The US stock market has been going gangbusters since bottoming out in the spring.
A confluence of factors have driven up valuations to startling levels, particularly in tech.
This lack of value has left thoughtful long-term investors feeling high and dry.
But this is why it’s so important to be diligent in all market conditions.
There are always businesses out there ripe for long-term investment.
And that’s just what this long-running series is designed to show.
Deals today are certainly less plentiful than they were in 2010.
However, I’ve never felt totally bereft of opportunity.
You have to stay diligent and optimistic, while also doing your homework.
Doing just this helped me to go from below broke at age 27 to financially free at 33, as I describe in my Early Retirement Blueprint.
I built my FIRE Fund by living below my means and investing my hard-earned capital throughout all market conditions.
That six-figure Fund generates the five-figure passive dividend income I live off of – while I’m still in my 30s.
It’s comprised of high-quality dividend growth stocks like those you can find on the Dividend Champions, Contenders, and Challengers list.
This strategy advocates investing in world-class enterprises that pay reliable and rising cash dividends to shareholders.
But you don’t invest at any valuation.
Valuation is always important, even for a great business.
Price is what you pay. But 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.
Fortunately, that diligence is made much easier with fellow contributor Dave Van Knapp’s Lesson 11: Valuation.
Part of an overarching series of “lessons” on DGI, this lesson puts forth a valuation template that you can apply 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…
Essex Property Trust Inc. (ESS) is a real estate investment trust that owns and operates a portfolio of US West Coast multifamily properties.
Founded in 1971, the company is now a $13.5 billion (by market cap) REIT giant.
The company focuses on three different supply-constrained markets: the San Francisco Bay Area, 42% of net operating income for FY 2019; Southern California, 41%; and the Seattle metropolitan area, 17%.
Their portfolio consists of approximately 60,000 apartment homes across almost 250 apartment communities.
Whereas a lot of REITs concentrate on more discretionary areas real estate, Essex concentrates on the non-discretionary need that is shelter.
This has been one of the most successful REITs since going public in 1994. The stock’s total return absolutely trounced the S&P 500 between its IPO and the end of 2019 – up almost 5,000% compared to the S&P 500’s total return of less than 1,100% over that time frame.
But 2020 has been a rough year for this stock, as well as most REITs in general.
There could be a paradigm shift upon us in terms of housing demand on the West Coast, with taxation, high COL, political issues, homelessness, and the accelerating work-from-home theme all conspiring to work against Essex.
Or maybe not.
Other than the WFH acceleration, none of this is new. Yet Essex has thrived.
Moreover, demand reduction is only one element of the supply-and-demand equation.
Factors like land availability and zoning restrictions constrain supply.
I’d also argue that this demand shock is temporary. The West Coast of the United States remains an extremely desirable geographical location. Its natural features have blessed it.
In addition, California has a massive economy. It would be in the top five of the world’s largest economies by GDP, if it were an independent country.
Also, not all of those industries in California are going to allow for 100% mobile jobs. Even a requirement to show up to the office for, say, a tech-oriented job only twice per week means you’ll still need to be based near your employer. There’s also the likely downward adjustment to pay if an employee working from home moves to a state with a lower COL, which could cause some to rethink leaving California.
California has competitive advantages, much in the same way a business can have competitive advantages. Despite California’s political blundering, it’s a sought-after place to live.
While pricing pressure might be a very real challenge over the near term, Essex is a well-managed business that owns some of the best properties in some of the most desirable locations.
Simply put, there are advantageous baselines in play here for both supply and demand.
And that bodes well for the company’s ability to grow their profit and dividend over the long run.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Essex has already increased its dividend for 26 consecutive years, making it a rare Dividend Aristocrat REIT.
The 10-year dividend growth rate is 6.5%.
I think it’s worth pointing out how consistent this dividend growth is – the most recent dividend increase was almost exactly 6.5%.
This yield, by the way, is more than 130 basis points higher than the stock’s five-year average yield.
And with a payout ratio of only 59.7% of TTM Core FFO/share, this is one of the more conservative payouts in the REIT space.
Revenue and Earnings Growth
These are great dividend metrics, but it’s really those future dividends and dividend raises that we care most about.
Today’s investors are putting capital at risk for tomorrow’s rewards.
Thus, I’ll now build out a forward-looking growth trajectory for Essex.
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 like this should allow us to come to a reasonable conclusion about where Essex’s growth might be going.
Essex increased its revenue from $416 million to $1.460 billion between FY 2010 and FY 2019.
That’s a compound annual growth rate of 14.97%.
This is obviously highly impressive.
