There is a technological revolution upon us.
It’s been playing out for years, but it’s now rapidly accelerating.
The recent stay-at-home campaign stemming from the COVID-19 pandemic has showcased this acceleration.
Data and machines are connecting everything.
And investors can massively profit from this revolution.
But there’s an intelligent way to go about doing that.
I’d argue the most intelligent approach is to use dividend growth investing.
This is a long-term investment strategy that promotes buying and holding shares in world-class businesses that pay reliable and rising cash dividends.
The Dividend Champions, Contenders, and Challengers list contains invaluable data on more than 700 US-listed stocks that have raised dividends each year for at least the last five consecutive years.
I’ve used this strategy to go from below broke at age 27 to financially free and retired at 33.
I lay out exactly how I did that in my Early Retirement Blueprint.
That’s my real-money early retirement stock portfolio.
The Fund generates the five-figure passive dividend income I live off of.
Dividend growth investing is a phenomenal long-term strategy because you’re investing in what are often the best businesses in the world.
After all, it’s almost impossible to run a low-quality business while simultaneously paying out ever-larger cash payments to shareholders.
While price is 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.
Buying undervalued high-quality dividend growth stocks with exposure to the technological revolution almost guarantees you mountains of wealth and passive income over time.
Fortunately, finding undervalued stocks isn’t all that difficult.
Fellow contributor Dave Van Knapp has made that endeavor much easier with the introduction of Lesson 11: Valuation.
Part of a larger series of “lessons” on DGI, this lesson puts forth a valuation template that can be applied to just about 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…
Broadcom Inc. (AVGO) is a leading designer, developer, and supplier of analog and digital semiconductor devices.
With a history dating back to 1961, Broadcom is now a $120 billion (by market cap) semiconductor giant that employs almost 20,000 people worldwide.
The company reports revenue in two primary segments: Semiconductor Solutions, 77% of FY 2019 sales; Infrastructure Software, 23%.
Their technology can be found in smartphones, servers, set-top boxes, storage systems, and controllers.
Broadcom is highly exposed to a range of major tech themes. That includes data centers, broadband, wireless connectivity, and automation.
In fact, you’d be hard-pressed to name a major theme in technology that Broadcom isn’t exposed to.
These aren’t just themes, either. They’re real-life, large-scale changes in the way our society will function.
Investing in Broadcom is investing in the future of the Internet. It’s investing in the future of work and communication.
That bodes well for Broadcom, its shareholders, and the company’s ability to pay a growing dividend.
Dividend Growth, Growth Rate, Payout Ratio and Yield
The company has already increased its dividend for 10 consecutive years.
And with a blistering five-year dividend growth rate of 55.5%, shareholders have had plenty to cheer for.
I think there’s plenty more dividend growth to come, although the rate of dividend growth will probably meaningfully slow down.
The payout ratio, at 62.1%, is reasonable, if slightly high.
That’s not extremely high, but a lot of the prior dividend growth came from an aggressive expansion of the payout ratio. With payout ratio now expanded, future dividend growth will largely rely on underlying EPS growth.
However, even with slowing dividend growth, this is still a great dividend story.
The stock yields a monstrous 4.23% right now, which is more than twice as high as the broader market.
That’s also 200 basis points higher than the stock’s own five-year average yield.
So even with slowing dividend growth, there’s still a lot of income to be had here.
Revenue and Earnings Growth
Of course, this is looking at what’s already come to pass.
But it’s what is yet to be that concerns investors most.
We put capital to work for tomorrow’s gains, not yesterday’s results.
As such, I’ll now build out a forward-looking growth trajectory for Broadcom, which will also later help us value the stock.
I’ll first show you what the company has done over the last decade in terms of top-line and bottom-line growth.
Then I’ll compare that to a near-term professional prognostication for profit growth.
Combining the proven past with a future forecast in this manner should help us reasonably extrapolate out an estimated growth path.
Broadcom grew its revenue from $2.093 billion in FY 2010 to $22.597 billion in FY 2019.
That’s a compound annual growth rate of 30.26%.
This is obviously phenomenal; however, much of this growth is the result of serial M&A activity.
A series of large mergers and acquisitions built the Broadcom we see today.
A recent example of this is the $18.9 billion acquisition of CA Technologies, which was one of the largest independent software companies in the world.
Looking at bottom-line growth on a per-share basis should give us a better idea of how this non-organic growth has been shaping up for the company – as well as whether or not it was accretive.
Earnings per share advanced from $1.69 to $21.29 (adjusted) over this period, which is a CAGR of 32.51%.
Now, I did use adjusted EPS for the most recent fiscal year due to routine charges to GAAP EPS that have rendered GAAP numbers practically useless.
