The broader market has gone on a nice run over the last few weeks.
You can look at this in one of two ways.
On one hand, the value of your portfolio (and your net worth) rises.
On the other hand, it makes new equity purchases more expensive.
No matter how you feel about that, I think it’s even more important during market run-ups to find the deals.
It’s so helpful to have the mentality of a bargain hunter.
What can I say?
I like the deals.
But I’m looking for deals on a particular type of merchandise.
I’m talking about high-quality dividend growth stocks.
These stocks represent equity in world-class businesses that pay reliable, rising dividends.
And how do those reliable, rising dividends get funded?
Through reliable, rising profits.
I’ll show you what I mean.
The Dividend Champions, Contenders, and Challengers list contains invaluable information on hundreds of US-listed stocks with at least five consecutive years of dividend raises.
And for good reason.
It takes a special kind of business to do what I’m laying out here.
I’ve been buying dividend growth stocks for years, loading up my FIRE Fund with them.
That’s my real-money portfolio, and it produces enough five-figure passive dividend income for me to live off of.
Indeed, I’ve been living off of dividends for years.
In fact, I retired in my early 30s.
My Early Retirement Blueprint describes how I was able to retire so early in life.
A crucial element of my success relates not just to the stocks I have been buying but the valuations at which I’ve been buying them.
Price is 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.
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.
Constantly seeking, and receiving, deals on high-quality dividend growth stocks sets up an investor for prodigious wealth, passive dividend income, and freedom over the long term.
Now, a prerequisite for all of this is having some understanding of the concept of valuation.
Fellow contributor Dave Van Knapp has you covered.
His Lesson 11: Valuation, which is part of an overarching series of “lessons” on all aspects of dividend growth investing, puts forth a simple-to-understand valuation model 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…
Cisco Systems, Inc. (CSCO) is a leading designer, manufacturer, and supplier of data networking equipment and software.
Founded in 1984, Cisco is now a $196 billion (by market cap) tech monster, employing approximately 83,000 people.
The company reports results across six groups: Secure, Agile Networks, 54% of FY 2022 sales; Optimized Application Experiences, 28%; Internet for the Future; 11%; Collaboration, 7%; End-to-End Security, less than 1%; and Other Products, less than 1%.
The investment thesis here is actually very simple, in my view.
Investing in Cisco is investing in the current and future infrastructure of technology we all use every single day.
Without this infrastructure, there is no such thing as, for example, jumping “online” to use the Internet.
Cisco is the major supplier of switches, routers, firewalls, and supportive networking products.
The various products and services that Cisco sells are critical to network performance and security.
But this is about tomorrow, too.
As the Internet continues to evolve into the Internet of Things – a ubiquitous interconnection of computing devices into everyday objects – Cisco’s products and services will become that much more critical.
And that’s what paves such a long runway for the company’s growth across its revenue, profit, and dividend.
Dividend Growth, Growth Rate, Payout Ratio and Yield
As things stand, Cisco has increased its dividend for 12 consecutive years.
The 10-year dividend growth rate is 18.3%.
That is clearly outstanding.
However, it’s important to point out that more recent dividend raises have been in the 3% range.
I see Cisco’s long-term dividend growth path as being somewhere between these two numbers.
That belief is partially supported by the moderate payout ratio of 53.9%.
This gives the company leeway on the dividend.
Meantime, the stock yields a market-beating 3.1%.
This yield, by the way, is 20 basis points higher than its own five-year average.
Investors are looking at a nice mix of income and growth here.
Speaking of that, 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 higher) dividend growth rate.
Cisco is right in the sweet spot.
Revenue and Earnings Growth
As much as that may be true, these dividend metrics are largely looking in the rearview mirror.
But investors are risking the capital of today for the rewards of tomorrow.
That’s why 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 its top-line and bottom-line growth.
And I’ll subsequently unveil a professional prognostication for near-term profit growth.
Deftly amalgamating the proven past with a future forecast should allow us to draw a sensible conclusion as to where the company might be going from here.
Cisco increased its revenue from $48.6 billion in FY 2013 to $51.6 billion in FY 2022.
That’s a compound annual growth rate of 0.7%.
I usually look for a mid-single-digit top-line growth rate from a mature company like this, and Cisco’s lack of more meaningful revenue growth is slightly disappointing.
Meanwhile, earnings per share rose from $1.86 to $3.36 (adjusted) over this period, which is a CAGR of 6.8%.
After looking at Cisco a number of times over the years, boiling it down, it’s always struck me as a business that should be good for a ~7% bottom-line growth rate over the long run.
But certainly not bad.
Cisco isn’t growing as fast as some other tech companies out there, but it’s been pretty reliable.
