Dividend growth investing has treated me exceedingly well.
It’s the investment strategy I’ve used to unlock value, create passive income, and achieve financial freedom in my early 30s.
I’m an ardent fan of this strategy because it radically transformed my life.
And I enthusiastically share some of my best investment ideas because it’d be remiss of me not to pass along this information.
Well, a great investment idea recently popped up on my radar…
This stock was sourced from the Dividend Champions, Contenders, and Challengers list, which is where all of the ideas in this series come from.
This list is the most robust compilation of data on US-listed dividend growth stocks that I’m aware of.
It contains invaluable information on more than 800 US-listed stocks that have raised their dividends each year for at least the last five consecutive years.
I’ve personally used this list to build my own early retirement dividend growth stock portfolio, which I call my FIRE Fund.
I’m able to live off of the five-figure and growing passive dividend income that portfolio generates.
Of course, I didn’t build that portfolio overnight.
It took me six years to build the bulk of it, going from below broke to financially free in the process.
You can read how that journey unfolded by checking out my Early Retirement Blueprint.
It’s quite easy to understand why I’ve selected dividend growth investing as the strategy to help me retire in my early 30s.
After all, only a profitable and successful enterprise is capable of paying shareholders rising cash payments for years on end.
Since shareholders are the collective owners of any publicly-traded company, they should expect their fair share of whatever growing profit is being produced.
These concepts go hand-in-hand.
I mentioned earlier that this strategy radically transformed my life.
Well, I believe it can radically transform your life, too.
That said, one shouldn’t go out and buy dividend growth stocks randomly.
You should only select stocks that clear certain hurdles.
Namely, I aim to invest in high-quality dividend growth stocks that feature strong fundamentals, durable competitive advantages, low risk, and undervaluation.
It’s that last part that’s particularly important.
Price is what you pay, but value is what you get for your money.
An undervalued dividend growth stock should present a higher yield, greater long-term total return prospects, and less risk.
That is relative to what the same stock would offer at fair value or overvaluation.
All else equal, a lower price will result in a higher yield.
The higher yield leads to greater long-term total return prospects.
Total return includes investment income and capital gain.
A higher yield positively affects investment income.
Capital gain, though, is also potentially given a boost via the “upside” that exists between a lower price paid and higher intrinsic value.
If the stock market corrects that favorable disconnect between price and value, that results in capital gain.
That’s on top of whatever capital gain would naturally occur as a company increases its profit and becomes worth more.
Naturally, these conditions should reduce risk.
It’s obviously less risky to pay less for an asset.
This also introduces a margin of safety.
That protects the investor against unforeseen issues that can crop up as a course of doing business.
Anything from mismanagement to new competition can reduce the fair value of a company.
This is why an investor should always seek out the lowest valuation possible, which limits downside.
These advantageous dynamics fortunately aren’t difficult to spot.
Fellow contributor Dave Van Knapp has made it fairly easy to find undervalued dividend growth stocks.
He developed a valuation process that can act as a template. You can apply it to just about any dividend growth stock out there.
Access that valuation process by reading through Lesson 11: Valuation, which is part of an overarching series of articles designed to introduce and teach dividend growth investing.
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…
Bank of New York Mellon Corp. (BK)
Bank of New York Mellon Corp. (BK) is a global financial services company.
They are the largest global custody bank in the world, with over $32 trillion in assets under custody and administration.
It provides investment management and investment services in 35 countries and more than 100 markets.
The company as it exists today was formed through a series of M&A activities. It’s now a powerhouse bank that provides critical services behind the global banking infrastructure.
Through industry consolidation, M&A, and moves toward sticky custody assets, Bank of New York Mellon now has an enviable business model focused on scalable, fee-based securities servicing and fiduciary businesses.
They specialize in institutional services, including trade execution, custody, securities lending, and clearance and settlement. A broad array of accounting and administrative services are also available.
Meanwhile, rising interest rates (something almost inevitable at this point) should serve as a tailwind for this company since they have almost $2 trillion in assets under management.
That should also provide a nice tailwind for the bank’s dividend, which has been growing nicely of late.
The company has increased its dividend for eight consecutive years.
The knock against the dividend is the fact that they cut it during the financial crisis.
That generational event is unlikely to happen again, however.
Moreover, the aforementioned M&A has given the bank scale and breadth it didn’t have before 2007.
The five-year dividend growth rate is sitting at 10.6%, so they’re making up for lost ground.
Furthermore, dividend growth has actually been accelerating recently. The most recent dividend increase came in at over 16%.
With a payout ratio of just 27.3% (after factoring out a one-time tax gain for Q4 2017), this appears to be one of the safest dividends in all of banking.
And the yield is solid, at 2.31%.