But the company’s free cash flow, which is ultimately what matters most, lines up well with adjusted EPS. That indicates to me that this is an accurate gauge of the company’s profit.
Just really incredible stuff here. Not only did the company manage to use serial M&A activity to build itself into a technology juggernaut, but they did so in a way that actually prompted accretive growth.
It’s highly impressive.
Looking forward, CFRA is projecting that Broadcom will compound its EPS at an annual rate of 9% over the next three years.
This would clearly be a step down from the 30%+ growth the company has enjoyed in the past.
But I believe this is a fair take on the current situation.
Broadcom’s size has limited its ability to move the needle with acquisitions. Much of the future growth will be based on the organic potential of the company.
That potential, though, is huge.
CFRA notes growth drivers in routing platforms, custom cloud solutions, and RF content gains from 5G phone launches. Plus, there’s the more stable infrastructure spending.
Broadcom has essentially positioned itself in every major tech motif that investors would want exposure to. It’s a tech smorgasbord.
There is the current uncertainty around COVID-19, which has possibly extended the smartphone upgrade cycle.
But if anything, Broadcom stands to gain from new work-from-home trends.
This 9% EPS growth forecast, which I think is fair-minded, would allow for like dividend growth.
And when you’re getting a 4% yield to start with, high-single-digit dividend raises add up quickly.
Financial Position
Moving over to the balance sheet, Broadcom does have a stretched financial position.
The stretching of the balance sheet has come on the heels of the aforementioned M&A activity.
With a likely slowing of this activity, Broadcom now has the ability to reduce its debt load and clean up the balance sheet.
The long-term debt/equity ratio is 1.20, while the interest coverage ratio is below 3.
Total cash is around $5 billion, which is relatively insignificant for the business.
I think the balance sheet is the one area of real concern here.
Honestly, the only reason that I haven’t personally invested more heavily into Broadcom is because of the balance sheet.
Other than the debt load, it’s a dream stock.
Profitability is robust, as one might expect for a tech company like this.
Over the last five years, Broadcom has averaged annual net margin of 17.44% and annual return on equity of 18.17%.
As solid as these numbers are, I think they belie the true potential of the business.
The last few years have been messy. Once the company starts to relax and smooth out the numbers, the net margin in particular should improve off of this average.
Broadcom has positioned itself well. They’re a player in almost every major theme in tech.
Of specific interest is 5G.
The 5G revolution is going to change the very nature of our lives. And Broadcom is aiming to be a key player in this massive transition in the way mobility, communications, and wireless are all used.
And with durable competitive advantages like scale, patents, IP, and technological expertise, Broadcom has the ability to protect the business while competing.
Of course, there are risks to consider.
Litigation, regulation, and competition are omnipresent risks in every industry.
The stretched balance sheet limits their flexibility.
There’s also customer and product concentration. Approximately 25% of the company’s revenue comes from Apple Inc. (AAPL). Moreover, almost 1/3 of the company’s revenue is from the smartphone space.
Demand for electronics is economically sensitive.
Lastly, technology changes fast. If Broadcom isn’t constantly innovating, they run the risk of falling behind.
Even with these risks, this still looks like a very attractive long-term investment.
The current valuation only adds to that attractiveness…
Stock Price Valuation
Based on TTM adjusted EPS, the P/E ratio is 14.66.
That’s obviously well below where the broader market is at.
If you don’t like using adjusted numbers, we can also look at straight cash flow.
The P/CF ratio is 12.3 right now.
That’s way off of the stock’s own three-year average cash flow multiple of 15.6.
And the current yield, as shown earlier, is substantially 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 looks downright pessimistic when compared to the proven EPS and dividend growth from Broadcom over the last 5-10 years.
However, growth has slowed of late as maturity and lack of further M&A activity have set in.
The payout ratio has climbed, the balance sheet is stretched, and CFRA’s forward-looking EPS growth forecast would portend high-single-digit dividend growth in this range.
I think 7% dividend growth is plenty when you’re locking in a 4%+ yield.
The DDM analysis gives me a fair value of $463.67.
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 we could have a very cheap tech stock here, which is almost unheard of these days.
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 AVGO as a 3-star stock, with a fair value estimate of $310.00.
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 AVGO as a 5-star “STRONG BUY”, with a 12-month target price of $370.00.
I’m surprised to see I came out high. All the same, I think Morningstar is too cautious. Averaging the three numbers out gives us a final valuation of $381.22, which would indicate the stock is possibly 24% undervalued.
-Jason Fieber
Note from DTA: How safe is AVGO’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 67. 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, AVGO’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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