However, a REIT often funds growth through the issuance of equity and debt. That’s because a REIT is legally obligated to return at least 90% of its taxable income back to shareholders in the form of dividends.
Indeed, Essex’s outstanding share count more than doubled over the last 10 years.
It’s never more important to look at growth on a per-share basis than when you’re dealing with a REIT.
Furthermore, REIT profit is best viewed through the prism of funds from operations.
FFO is a measure of cash generated by a REIT, which adds depreciation and amortization expenses back to earnings.
The company grew its FFO/share from $5.35 to $13.73 over this 10-year period, which is a CAGR of 11.04%.
Still excellent, although profit growth on a per-share basis did trail absolute revenue growth.
Looking forward, CFRA believes that Essex will compound its FFO/share at an annual rate of 2% over the next three years.
CFRA’s call for lower growth chiefly revolves around the pandemic’s impacts to multifamily housing, particularly on the West Coast.
The pandemic will impact Essex. I think it’d be silly to think otherwise.
However, this impact doesn’t exist in a vacuum. You have to compare the magnitude and time frame of the impact against the valuation of the stock.
Regarding the magnitude, we can see that financial occupancies fell from 96.6% in Q2 2019 to 94.9% in Q2 2020. This went from outstanding to slightly less outstanding. Core FFO/share dropped just over 5% YOY for Q2 2020. Compared to other areas of real estate (like retail and office), this is a very minor drop in cash flow.
As for the time frame, I don’t see a permanent shift here. The locations in which Essex has concentrated itself benefit from natural and man-made competitive advantages.
And then there’s the valuation. The stock is now trading for 2014 prices, even though the company was doing less than $1 billion in revenue back then. This valuation compression is fortuitous in some ways, as Essex bought back just over $20 million in stock during Q2.
CFRA’s forecast is implying a substantial reduction in growth. I think much of the caution is warranted, but I also see much of that caution already more than priced in.
With the modest payout ratio, relatively minor drop in cash flow, the prime need of their product, and consistency of the business, I think mid-single-digit dividend growth is a reasonable long-term expectation from here.
Financial Position
Moving over to the balance sheet, Essex maintains a very good financial position.
There are $12.7 billion in total assets against $6.5 billion in total liabilities.
Credit ratings are as follows: BBB+, Fitch; Baa1, Moody’s; and BBB+, Standard & Poor’s.
This has been an amazing investment over the last 25 years.
And while there are undoubtedly near-term challenges facing Essex, I see no reason to believe that the next 25 years will be all that different.
Essex has the prime need of housing, quality properties in sought-after locations, a concentration in supply-constrained markets, and excellent fundamentals all working to their advantage.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
Real estate is highly cyclical. This cyclicality is being supercharged right now by the pandemic.
A REIT’s capital structure means they must consistently rely on external funding for growth.
Essex’s West Coast concentration can work against them if this area truly does suffer a more permanent drop in demand.
There’s also a scarcity of durable competitive advantages in real estate.
Even with these risks, I believe that Essex makes a lot of sense as a long-term investment.
That’s particularly true right now, with the valuation about as appealing as I’ve ever seen it.
With the stock trading at 2014 prices after a 61% drop from its 52-week high, the stock looks attractively valued…
Stock Price Valuation
The stock is trading hands for a P/FFO ratio of 14.86.
Using a P/FFO ratio as a proxy for a P/E ratio, this valuation is well below where the broader market is at.
Then there’s cash flow, which mimics FFO.
The stock’s P/CF ratio of 14.9 is way off of its own three-year average P/CF ratio of 22.0.
And the yield, as noted earlier, is materially higher than its 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 6.5%.
That DGR lines right up with Essex’s own long-term, proven dividend growth. With the most recent dividend increase coming in at almost exactly 6.5%, and with the payout ratio remaining modest, Essex should be able to continue on with the status quo.
Notably, FFO/share growth has been much higher than dividend growth over the last decade. This has created a margin of safety as it pertains to the payout ratio.
With the possibility of a short-term expansion of the payout ratio, coupled with a temporary reduction in dividend growth, the dividend should remain sustainable and in a position to grow at a faster rate when things normalize.
The DDM analysis gives me a fair value of $252.86.
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.
This stock looks quite undervalued from where I’m sitting.
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 ESS as a 4-star stock, with a fair value estimate of $273.00.
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 ESS as a 3-star “HOLD”, with a 12-month target price of $235.00.
I came out right in the middle this time. Averaging the three numbers out gives us a final valuation of $253.62, which would indicate the stock is possibly 23% undervalued.
-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 ESS’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 93. 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, ESS’s dividend appears Very Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
