“You can’t have your cake and eat it, too.”
How many times have we heard that?
If you eat your cake, you will no longer have a cake. And if you want to keep your cake, you can’t very well eat it.
Call me greedy, but I want both.
I want my cake. And I want to also be able to eat it!
Well, that’s what’s so great about dividend growth investing.
This fantastic long-term investment strategy allows for both.
Building a diversified portfolio full of high-quality dividend growth stocks allows you to have your cake via the equity in numerous wonderful businesses.
Simultaneously, you get to eat your cake – these wonderful businesses are sending their shareholders growing dividend payments, which are real-life, growing cash payments funded by real-life, growing profits.
You can see what I mean by checking out my real-money, six-figure dividend growth stock portfolio.
I call it my FIRE Fund, because it allows me financial independence/retired early (FIRE).
Indeed, the five-figure and growing passive dividend income my FIRE Fund generates for me is enough to cover my basic expenses in life, rendering me financially independent in my 30s.
That dividend income is me eating my cake.
And the portfolio is my cake.
The great thing is that you, too, can have your cake and eat it, too.
It simply involves saving and then investing that capital into high-quality dividend growth stocks that are trading at appealing valuations.
You won’t have to go far for investment ideas, for David Fish’s Dividend Champions, Contenders, and Challengers list has compiled invaluable data on more than 800 US-listed stocks that have increased their dividends each year for at least the last five consecutive years.
But while there are plenty of investment ideas on Mr. Fish’s list, not every single stock is a great idea at every single moment.
You first have to look at companies within your circle of competence.
You then have to perform a full quantitative and qualitative analysis, factoring in known risks, making sure the business is high quality.
And, perhaps most importantly, you then value the business.
The valuation at the time of investment is very important, as it could have a significant impact on how well the investment performs for you, especially over the short term.
Price is only what you pay, but value is what you’re going to get in return for your money.
Value gives context to price. Without knowing value, price is practically meaningless.
But if you know how to estimate the value a business before investing, you put yourself in a great position to have more cake for the same amount of money, which gives you that much more cake to eat over the long term.
Fortunately, fellow contributor Dave Van Knapp has put together an excellent guide to valuing dividend growth stocks, which puts you in control.
Boy, can this be helpful.
That’s because an undervalued dividend growth stock can offer an investor greater long-term total return prospects, less risk, and a higher yield.
This is relative to what the same stock might otherwise be able to offer if it were fairly valued or overvalued.
This occurs, firstly, due to the way price and yield are inversely correlated.
All else equal, a lower price will result in a higher yield.
That higher yield not only positively affects current investment income, as well as possibly aggregate investment income over the long run, but it also gives the long-term total return potential a boost via the very nature of total return.
Total return is comprised of investment income (via dividends or distributions) and capital gain.
The former is given a boost right off the bat via the higher yield.
Plus, capital gain is positively affected through the “upside” that exists between a lower price and higher intrinsic value.
While the market might not necessarily price all stocks correctly at all times, price and value to tend to roughly correlate over the long run.
Taking advantage of any favorable mispricing in the short term means you could be looking at additional capital gain as price meets value, which is on top of whatever organic capital gain is possible as a business naturally becomes worth more through the process of increasing its profit.
And these dynamics should reduce your risk as an investor.
After all, it’s naturally less risky to pay less (versus more) for the same asset.
Undervaluation should provide a margin of safety, which could limit downside in case a business doesn’t perform as expected, or in case a business does something unexpected and/or wrong.
Of course, limiting downside should simultaneously maximize upside. That’s the very nature of things.
With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued…
Qualcomm (QCOM)
Qualcomm, Inc. (QCOM) develops and licenses products and services based on its advanced wireless broadband technology including semiconductors for mobile phones.
Smartphones were a luxury a decade or so ago.
They’re now arguably a utility-like necessity.
Many people are practically addicted to their smartphones.
And therein lies a massive opportunity.
There are a few select companies that absolutely dominate the mobile phone space.
Think the phones themselves. Then there are the mobile communication packages. And there’s also the underlying tech infrastructure.
