The stock market is very chaotic when viewed through a short-term lens.
And that’s because market is largely made up of countless human beings.
Human beings are known to overreact in emotional ways to events.
And so it shouldn’t be a surprise to see volatile human beings rubbing off on a market they’re participating in.
However, the market becomes far more functional when viewed through a long-term lens.
The more you zoom in, the more nonsensical things look.
Second-by-second trading action is seemingly senseless.
But when you zoom out to a 30-year chart on the US stock market, you see that it’s been a relatively smooth ride upward.
That’s because great businesses tend to steadily increase their profits when measured over long periods of time.
And the market likes to eventually track those profits, even if it also dramatically meanders off of that path over short periods of time.
The key to all of this?
Invest in great businesses for the long term.
How do you find great businesses?
Well, I’d argue it’s very easy.
Look to high-quality dividend growth stocks.
These are stocks that pay reliable, rising dividends to their shareholders.
Reliable, rising profits are necessary to fund reliable, rising dividends.
And it takes great businesses in order produce reliable, rising profits.
These are some of the best stocks in the world because they represent equity in some of the best businesses in the world.
The Dividend Champions, Contenders, and Challengers list contains invaluable data on more than 700 US-listed stocks that have raised their dividends each year for at least the last five consecutive years.
I’ve been personally investing in high-quality dividend growth stocks for more than a decade.
I built the FIRE Fund in the process of doing so.
That’s my real-money portfolio, and it produces enough five-figure passive dividend income for me to live off of.
Indeed, I do actually live off of dividends.
In fact, I’ve been doing just that for years now.
I actually retired in my early 30s.
I explain exactly how I did that in my Early Retirement Blueprint.
It should go without saying that a major aspect of the Blueprint comes down to investing in the right stocks.
But it’s not just that.
It also comes down to valuation at the time of investment.
Price is only 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.
Ignoring the chaotic dysfunction of the stock market over the short term by instead focusing on investing in undervalued high-quality dividend growth stocks for the long term sets you up to experience terrific financial results over the course of your life.
Of course, this idea does mean that one has to first develop a framework for understanding valuation.
Fortunately, this is easier than it sounds.
Fellow contributor Dave Van Knapp has made it even easier via Lesson 11: Valuation.
Part of a comprehensive series of “lessons” on dividend growth investing that are designed to teach budding investors the ins and outs of dividend growth investing, it lays out a simple valuation process that can help you to value just about any dividend growth stock.
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…
Qualcomm, Inc. (QCOM)
Qualcomm, Inc. (QCOM) is a multinational technology corporation that creates semiconductors, software, and services related to wireless technology and connectivity.
Founded in 1985, Qualcomm is now a $151 billion (by market cap) tech giant that employs 45,000 people.
The company reports results across two business segments: Qualcomm CDMA Technologies (QCT), 80% of FY 2021 revenue; and Qualcomm Technology Licensing (QTL), 19%.
The world is becoming more reliant on technology, in general. In particular, wireless technologies based around connectivity are becoming critical to everyday life.
A digital transformation is playing out.
This was true before the pandemic hit.
But it’s even more true now, with a greater number of people working remotely.
This digital transformation started with the smartphone revolution.
Well, Qualcomm has long been a leader in the wireless space, and the company holds virtually all essential patents used in 3G, 4G, and 5G networks.
Because of this, Qualcomm collects royalty income on the majority of 3G, 4G, and 5G handsets sold worldwide.
A very lucrative start.
But the smartphone revolution has been evolving into the Internet of Things, where everything from your watch to your refrigerator can and will communicate with one another.
This benefits Qualcomm to an even greater degree.
The company had the foresight to parlay their early IP success into a diversified business model that offers a suite of technologies and services across an entire IoT ecosystem.
The company is now exposed to some of the biggest and most enduring trends in all of technology.
We’re talking about 5G, broadband, modern RF systems, gaming, IoT, self-driving autos, AI, and AR/VR.
Unless society suddenly does a giant U-turn back toward the stone age, Qualcomm is poised to continue benefiting to ever-greater degrees from the continued shift toward the digital transformation.
And that should mean growth in the company’s revenue, profit, and dividend for many years into the future.
Dividend Growth, Growth Rate, Payout Ratio and Yield
As it sits, Qualcomm has increased its dividend for 20 consecutive years.
That’s actually an impressive dividend growth track record, considering the industry and business model.
20 years is a lifetime in tech.
The 10-year dividend growth rate is 12.5%, which is also impressive.
Now, the dividend raises have been a bit lumpy.
But a lot of that comes down to certain idiosyncratic factors, such as longstanding legal issues.
With these issues largely cleared up, however, I suspect that future dividend raises will be more consistent in size.
Also, the stock offers an appealing yield of 2.2%.
That yield easily beats the market, and it’s not terribly far off from the stock’s own five-year average yield.
And the payout ratio is at only 30.7%.
This well-covered dividend is positioned for a lot more growth.
I really like these dividend metrics.
Revenue and Earnings Growth
As much as I like them, these numbers are admittedly mostly looking backward.
However, investors are risking today’s capital for tomorrow’s rewards.
Thus, 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 top-line and bottom-line growth.
And I’ll then compare that to a near-term professional prognostication for profit growth.
Blending the proven past with a future forecast like this should give us a good idea as to what the growth path might look like from here.
Qualcomm increased its revenue from $19.1 billion in FY 2012 to $33.6 billion in FY 2021.
