2020 has been one of the most interesting years I’ve ever experienced.
As an investor, I’ve seen some valuations become totally disconnected from fundamentals.
Some valuations have gravely overshot fundamentals, while other valuations are deeply depressed.
I don’t know how this will shake out over the short term, but the long-term is another story.
Undervalued high-quality stocks almost always make excellent long-term investments.
I’ve also seen this play out in my own results.
I built my real-money FIRE Fund by following this logic.
That portfolio now produces enough five-figure passive dividend income for me to live off of.
In fact, this portfolio and the investments that constitute it allowed me to retire in my early 30s, as I describe in my Early Retirement Blueprint.
This portfolio was built using the tents of dividend growth investing.
This strategy advocates buying stock in world-class businesses that pay reliable and rising cash dividends.
I’m talking about stocks like those you can find on the Dividend Champions, Contenders, and Challengers list.
But there’s still the matter of finding the highest-quality stocks, as well as going through the valuation process.
The latter is so important.
That’s because price is only what you pay. It’s value that you actually 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.
Investing in high-quality businesses when they’re undervalued is almost a guaranteed path toward great wealth and passive income over the long term.
What’s perhaps surprising is, the process of valuation isn’t that complicated.
Lesson 11: Valuation puts forth an excellent valuation template that you can apply to almost any dividend growth stock out there.
Provided by fellow contributor Dave Van Knapp, it’s part of a more comprehensive series of “lessons” on 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…
Enbridge Inc. (ENB) is an energy distribution and transportation company that owns and operates crude and natural gas pipelines across the United States and Canada. It also operates a gas utility business. Additionally, the company has considerable exposure to renewable energy through a diversified portfolio of renewable energy projects.
Founded in 1949, Enbridge is now a $59 billion (by market cap) energy powerhouse that employs 13,000 people.
The company has five business segments: Energy Services, 58% of FY 2019 revenue; Liquids Pipelines, 20%; Gas Transmission and Midstream, 10%; Gas Distribution, 10%; and Renewable Power Distribution, 1%.
After merging with Spectra Energy Corp. in 2017, Enbridge is now the largest energy infrastructure company in North America. The company operates the world’s longest and most complex crude oil and liquids transportation system.
For perspective, their pipeline network stretches from Norman Wells, Canada to Brownsville, Texas.
They operate over 17,000 miles of active crude pipeline across North America, split almost evenly between the US and Canada.
The company transports 25% of the crude oil produced in North America; they also transport ~19% of all natural gas consumed in the US
Put simply, they are a massive and critical energy infrastructure company.
In addition to this energy infrastructure, Enbridge is Canada’s largest natural gas utility. They have approximately 3.8 million retail customers in Ontario and Quebec.
To cap it all off, they’ve committed more than $7.8 billion to renewable energy and power transmission projects that are currently in operation or under construction. This area of the business will take on a greater percentage of revenue as projects complete.
While the role of hydrocarbons in meeting the world’s energy needs is slowly deteriorating, there’s no doubt that our society currently cannot function without these products.
And there’s no immediate future in which that reality is all that different.
Furthermore, Enbridge has largely insulated itself from volatile commodity pricing.
The company estimates that ~98% of its cash flow is predictable through regulated operations, take or pay contracts, or fixed fees.
This is a big reason why Enbridge has been able to stack up one of the most impressive dividend growth track records in all of energy.
Dividend Growth, Growth Rate, Payout Ratio and Yield
They’ve increased their dividend for 24 consecutive years.
Impressively, their overall dividend history goes back 65 years.
The 10-year dividend growth rate is 13.0%.
That’s a very high growth rate when paired with the stock’s current yield of 7.75%.
This yield smashes the market – it’s more than four times higher than what the S&P 500 offers.
It’s also more than 270 basis points higher than the stock’s own five-year average yield.
And with the company guiding for FY 2020 DCF/share at a midpoint of CAD $4.65, the dividend is covered by a payout ratio of 69.7%.
Revenue and Earnings Growth
A lot to like about where the dividend currently stands.
However, investors are putting today’s capital at risk for tomorrow’s rewards.
As such, I’ll now build out a forward-looking growth trajectory for the business, which will later help us estimate the stock’s intrinsic value.
I’ll first rely on long-term top-line and bottom-line growth results as a base.
Then I’ll compare those results to a near-term professional prognostication for profit growth.
Combining the proven past with a future forecast in this way should allow us to extrapolate out some reasonable assumptions about where the business is going.
Enbridge grew its revenue from CAD $15.127 billion in FY 2010 to CAD $50.069 billion in FY 2019.
That’s a compound annual growth rate of 14.22%.
Super impressive growth here.
Now, much of this was was a result of the 2017 merger. Still, there was evidence of secular growth even prior to that event.
Meanwhile, the bottom line also shows healthy growth.
I won’t be looking at earnings per share in this case due to the way Enbridge operates and shows profit. Being an infrastructure business with a large midstream presence, it reports cash flows more in line with an MLP.