Consistent and substantial share buybacks have long been part of that narrative, and Cisco did reduce its outstanding share count by 22% over the last 10 years.
That definitely helped to create a lot of the excess bottom-line growth we can see here.
Looking forward, CFRA anticipates that Cisco will compound its EPS at an annual rate of 6% over the next three years.
This is unsurprising to me.
As I just alluded to, it’s right in line with what, in my view, Cisco boils down to – a consistent 6% to 7% EPS grower over the long run.
CFRA almost perfectly captures the Cisco investment thesis well with this: “…We continue to believe the long-term prospects for [Cisco] are positive, including the WiFi 6 upgrade cycle and 5G core deployments. We expect component shortages to be a short-term drag on revenue growth, but see the issue subsiding early in FY 23. We see [Cisco] benefiting from a rapid rise in bandwidth consumption, the high demand for data center solutions, and the migration to cloud networking. [Cisco’s] strong balance sheet will facilitate further M&A activity, share buybacks, and dividend hikes.”
Touching on share buybacks again, which circles back to what I noted earlier, Cisco added $15 billion to its buyback program earlier this year.
That amounts to 7.5% of the entire company’s market cap.
If we assume that Cisco will grow its EPS at this 6% to 7% level over the years to come, that should translate to similar dividend growth.
That would split the difference between the 10-year demonstrated dividend growth rate and the more recent dividend raises in the 3% range.
I think an expectation for Cisco to grow its dividend at somewhere around 7% over the long run would be a reasonable expectation to have.
Combining that kind of dividend growth with the 3.1% starting yield makes for a compelling total package.
Moving over to the balance sheet, Cisco has a fantastic financial position.
The long-term debt/equity ratio is 0.2, while the interest coverage ratio is over 41.
Furthermore, total cash laps long-term debt more than twice over.
This is a fortress balance sheet.
Profitability is undoubtedly robust.
Over the last five years, the firm has averaged annual net margin of 17.7% and annual return on equity of 22.4%.
Cisco isn’t super exciting, but boring can be beautiful.
There’s something inherently attractive about a steady-eddy, dependable business.
And with economies of scale, IP, technological know-how, and switching costs, the company does benefit from durable competitive advantages.
Of course, there are risks to consider.
Litigation, regulation, and competition are omnipresent risks in every industry.
Cisco must constantly innovate and stay ahead of the tech curve.
The company is reliant on enterprise spending, and a broader economic slowdown could impact this spending.
Cisco has been acquisitive, with bolt-on acquisitions being a consistent strategy, which introduces execution and integration risks.
And recent kinks in the global supply chain have been hurting Cisco’s ability to deliver products.
The risks should be acknowledged, but so should the overall stability and appeal of the business.
And after the stock’s 25% drop from its 52-week high, the valuation is definitely worth acknowledging…
Stock Price Valuation
The forward P/E ratio is only 13.7.
That’s based on midpoint adjusted EPS guidance for FY 2023.
Cisco isn’t growing super fast, but this valuation has clearly already priced that in.
We are looking at a very undemanding earnings multiple.
Also, the P/CF ratio of 4.9 is lower than its own five-year average of 5.1.
And the yield, as noted earlier, is 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 DGR ties back to what I’ve been noting all along: Cisco should be good for 7% bottom-line and dividend growth over the long run.
This number conservatively splits the difference between the 10-year demonstrated dividend growth rate and the size of more recent dividend raises.
It’s also not far off from Cisco’s 10-year EPS growth rate, or CFRA’s near-term EPS growth forecast.
I see this as a reasonable long-term expectation, although I would anticipate some modest lumpiness along the way.
The DDM analysis gives me a fair value of $54.21.
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 was very careful with my valuation, yet the stock’s pricing still looks quite 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 CSCO as a 4-star stock, with a fair value estimate of $54.00.
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 CSCO as a 5-star “STRONG BUY”, with a 12-month target price of $60.00.
I think we have a nice consensus here, with my number coming out within pennies of where Morningstar is at. Averaging the three numbers out gives us a final valuation of $56.07, which would indicate the stock is possibly 15% undervalued.
Bottom line: Cisco Systems, Inc. (CSCO) is favorably exposed to the technology needs of today, yet it’s also poised to benefit from the technology needs of tomorrow. The fortress balance sheet and super consistent results offer a rare level of dependability in the industry. With a market-beating yield, a moderate payout ratio, a double-digit long-term dividend growth rate, more than 10 consecutive years of dividend increases, and the potential that shares are 15% undervalued, dividend growth investors looking for more tech exposure should seriously consider investing in this business here.
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 CSCO’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 91. 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, CSCO’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