That’s a compound annual growth rate of 6.5%.
I usually look for a mid-single-digit top-line growth rate from a mature company like this.
They more than delivered.
Meanwhile, earnings per share moved up from $3.51 to $7.87 over this period, which is a CAGR of 9.4%.
Strong bottom-line growth here.
What I really like about it is, there’s been a recent acceleration in EPS growth after a multiyear period of languishing.
Almost all of this growth has occurred over just the last few years.
I think this surge is sustainable.
Looking forward, CFRA believes that Qualcomm will compound its EPS at an annual rate of 19% over the next three years.
This builds on what I was just outlining.
Qualcomm could be in the early innings of a growth speedup, which is the result of a thoughtful transformation across the business.
Whereas Qualcomm was mainly a handset/IP play a decade ago, the company has broadened itself out into areas like auto and IoT.
The company took a solid foundation and built something even bigger and better on top of it.
Indeed, their recent Q2 FY 2022 earnings report showed 40.7% YOY revenue growth and 68.0% YOY EPS growth.
Jaw-dropping numbers here.
Speaking on the legacy aspect of the business, Qualcomm has long been a leader in the Android space.
However, the company has two additional tailwinds in that space.
First, even more market share.
CFRA notes that it believes Qualcomm “has been able to take share in the Android ecosystem, given Huawei’s chip manufacturing limitations.”
Second, 5G.
CFRA states this: “We believe QCOM is benefiting from 5G adoption, given its offerings span baseband, transceiver, RF front end, and antennas.”
Then there’s the diversification.
Qualcomm states that its auto pipeline is now at $16 billion.
And CFRA states this about the company’s opportunities in IoT: “We see IoT growing at a 3-year CAGR of 17%, led by the metaverse and edge networking, among other verticals.”
Qualcomm was a really good business a decade ago.
I think it’s a far better business today with less reliance on handsets and more growth promise.
It appears to be positioned for easy double-digit dividend growth for the foreseeable future, which would come on top of the market-beating yield.
I see a lot to like about that combination of yield and growth.
Financial Position
Moving over to the balance sheet, the company has a rock-solid financial position.
The long-term debt/equity ratio is 1.4, while the interest coverage ratio is over 24.
Profitability is quite robust.
Over the last five years, the firm has averaged annual net margin of 11.8% and annual return on equity of 64.2%.
Both numbers look lower than they ought to. FY 2018 was an anomaly that reduces average profitability over the last five years. Net margin, for instance, came in at nearly 27% for the last fiscal year.
I think Qualcomm is a great business that looks greater than it ever has.
And it does benefit from durable competitive advantages that include IP, R&D, economies of scale, pricing power, and switching costs.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
Litigation has been an especially thorny issue for Qualcomm.
Qualcomm has a near-monopoly on CDMA technology patents. These valuable patents (and the lucrative royalty fees they generate) have led to legal battles worldwide. Many cases have been settled, but this will likely be a persistent risk for years to come.
The very business model is a risk unto itself. Technology is constantly evolving. And this is happening at an ever-faster speed. Qualcomm will have to keep up with the changes in order to remain competitive.
Handset makers have been vertically integrating. This threatens Qualcomm’s handset chip business.
A number of Qualcomm’s end markets are still novel. Questions remain about their long-term prospects.
I think it’s important to carefully consider the risks here, but I also think Qualcomm’s overall quality and appeal transcends the risks.
And after a 28% drop from its 52-week high, the stock’s current valuation makes it that much more appealing…
Stock Price Valuation
The stock is trading hands for a P/E ratio of 14.3.
That’s quite a bit lower than the broader market’s earnings multiple.
It’s also substantially lower than the stock’s own five-year average P/E ratio of 27.2.
Now, EPS has not been super consistent over the last few years, making the comparison difficult.
Still, scoring a lower multiple when growth is higher strikes me as opportunistic.
And the yield, as noted earlier, is not far off from 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 8%.
This DGR is at the very top end of what I allow for.
If there’s any company that deserves it, it’s Qualcomm.
Both their short-term and long-term EPS and dividend growth has been outstanding. And CFRA’s near-term EPS growth expectation is more than twice as high as this number.
Plus, the payout ratio is low.
I think it’s likely that Qualcomm will actually exceed this 8% dividend growth rate over the next few years. On the other hand, it would be prudent to assume a moderation over the long haul.
The DDM analysis gives me a fair value of $162.00.
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 feel that my valuation model was reasonable, yet the stock still looks very undervalued.
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 QCOM as a 4-star stock, with a fair value estimate of $163.00.
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 QCOM as a 3-star “HOLD”, with a 12-month target price of $160.00.
We have an extremely tight consensus this time around. Averaging the three numbers out gives us a final valuation of $161.67, which would indicate the stock is possibly 16% undervalued.
Bottom line: Qualcomm, Inc. (QCOM) is a high-quality company that’s arguably never looked better. A transformation of the business has led to exciting new verticals and more growth. With a market-beating yield, double-digit dividend growth, a low payout ratio, 20 consecutive years of dividend increases, and the potential that shares are 16% undervalued, dividend growth investors would be wise to consider answering the door while opportunity is knocking.
-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 DTA: How safe is QCOM’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 80. 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, QCOM’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
The goal? To build a reliable, growing income stream by making regular investments in high-quality dividend-paying companies. Click here to access our Income Builder Portfolio and see what we’re buying this month.
Source: DividendsAndIncome.com