And I’ll also be showing DCF/share growth from FY 2017 onward. This is due to the Spectra acquisition and the move away from prior reporting of cash flows in an ACCFO format.
Enbridge produced CAD $3.68 DCF/share in FY 2017. They’re guiding for CAD $4.65 in DCF/share for FY 2020.
This would be a CAGR of 8.11%.
The structure of the business is responsible for the lower bottom-line growth. Like an MLP would do, Enbridge funds a lot of their growth through equity and debt.
This is not as impressive as top-line growth. But you’re pairing that with the near-8% yield. It’s more than enough.
Looking forward, CFRA is anticipating that Enbridge will compound its EPS at an annual rate of 7% over the next three years.
I’m assuming they’re using EPS growth as a proxy for cash flow growth on a per-share basis.
Notably, Enbridge management has been repeatedly guiding for 5-7% growth in DCF/share post-2020.
Severe disruption is obviously upon us with the pandemic. However, even with reduction in demand for energy products, Enbridge’s business hasn’t been affected much.
This circles back to what I mentioned earlier about the fairly insulated business model.
For context, Enbridge recently reported Q3 FY 2020 results that showed almost completely flat YOY DCF. That’s vastly different than what a lot of other companies in the energy space have experienced.
And this is why Enbridge is one of the clear leaders in energy as it relates to quality and reliability. This is also why they’ve built up such an outstanding dividend growth track record.
CFRA’s growth forecast is at the top end of what Enbridge management has been guiding for, and I’d personally scale things back in the face of so much uncertainty.
But even a mid-single-digit growth rate closer to the low end of management’s expectations would still be more than enough to propel a fantastic total return and plenty of overall income.
Financial Position
Moving over to the balance sheet, the company has a really good financial position.
This position has improved in recent years.
The long-term debt/equity ratio is 0.90.
Enbridge has lowered its consolidated debt to EBITDA down from approximately 6x in 2016 to under 5 for this full year.
Their credit ratings are in investment-grade territory: Standard & Poor’s rates their senior unsecured debt BBB+; Moody’s, Baa2; Fitch, BBB+.
Profitability is somewhat difficult to gauge because of the way the company reports profitability. GAAP numbers can be irrelevant in some cases.
Over the last five years, the firm has nonetheless averaged annual net margin of 5.56% and annual return on equity of 6.79%.
Energy has been one of the worst-performing areas of the whole market over the last year.
Enbridge’s stock got caught up in the mayhem, but the business hasn’t been negatively affected to a great degree. I think that’s due to durability of the business model.
The company has built up massive scale on a network of integrated infrastructure that would be nigh impossible to now replicate from scratch, conferring them durable competitive advantages.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
While Enbridge may face few truly formidable competitors because of their size, regulation and litigation are huge risks in their industry.
The constant legal wrangling surrounding their Line 5 pipeline is an example of that.
Their large size also works against them in some ways, as there’s less growth potential with a mature business such as this.
Even though the company is largely insulated from volatile commodity pricing, they are ultimately somewhat sensitive to this over the long run via volume, demand, and counterparty risk.
There’s a broader move away from traditional energy products. Enbridge has invested in renewable, but the core business model remains based on hydrocarbon consumption.
Their balance sheet is solid and has been improving, but plenty of debt is on the balance sheet. And any increase in costs as it relates to raising equity or debt capital would harm the company’s growth plans.
Overall, Enbridge presents as a compelling long-term investment for those looking for a high yield.
This is especially true with the stock down 20% YTD and now trading for an attractive valuation…
Stock Price Valuation
The stock is available for a P/DCF ratio of 6.84, based on the guidance midpoint for FY 2020 DCF/share.
That’s fairly analogous to a P/E ratio, showing just how cheap the stock is right now.
Then there’s the cash flow multiple.
The P/CF ratio is 8.8 right now, which is disconnected from its three-year average of 9.4.
And the yield, as noted earlier, is significantly 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 an 8% discount rate (to account for the high yield) and a long-term dividend growth rate of 3%.
That DGR is markedly lower than what Enbridge has shown itself capable of delivering, both in terms of dividend growth and DCF/share growth.
And their minimal business impact throughout the pandemic has been impressive.
However, with so much uncertainty around hydrocarbon demand both for the near term and long term, as well as Enbridge’s large size naturally leading to less growth relative to the past, I think it makes sense to set ourselves up for low expectations.
Enbridge could certainly do better than this. But I think it makes sense to be cautious.
The DDM analysis gives me a fair value of $51.09.
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’ve put up a low bar, yet the stock still looks remarkably cheap.
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 ENB as a 4-star stock, with a fair value estimate of $43.00.
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 ENB as a 4-star “BUY”, with a 12-month target price of $37.00.
I ended up with a higher number, surprisingly. Averaging the three numbers out gives us a final valuation of $43.70, which would indicate the stock is possibly 37% 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 ENB’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 57. 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, ENB’s dividend appears Borderline Safe with a moderate risk of being cut. Learn more about Dividend Safety Scores here.
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