Our current economic recovery is unlike any other recovery we’ve ever experienced.
The world is awash in capital.
The combined monetary and fiscal response by the US government to the pandemic has been unprecedented.
And this level of extreme liquidity benefits a lot of businesses out there.
Investors can also benefit from this by investing in the businesses that benefit.
Investing in wonderful businesses taking advantage of major trends (like the current liquidity trend) is something I’ve repeatedly done over the years.
That’s my real-money portfolio.
The portfolio is chock-full of high-quality dividend growth stocks like those you’ll find on the Dividend Champions, Contenders, and Challengers list.
This list contains invaluable data on hundreds of stocks that have regularly and reliably increased their dividends.
Consistently increasing dividends is a central tenet to the dividend growth investing strategy.
After all, how better to prove how profitable you are than to send your shareholders ever-larger cash dividends?
I’ve used this strategy to exponentially increase my wealth and passive dividend income.
It even allowed me to retire in my early 30s.
My lifestyle is now covered by five-figure annual passive dividend income.
Suffice it to say, investing in the right businesses at the right valuations is critical.
That latter part will have a lot to say about your investment success.
Price is only what you pay. Value is what you get for your money.
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.
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.
Buying high-quality dividend growth stocks that are taking advantage of current trends, and doing so at attractive valuations, can lead to your wealth and passive income increasing exponentially over the long run.
Trends are obvious, but valuation is perhaps less so.
Fear not, as fellow contributor Dave Van Knapp greatly demystified the valuation process with Lesson 11: Valuation.
Part of a more holistic series of “lessons” on dividend growth investing, it puts forth a valuation template that you can use to estimate the intrinsic value of almost 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…
T. Rowe Price Group Inc. (TROW) is a large investment management company that manages assets for individual and institutional investors.
Founded in 1937, T. Rowe Price is now a $40 billion (by market cap) investment management mammoth that employs more than 7,500 people.
With approximately $1.5 trillion in assets under management, T. Rowe Price ranks as one of the largest US-based asset managers.
Asset managers like T. Rowe Price operate phenomenal business models.
That’s because they have a multifaceted path to extraordinary growth.
First, they have a lot of exposure to global equities.
And since global equities are almost certainly headed higher over the long run, the company stands to benefit and profit from this. Plus, their assets tend to be “sticky” in nature. This limits outflows.
Stimulative fiscal and monetary policies have recently created unprecedented levels of liquidity, exacerbating the naturally favorable dynamics that T. Rowe Price enjoys.
Almost all asset classes have gone higher. And the company has benefited from this.
Then you have the recurring fees on top of it.
Asset managers collect attractive fees for their services, which gives them a way to supercharge the compelling underlying business model of being located in a rising tide of markets that’s lifting all boats.
While results can be somewhat lumpy from time to time, as markets are volatile, the steady nature of fees helps to smooth things out.
This one-two punch means the business is almost a lock for more profit over the long run.
And more profit translates to higher dividends, which is exactly what you get here.
Dividend Growth, Growth Rate, Payout Ratio and Yield
The company has increased its dividend for 35 consecutive years, making them a Dividend Aristocrat.
Even with the inherent volatility in markets, the dividend has been anything but volatile.
The 10-year dividend growth rate is 12.8%, which is outstanding.
And you’re pairing that double-digit dividend growth rate with the stock’s market-beating yield of 2.41%.
Also, the dividend is quite safe. The payout ratio is only 43.3%.
I view the “sweet spot” for a dividend growth stock to be a yield of between 2.5% and 3.5%, paired with a high-single-digit (or better) dividend growth rate.
As great as these dividend metrics are, though, this is what’s already come to pass.
It’s future growth that is really consequential.
Investors are risking today’s capital for tomorrow’s rewards.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will later help us to estimate the stock’s intrinsic value.
I’ll first show you what the business 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.
Blending the proven past with a future forecast in this manner should allow us to develop a reasonable idea of where the business is going from here.