That’s an above-average yield. It’s also 70 basis points higher than the stock’s own five-year average yield.
Double-digit dividend growth on top of a market-beating yield is a lot to like.
But in order to build our expectation for future dividend growth, we’ll first need to build out an expectation for future business growth.
To do so, we’ll look at what the company has done over the last decade. That’s a reasonable proxy for the long term. We’ll then compare that to a professional near-term expectation for profit growth.
Combining a long-term track record with what may come to pass over the near term should give us a lot to work with in terms of estimating the company’s earnings power moving forward.
The bank increased its revenue 13.652 billion in FY 2008 to $15.124 billion in FY 2017.
That’s a compound annual growth rate of 1.14%.
Not a fantastic top-line growth rate, but it’s not uncommon to see a bank struggle over this challenging period.
The bottom line has fared better thanks to improved profitability across the board, along with share buybacks.
Earnings per share grew from $1.20 to $3.56 over this 10-year period, which is a CAGR of 12.84%.
I factored out a one-time gain for FY 2017.
This is more than respectable. They had a tough, tight environment a decade ago.
They’re now flourishing and also better equipped to handle a downturn in the future, in my opinion.
The outstanding share count is down by approximately 10% since FY 2008, but it’s been an aggressive improvement in operating metrics that has really moved the dial here.
Moving forward, it looks like much of the same.
CFRA is predicting that the bank will compound its EPS at an annual rate of 10% over the next three years.
The analysis firm cites rising interest rates, continued consolidation, modest repurchases, and cost-cutting initiatives in its thesis.
With an extremely low payout ratio, this sets up conditions for double-digit dividend growth for the foreseeable future.
Their balance sheet is very strong.
The long-term debt/equity ratio is 0.68, while the interest coverage ratio is over 19.
Treasury stock negatively skews the latter.
Long-term senior debt is rated Aa2 by Moody’s and AA- by S&P. Investment grade.
Profitability is robust, especially looking at where things sit now relative to a few years ago.
Over the last five years, the company has averaged annual net margin of 20% and average return on equity of 10.31%.
The treasury stock that reduces common equity unfairly punishes ROE, but these numbers are still very good.
I see this bank as a firm that has truly found its position in the market.
Operations have been improved and solidified as they’ve moved away from retail banking and toward fee-based institutional services.
The last five or so years have been nothing short of remarkable across the board.
That probably explains why Warren Buffett has lately been such a fan of this stock, regularly adding to Berkshire Hathaway Inc.’s (BRK.B) position in Bank of New York Mellon.
Of course, there are risks to consider.
The bank is highly exposed to broader economic cycles. That was highlighted during the financial crisis; however, that was an extreme event that is unlikely to be repeated.
Still, the sizable AUM means a reduction in asset market value impacts the bank through a reduction in fees. And any broader slowdown across the global economy would likely reduce overall demand and traffic for and toward services.
But the appealing valuation seems to price in more risks than upside…
The stock is trading hands for a P/E ratio of 11.83.
That’s about half the broader market. It’s also well below the stock’s own five-year average P/E ratio of 17.4.
And that’s using an unfavorable TTM EPS that factors out the one-time gain for Q4 2017.
The P/CF ratio, at 12.1, is also quite a bit lower than the three-year average P/CF ratio of 13.4.
Plus, the yield, as noted earlier, is significantly higher than its own recent historical average.
So the stock does look attractive. But how attractive might it be? What would a reasonable look at 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%.
That’s a very conservative DGR considering the recent dividend growth and EPS growth, along with the forecast for EPS growth moving forward. Also, the payout ratio is extremely low.
If anything, the company would be more likely to grow its dividend at something twice that rate for the near term.
However, I err on the side of caution, especially with banks that are exposed to the global economy.
The DDM analysis gives me a fair value of $48.16.
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 was being purposely conservative here, yet the stock still comes up as at least fairly valued. That speaks volume about the possible margin of safety here.
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 BK as a 4-star stock, with a fair value estimate of $55.00.
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 BK as a 5-star “STRONG BUY”, with a 12-month target price of $60.00.
I came out low here, which isn’t a surprise with how cautious I was with the growth. Averaging out the three numbers gives us a final valuation of $54.39, which would indicate the stock is potentially 12% undervalued right now.
Bottom line: Bank of New York Mellon Corp. (BK) is an entrenched, high-quality financial firm that provides necessary services across the backbone of global banking. Warren Buffett is a big fan. So am I. With an extremely low payout ratio, improving metrics across the board, a recent 16%+ dividend raise, and the potential that shares are 12% undervalued, this is a dividend growth stock that should definitely be on your radar.
-Jason Fieber
Note from DTA: How safe is BK’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, BK’s dividend appears safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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