, the work-from-home trend makes it easier for West Coast professionals to move to cheaper locations inland, further reducing demand.

On balance, I believe the strengths greatly outweigh the weaknesses.

And this belief stems from the company’s financial results, which continue to show growth across revenue, profit, and the dividend.

Dividend Growth, Growth Rate, Payout Ratio and Yield

As it sits, Essex Property Trust has increased its dividend for 28 consecutive years.

Yes, this is a vaunted Dividend Aristocrat.

In fact, it’s one of the very few Dividend Aristocrats that’s a REIT.

The 10-year dividend growth rate is a solid 7.2%.

And the stock offers a market-beating 3.9% yield to go along with that.

This yield, by the way, is 80 basis points higher than its own five-year average.

Since the payout ratio is just 60.9%, based on midpoint guidance for this year’s FFO/share, we have what appears to be a very secure dividend.

This is a Dividend Aristocrat offering a pretty high yield and a pretty high dividend growth rate.

I’m not sure what else one might want.

These are great dividend metrics right across the board.

Revenue and Earnings Growth

As great as the metrics might be, though, they’re mostly looking at the past.

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

As such, I’ll now build out a forward-looking growth trajectory for the business, which will later be instrumental when it comes time to estimate the stock’s intrinsic value.

I’ll first go over what this company has done in terms of its top-line and bottom-line growth.

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

Combining the proven past with a future forecast should give us the ability to draw reasonable conclusions about where the business could be going.

Essex Property Trust increased its revenue from $535 million in FY 2012 to $1.4 billion in FY 2021.

That’s a compound annual growth rate of 11.3%.

Great top-line growth, but we have to keep in mind that a REIT (like this) typically funds absolute growth by issuing equity and debt.

That’s why it’s especially important to look at profit growth on a per-share basis when dealing with a REIT.

Moreover, instead of looking at earnings, you want to look at funds from operations.

FFO is a measure of cash generated by a REIT, which adds depreciation and amortization expenses back to earnings.

The company grew its FFO/share from $6.71 to $13.98 over this period, which is a CAGR of 8.5%.

Not quite as sharp as top-line growth, but this is still a strong number.

We can now see how the REIT has been able to fund that high-single-digit dividend growth over the last decade – high-single-digit FFO/share growth funded it.

Looking forward, CFRA currently has no three-year growth projection for the REITs FFO/share.

This is unfortunate, as I do like to compare the proven past up against a future forecast.

Doing so allows us to develop a pretty good idea as to where the business might be going from here.

Instead, I’ll go straight to Essex Property Trust’s guidance.

The company actually increased its FY 2022 guidance in its most recent Q2 report, which was released in late July.

Here’s the quote straight from the earnings release: “Increased full-year Core FFO per diluted share guidance by $0.29 at the midpoint to $14.45, representing 15.7% year-over-year growth.”

I mean, that says it all.

Essex Property Trust continues to reliably grow at a brisk pace.

This shouldn’t be a surprise, as rents across the US have been rapidly inflating.

The company points this out in their recent earnings report: “Return to office mandates at many of the large technology companies became a catalyst for strong housing demand in our Northern California and Seattle markets, which now lead the Essex portfolio with year-to-date net effective rent growth of 18.1% and 19.9%, respectively.”

In that same quarter, the company reported a 96.1% occupancy rate.

For anyone fearing the narrative around people fleeing California, because of remote work or other issues, that’s simply not showing up in the numbers.

And I think this really comes back around to the unique geography of California, which serves as a competitive advantage for the company.

Limited supply of both houses and apartments across California is keeping prices high, but apartments remain far more affordable for most people.

And the thing about California is that it’s a great place to have a real estate footprint.

If California were an independent country, it’d have the fifth-largest GDP in the world.

California has a massive economy supported by the high-paying jobs that are required to afford high shelter costs, and California remains a desirable place to live in terms of climate and nature.

It all boils down to this: Essex Property Trust is renting almost all of its units out, and these units are commanding substantially higher rents than before the pandemic.

That bodes well for continued growth across revenue, FFO/share, and the dividend.

With the near-4% yield to start with, the total package here is quite appealing.

Financial Position

Moving over to the balance sheet, the company’s financial position is very good.

Essex Property Trust has $13 billion in total assets against $6.8 billion in total liabilities.

The company’s investment-grade credit ratings are as follows: BBB+, Fitch; Baa1, Moody’s; and BBB+, Standard & Poor’s.

Essex Property Trust has been a fantastic investment for 25+ years.

From its 1994 IPO through July 2022, the stock’s 5,123% total return blows away the 1,452% total return from the S&P 500.

I see no reason why the next 25 years won’t also be fantastic.

And with economies of scale, higher-end properties, regulatory know-how in difficult markets, and an entrenched footprint in supply-constrained and desirable locations, 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.

California’s notorious red tape is a double-edged sword – supply limitations aid existing properties, but it’s difficult to grow the portfolio.

Real estate is cyclical, and a major recession could reduce demand for luxury apartments, although the basic need of shelter does cushion the overall cyclicality.

Concentration around tech hubs could impact demand for the company’s apartments if a major downturn strikes tech companies at large.

The capital structure of a REIT creates reliance on external funding for growth, and rising interest rates will impact the business.

Essex Property Trust lacks geographic diversification.

The West Coast exposure introduces risks of natural disasters, such as earthquakes.

As work becomes more flexible, more people could choose to leave the company’s geographic area.

The risks here are definitely worth thinking over, but most of these risks are not new.

And with the stock down almost 40% YTD and back to 2015 prices, despite the business growing dramatically since 2015, I see the valuation as attractive enough to overcome the risks…

Stock Price Valuation

The forward P/FFO ratio is 15.7, based on guidance.

That’s analogous to a P/E ratio on a normal stock, showing just how lowly valued this name has become.

As I noted earlier, you measure a REIT by its cash flow.

Well, the P/CF ratio of 15 is well off of its own five-year average of 21.3.

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 6.5%.

This dividend growth rate is nowhere near as high as I can go, but it’s also not the bottom.

It strikes a balance, which I believe is appropriate here.

The 10-year dividend growth rate is higher than this, and the company has been growing the bottom line at a faster rate.

However, the company’s most recent dividend increase was only 5.3%.

And there are near-term challenges and uncertainties to work through.

It’s quite possible that the dividend grows faster than my number over the long run, but I always like to err on the side of caution.

The DDM analysis gives me a fair value of $267.77.

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 put forth a very reasonable valuation model, yet the pricing still looks low.

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 ESS as a 4-star stock, with a fair value estimate of $322.00.

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 ESS as a 3-star “HOLD”, with a 12-month target price of $305.00.

I came out low this time around, which supports the notion of my caution. Averaging the three numbers out gives us a final valuation of $298.26, which would indicate the stock is possibly 31% undervalued.

Bottom line: Essex Property Trust Inc. (ESS) is a high-quality REIT providing a basic, non-discretionary need. And it has absolutely trounced the broader market over the course of decades by doing so. With a market-beating yield, a moderate payout ratio, a high-single-digit dividend growth rate, almost 30 consecutive years of dividend increases, and the potential that shares are 31% undervalued, long-term dividend growth investors should seriously consider buying this Dividend Aristocrat.

-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 D&I: How safe is ESS’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 93. 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, ESS’s dividend appears Very Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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Source: Dividends & Income