One of those select companies that dominate this space is Qualcomm.
This company owns the majority of the applicable patents around CDMA and OFDMA technology.
What this essentially boils down to is that most 3G and 4G (and soon-to-be 5G) handsets essentially cannot connect to mobile networks without Qualcomm collecting royalties through the licensing of their tech/patents.
Qualcomm has done incredibly well building up this business model.
With mobile phones becoming even more iniquitous, and with mobile networks quickly moving to 5G, the company should be able to further cement their domination.
Moreover, their technology and business model can be broadly applied to mobile communication across more than just phones – Qualcomm is poised to be a leader in the Internet-of-Things revolution, where devices of all kinds communicate with one another.
Think cars, appliances, and even buildings.
And while this revolution plays out, Qualcomm is paying its shareholders a healthy and growing dividend.
The company has increased its dividend for 15 consecutive years.
That’s a pretty good track record in any industry; it’s practically a lifetime in tech.
It’s even more impressive when you consider the 10-year dividend growth rate is 15.3%.
Investors have seen their purchasing power jump by leaps and bounds over this period.
While there’s been a marked deceleration in dividend growth recently (15%+ annual dividend growth can’t continue indefinitely), the dividend still continues to be increased at a very strong clip – the most recent dividend increase was over 7%.
This dividend growth is on top of the 4.17% yield the stock offers right now.
That yield, by the way, is over 120 basis points higher than the stock’s five-year average yield.
That’s a very appealing combination of yield and growth that isn’t exactly easy to replicate elsewhere.
That big dividend might at first glance appear to be unsustainable due to the company’s negative TTM EPS; however, Qualcomm has been taking a number of large hits against GAAP EPS.
The company has been facing disputes from a number of its partners over its patents, licensing, and royalties.
Furthermore, Q1 FY 2018 showed a massive $6.0 billion charge to GAAP EPS relating to the enactment of the Tax Cuts and Jobs Act of 2017, as this will impact the company from the standpoint of charging a tax on repatriated earnings. However, this is obviously a one-time charge that doesn’t impact the company’s actual ongoing profit.
Nonetheless, Qualcomm is a machine in terms of cash flow.
For perspective on the dividend in relation to the company’s ability to pay it, the Q1 2018 dividend consumed about 50% of the company’s free cash flow for over the same period, indicating a very healthy and sustainable dividend.
But in order to get a feel for what kind of dividend growth to expect moving forward, as well as to build a case for the valuation of the business and its stock, we need to look at overall business growth.
So we’ll first see what Qualcomm has done over the last decade (a proxy for the long term) in terms of top-line and bottom-line growth. And we’ll then compare that to a near-term forecast for profit growth.
Combining the known past and estimated future in this fashion should allow us to have a pretty good idea as to what kind of growth Qualcomm is capable of as a business, which should more or less translate into dividend growth.
The company increased its revenue from $11.142 billion to $22.291 billion from FY 2008 to FY 2017. That’s a compound annual growth rate of 8.01%.
This is more than respectable, in my view. I generally look for mid-single-digit revenue growth from a fairly mature company like this. Qualcomm easily blew past that.
Meanwhile, earnings per share grew from $1.90 to $4.28 over this same period, if we’re using adjusted EPS for FY 2017. That’s a CAGR of 9.44%.
Admittedly, Qualcomm’s results have been muddied lately, which is why I used adjusted numbers for FY 2017.
But that doesn’t mean the company isn’t making a ton of money, and it also doesn’t mean the long-term outlook for this business is poor.
Looking out over the next three years, however, CFRA is calling for Qualcomm to compound its EPS at an annual rate of just 1%.
This could come to pass in terms of GAAP results. It greatly depends on the timeline for continued royalty disputes.
That said, Qualcomm’s management team is confident in its ability to deliver $6.75-7.50 in FY19 Non-GAAP EPS, per a recent letter it sent to shareholders.
Either way, the company’s FCF situation is very strong; they produce prodigious amounts of cash.
And that ability could be boosted by the acquisition of NXP Semiconductors N.V. (NXPI).