T. Rowe Price has increased its revenue from $2.747 billion in FY 2011 to $6.206 billion in FY 2020.
That’s a compound annual growth rate of 9.48%.
This is outstanding.
I usually look for a mid-single-digit top-line growth rate from a mature business, but the company blew that out of the water.
Meanwhile, earnings per share advanced from $2.92 to $9.98 over this 10-year stretch, which is a CAGR of 14.63%.
Very, very impressive. The company has been mildly acquisitive, but I see most of this growth as being the result of an incredible business.
A combination of margin expansion and buybacks drove excess bottom-line growth. Regarding the latter, the float’s been reduced by approximately 12% over the last decade.
Looking forward, CFRA believes that T. Rowe Price will compound its EPS at an annual rate of 11% over the next three years.
CFRA cites key tailwinds as being the company’s strong relative investment performance and the popularity of their target-date retirement funds.
Giving further context to the performance, 77% of the company’s fund AUM was beating peers over the last 10 years as of the end of 2020 (per Morningstar).
Adding color to the other point, two thirds of the company’s AUM is comprised of retirement accounts and variable-annuity investment portfolios. These are long-duration assets with a low likelihood of ending up in outflows.
A key headwind that CFRA sees is the fact that more than 60% of T. Rowe Price’s AUM is in equities, exposing the company to volatility.
While CFRA’s near-term EPS growth forecast would represent a slowdown compared to the last decade, I think the caution is prudent and warranted.
Almost all asset classes are elevated. The US stock market is near all-time highs. And the last decade has been very kind to asset managers.
Still, a 11% EPS CAGR could provide for similar dividend growth, which would be a very appealing outcome over the foreseeable future.
Pairing double-digit dividend growth with the stock’s market beating yield is a compelling aggregate income and total return story.
Financial Position
Moving over to the balance sheet, the company has an excellent financial position.
There’s no long-term debt.
Profitability is also very robust.
Over the last five years, the firm has averaged annual net margin of 32.67% and annual return on equity of 28.52%.
There’s almost nothing to fault here. It’s almost a flawless business.
And with scale, performance-oriented brand value, and switching costs that keep assets “sticky”, the company does benefit from competitive advantages.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
The biggest risk might be the very business model, due to the high amount of volatility exposure from markets.
There’s cyclical risk here. A pronounced recession would hurt asset valuations, AUM, fees, and profits.
The overall shift to passive investments reduces demand for active management and the associated fees.
I view the company’s size as also working against them in some ways, as the law of large numbers starts to creep in and make it more difficult to meaningfully grow AUM in relative terms.
Overall, I see these risks as manageable and more than offset by the quality of the business.
The valuation only adds to the appeal…
Stock Price Valuation
The stock’s P/E ratio is 17.96.
That’s materially below the broader market’s earnings multiple.
While it’s actually higher than the stock’s own five-year average P/E ratio, I think this is a case where the market simply got it wrong before. I don’t see any reason why the stock should deserve such a lowly multiple.
On the flip side, the P/CF ratio of 21.6 is well off of its own three-year average of 30.5.
And the yield is also roughly in line with 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 8%.
This long-term DGR is on the high end of what I ordinarily allow for.
But I think this business has earned the benefit of the doubt.
The payout ratio is low, there’s no debt, and both the 10-year EPS growth rate and 10-year dividend growth rate are well over 8%. There’s also CFRA’s near-term EPS growth forecast, which is well above 8%.
I think this is a sensible long-term expectation for valuation.
The DDM analysis gives me a fair value of $233.28.
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 don’t think my analysis was aggressive, yet the stock looks noticeably 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 TROW as a 2-star stock, with a fair value estimate of $170.00.
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 TROW as a 4-star “BUY”, with a 12-month target price of $190.00.
We have a bit of a spread here, although I think Morningstar is being too conservative. Averaging the three numbers out gives us a final valuation of $197.76, which would indicate the stock is possibly 10% 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 D&I: How safe is TROW’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 94. 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, TROW’s dividend appears Very Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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