There are a lot of ways to make money in this world.
I’d argue we have more ways than ever right now.
But almost every way that exists will require you to give up something very valuable in exchange for the money.
Time is your most valuable asset, and it’s slowly dwindling.
On the other hand, money isn’t going anywhere at all.
There’s plenty of it, and the supply of it is steadily expanding.
So how do you go about making money without giving up your time?
The most effective way to that, in my experience, is to employ the dividend growth investing strategy to your advantage.
This strategy involves buying and holding shares in world-class businesses that pay safe, growing dividends to their shareholders.
These safe, growing dividends are funded by underlying profit that is also safe and growing.
You can find hundreds of businesses on the Dividend Champions, Contenders, and Challengers list.
This list has compiled an incredible amount of data on hundreds of US-listed stocks that have raised dividends each year for at least the last five consecutive years.
Dividends are completely passive.
Once you own shares in a company that pays dividends, you’re entitled to that ongoing stream of dividend income so long as the dividends remain forthcoming and you don’t sell the shares.
Dividends are awesome.
You wake up, and the dividend income is in your account.
It doesn’t get much easier or better than that, and no time is exchanged for the money.
I’ve employed this strategy for myself for more than 10 years now, building my 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.
I’m such a fan of living off of dividends, I quit my job and retired in my early 30s in favor of sustaining myself on dividend income.
My Early Retirement Blueprint explains how I was able to do such a thing.
Suffice it to say, a major aspect of my success has been buying the right stocks.
Not only that, but one has to buy when valuation is right.
Whereas price is what you pay, 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.
There are many ways to make money in this world, but buying high-quality dividend growth stocks when they’re undervalued and then collecting safe, growing dividend income for years afterward has got to be one of the best ways of all.
To be fair, this does mean that one has a basic understanding of valuation.
But it’s not that hard.
My colleague Dave Van Knapp put together Lesson 11: Valuation, one of his many “lessons” on dividend growth investing, in order to explain, in simple terms, valuation.
He provides an easy-to-follow valuation template that can be easily applied across most dividend growth stocks.
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…
Discover Financial Services (DFS)
Discover Financial Services (DFS) is an American financial services company.
Founded in 1985, Discover Financial is now a $27 billion (by market cap) major financial services player that employs 20,000 people.
The company reports results across two business segments: Digital Banking, 98% of FY 2022 revenue; and Payment Services, 2%.
Discover Financial has a very interesting business model.
At its core, it’s a bank.
And banks have been around since antiquity, showing a rare kind of enduring usefulness.
Without an organized way to handle commerce, which banks allow for, our society doesn’t really function.
Banks fill a necessary role, and they make a lot of money by doing so.
Not only that, but banks make money from other people’s money.
This occurs through the float, which is the low-cost, low-risk source of capital that accrues to a bank via deposits.
Take in money at one rate, lend at a higher rate.
Earning from a spread isn’t a bad way to go.
Discover Financial has all of this, except it does traditional banks one better by operating totally digitally.
The company boasts $71 billion in direct-to-consumer deposits.
Going direct reduces overhead.
Discover Financial has also bolted a payment network on top of the digital bank.
In fact, Discover Financial operates one of the world’s four major payment networks, putting it in an exclusive (and profitable) club.
Its Discover Network processed $263 billion in volume in FY 2022.
The world is increasingly moving to digital payments and becoming cashless.
This is a secular trend that plays right into the hands of Discover Financial.
While the Payment Services business segment is quite small on paper for Discover Financial, it’s much more important and valuable than it seems.
A symbiotic and harmonious business model has been designed where the networks feeds into the Digital Banking side of the business by creating customers, transactions, and loans (via credit card balances).
Since Discover Financial has no physical footprint, its Payment Services segment serves as a major gateway into the company’s fold.
Discover Financial operates two businesses that are independently powerful, and it then put them together in a highly complementary manner.
This is what positions the company for growth across its revenue, profit, and dividend for years to come.
Dividend Growth, Growth Rate, Payout Ratio and Yield
To date, the company has increased its dividend for 13 consecutive years.
And what a start the company is off to, with a 10-year dividend growth rate of 19.1%.
Remarkably, there’s been no material slowdown here.
Even the most recent dividend raise came in at almost 17%.
Accessing that kind of double-digit dividend growth usually requires one to sacrifice yield.
Not in this case.
The stock offers a market-beating yield of 2.6%.
Rare to see a yield this high along with a dividend growth rate this high.
This yield, by the way, is 40 basis points higher than its own five-year average.
Yet again, there’s more.
The payout ratio is only 18.8%, giving the company all kinds of headroom when it comes to future dividend raises.
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.
It’s where you get both a nice amount of income and growth.
The yield is on the low end of its range, but the dividend growth rate is well above what I’d usually want to see.
We’re clearly in the sweet spot here.
Revenue and Earnings Growth
As sweet as these numbers might be, most of them are looking backward.
However, investors must look forward, as today’s capital is being risked for the rewards of tomorrow.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will be incredibly useful when the time comes to estimate fair value.
I’ll first show you what the business has done over the last decade in terms of its top-line and bottom-line growth.
I’ll then uncover a professional prognostication for near-term profit growth.
Amalgamating the proven past with a future forecast in this way should allow us to roughly determine where the business may be going from here.
Discover Financial advanced its revenue from $9.4 billion in FY 2013 to $15.2 billion in FY 2022.