This announced acquisition, while still pending, is believed to be highly accretive to Qualcomm’s EPS upon closing, as NXP will give the combined company massive opportunities for growth across automotive, IoT, security, and networking.
However, there’s a lot of uncertainty regarding this acquisition, especially in terms of whether or not Chinese regulators will allow for the acquisition to close in its current iteration. This uncertainty is further weighing on the company and its stock, which is in addition to the uncertainty regarding royalty litigation/disputes.
While Qualcomm continues to pump out a lot of cash, they also have a lot of cash saved up.
That shows up on the balance sheet.
As it sits, the long-term debt/equity ratio is 0.63, and the interest coverage ratio is a bit over 7.
However, the latter is negatively affected by EBIT that has been hurt by numerous impacts.
And the former is made to be somewhat moot when considering that cash and equivalents is over $37 billion – or almost twice what long-term debt is.
The balance sheet is very healthy, although one has to keep in mind that Qualcomm is earmarking that cash toward the NXP acquisition.
So we’re not looking at more debt, but we are looking at a lot less cash (if the acquisition closes).
That would mean the balance sheet is taking a hit in exchange for what Qualcomm believes will be much more growth.
I’m not particularly against this, as cash should always be used for the best opportunities. Sometimes cash itself is the best opportunity. Oftentimes, though, it’s not.
Profitability for Qualcomm is phenomenal, recent issues with reported numbers notwithstanding.
Over the last five years, the company has averaged annual net margin of 22.75% and annual return on equity of 16.35%.
These numbers are really great, but they’d be even better if the last year or so wasn’t so chaotic.
The fundamentals are really strong across the board.
But one has to consider risks like ongoing litigation/disputes, technological obsolescence, regulation, and the investments required to grow.
This is, in my view, a wonderful business that has a lot of uncertainty around it.
There’s the NXP acquisition. There’s disputes with partners like Apple Inc. (AAPL). And then there was the failed hostile takeover bid by Broadcom Ltd. (AVGO).
Nobody likes uncertainty, and so the stock has been hammered as a result.
And that’s exactly where long-term opportunity can often be found…
The stock is trading hands for a P/E ratio of 16.93 right now (using adjusted EPS for the last three quarters).
That compares to a broader market P/E ratio well over 20. And this stock’s own five-year average P/E ratio is 18.5.
We can say this isn’t an apples-to-apples comparison due to the adjusted numbers.
But the company’s revenue is also cheaper than its five-year average.
And the yield, as noted earlier, is substantially higher than its own recent historical average.
So there are a number of angles from which this stock appears to be cheap, but how cheap might it be? What’s a reasonable estimate of its intrinsic value?
I valued shares using a dividend discount model analysis.
I factored in a 9% discount rate and a long-term dividend growth rate of 6%.
That DGR is conservative, in my opinion. It’s well below the company’s demonstrated long-term and short-term dividend growth rate. And the potential moving forward looks massive.
However, I’m weighing that against the current operational uncertainty across a number of fronts.
Still, I’d be surprised if Qualcomm disappoints over the long run. If anything, I think they’ll do better than 6% for years to come.
The DDM analysis gives me a fair value of $80.56.
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.
We could be looking at a stock that is significantly undervalued. But that’s just my look at things. Let’s see what two professional stock analysis firms think about this stock and its valuation.
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 $75.00.
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 $70.00 (their fair value calculation is N/A).
The numbers vary a bit, but there’s a pretty clear consensus on this stock being worth much more than its current price. Averaging the three numbers out gives us a final valuation of $75.19. That would indicate the stock is potentially 37% undervalued.
Bottom line: Qualcomm, Inc. (QCOM) is a high-quality, global, and dominant firm in a niche that should be highly profitable for decades to come. They’re perfectly positioned to take advantage of huge trends in tech. While there’s plenty of uncertainty regarding this name right now, investors buying the stock now are looking at 4%+ yield, inflation-smashing dividend growth, and the possibility that shares are 37% undervalued. This stock could allow you to have your cake and eat it, too.
— Jason Fieber
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 68. 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.