That’s a compound annual growth rate of 5.5%.
A solid mid-single-digit top-line growth rate.
Pretty much right what I’d expect.
Meanwhile, earnings per share grew from $4.96 to $15.50 over this period, which is a CAGR of 13.5%.
A consistent and prolific share buyback program explains the delta between top-line growth and bottom-line growth.
The outstanding share count has been reduced by 43% over the last decade, marking one of the largest such 10-year declines that I’ve ever seen.
We can now see where the double-digit dividend growth has come from; it’s been funded by double-digit bottom-line growth.
While the dividend has been growing faster than EPS, the payout ratio remains low enough to eliminate any concern on this front for me.
Looking forward, CFRA believes that Discover Financial will compound its EPS at an annual rate of 3% over the next three years.
This is a pretty pessimistic take, but I don’t think it’s unreasonable at all.
The last few years have been a bonanza for Discover Financial.
Consumers have been flush with cash, undoubtedly helped by generous, but temporary, government stimulus checks.
This kept credit quality artificially high.
However, CFRA cites weakening savings rates, funding pressures, normalization of credit, and rising charge-off rates as near-term headwinds for Discover Financial.
Admittedly, it’s a tough call.
A lot of moving parts and uncertainty here.
Making matters more difficult to make heads or tails of, Discover Financial also recently reported that prior card misclassifications will require the company to provide refunds to merchants and merchant acquirers.
The thing is, even if Discover Financial only compounds its EPS at a 3% annual rate over the next few years, which seems to be a worst-case scenario, the dividend could still easily grow at a high-single-digit rate over that stretch.
The payout ratio is low enough to afford that kind of flexibility.
However, CFRA could be too gloomy here.
I pulled up the five-year period preceding the pandemic, and Discover Financial compounded its EPS at a 15%+ annual rate – before the recent bonanza.
Overall, I think CFRA’s lowball projection is unlikely to materialize, and it wouldn’t be that terrible anyway.
This puts the dividend in a pretty good position to continue growing at a compelling rate, and that’s coming off of a near-3% yield base.
I find it difficult to dislike that setup.
Moving over to the balance sheet, Discover Financial has a good financial position.
Total assets of $132 billion line up against $117 billion in total liabilities.
The parent company’s senior debt has the following credit ratings: Baa2, Moody’s; BBB-, S&P; BBB+, Fitch.
These are investment-grade credit ratings, although they are near the lower end of that spectrum.
Profitability for the company is fairly robust.
The firm’s net margin has averaged 27.1% over the last five years, while return on equity has averaged 28.7%. Net interest margin came in at 11% last year.
Discover Financial is running two highly complementary business models that accentuate each other.
Despite flying under the radar, it continues to put up great numbers.
And the company does benefit from durable competitive advantages that include “sticky” bank deposits, brand power, an entrenched float, a built-out payment network, and implied switching costs for cardholders.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
As we’ve seen recently, bank runs are a major risk for all banks; however, Discover Financial is somewhat insulated from this in the sense that its bank is attached to payments business.
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.
A recession would also likely reduce spending, in general, which could negatively impact card transactions and the associated fees.
Discover Financial usually runs higher charge-off rates than some of its card-issuing peers, indicating persistent credit quality issues.
Interest rates have been persistently low over the last decade, which has put a lid on what banks can do, but rates are finally on the rise.
The company is exposed almost completely to just the US, limiting growth potential.
These risks are worth contemplating.
But I also see the low valuation worth contemplating…
Stock Price Valuation
The P/E ratio is just 7.4.
That would be pretty low for a bank.
It would be obscenely low for a payments business.
In my view, Discover Financial gets credit for neither its banking business nor its payment network.
Now, to be fair, this stock always seems to get little respect from the market.
Its five-year average P/E ratio is only 10.3.
But the lack of respect present right now is noteworthy.
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 7.5%.
This dividend growth rate roughly splits the difference between exceptional dividend growth of the past and what could be more mediocre dividend growth over the next few years.
I’m not as pessimistic as CFRA is on Discover Financial’s near-term capabilities.
However, I also acknowledge the mounting headwinds.
The recent misclassification fiasco comes on top of rising charge-off rates.
Also, the company recently announced that buybacks – a major source of EPS growth over the last decade – are on pause while they sort out internal controls.
The good news is, the payout ratio remains very low.
Now, I wouldn’t expect the heady days of the last decade to return any time soon.
On the other hand, I don’t see anything close to a disaster here.
The DDM analysis gives me a fair value of $120.40.
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 don’t think I was unreasonable with my valuation, yet the stock looks at least modestly undervalued anyway.
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 DFS as a 4-star stock, with a fair value estimate of $146.00.
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 DFS as a 3-star “HOLD”, with a 12-month target price of $110.00.
I’m somewhere in the middle here. Averaging the three numbers out gives us a final valuation of $125.47, which would indicate the stock is possibly 15% undervalued.
Bottom line: Discover Financial Services (DFS) is running two great business models in a highly complementary way. However, it doesn’t appear to be getting proper credit for either one. With a market-beating yield, a double-digit long-term dividend growth rate, a low payout ratio, more than 10 consecutive years of dividend increases, and the potential that shares are 15% undervalued, value-oriented dividend growth investors may have a unique opportunity on their hands.
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 DFS’ dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 45. 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, DFS’ dividend appears Borderline Safe with a moderate risk of being cut. Learn more about Dividend Safety Scores here.