Short-term volatility is a long-term opportunity.
Let me repeat that.
Short-term volatility is a long-term opportunity.
Market participants tend to get uneasy when volatility rears its ugly head, but they really shouldn’t.
Getting a better deal on a great stock is something you should celebrate.
And this sanguine approach to volatility has definitely aided me as I’ve gone about building my FIRE Fund.
That’s my real-money stock portfolio.
It produces enough five-figure passive dividend income for me to live off – while I’m still in my 30s.
Indeed, I was able to retire in my early 30s.
How?
Well, I lay it all out in my Early Retirement Blueprint.
If you read through that, you’ll see that a major aspect of my success has been the investment strategy I’ve followed.
That strategy is dividend growth investing.
This strategy espouses buying and holding shares in world-class enterprises that pay reliable, rising dividends to shareholders.
You can find hundreds of examples by checking out the Dividend Champions, Contenders, and Challengers list.
And the reliable, rising profits are produced because these businesses are providing the world with the products and/or services it demands.
It’s a virtuous cycle.
As amazing as this strategy is, though, it can be even more amazing by taking advantage of volatility and snagging stocks at lower valuations.
After all, price is only what you pay. But 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.
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.
Seeing short-term volatility as a long-term opportunity, and buying high-quality dividend growth stocks at lower valuations, can make an amazing investment strategy that much more amazing.
Fortunately, separating price from value isn’t that hard.
Fellow contributor Dave Van Knapp has made that process a lot easier, via introduction of Lesson 11: Valuation.
Part of a comprehensive series on the dividend growth investing strategy, it provides a valuation guide that can be effectively applied to almost any dividend growth stock.
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…
Pinnacle West Capital Corporation (PNW) is a utility holding company that principally serves as the parent of Arizona Public Service, Arizona’s largest and longest-serving electric utility.
With corporate roots dating back to over 125 years ago, Pinnacle West is now a $9 billion (by market cap) utility whopper that serves more than 1 million customers.
The company’s one reportable segment is their regulated electricity segment, which consists of traditional regulated retail and wholesale electricity businesses engaged in electricity generation, transmission, and distribution.
Residential customers accounted for 50% of FY 2020 electric revenue, while industrial and commercial customers accounted for 49%. Other revenue occurred through wholesale, transmission for others, and miscellaneous customers.
APS is vertically integrated, providing retail or wholesale electric service to almost the entire state of Arizona. That is, except the metro Tucson area and about half of the metro Phoenix area.
Fuel sources for APS for 2020 were as follows: gas, 28%; nuclear, 23%; demand-side management, 16%; coal, 14%; renewables, 11%; and purchased power, 8%.
A significant portion of the company’s energy mix comes from clean resources. Moreover, they’ve announced a plan to deliver 100% clean, carbon-free electricity by 2050.
The investment thesis regarding a utility business like Pinnacle West is very straightforward.
In a modern-day society that quite simply cannot function without reliable access to power, Pinnacle West provides a service that practically sells itself.
They have captive customers that really can’t live without the service.
This inherent need creates unflinching demand and a built-in profit source.
That profit, of course, lead to dividends.
And as more people move to Arizona and demand power at higher prices, you get higher profit and more dividends.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Pinnacle West has already increased its dividend for 10 consecutive years.
That DGR beats inflation and is rather nice when you layer that on top of the stock’s current market-smashing yield of 4.0%.
This yield doesn’t just cream the market, by the way; it’s also 60 basis points higher than the stock’s own five-year average yield.
And with a payout ratio of 67.5%, this is a well-protected dividend.
Revenue and Earnings Growth
These are very appealing dividend metrics.
As appealing as they are, though, they’re looking into the past.
However, investors are risking today’s capital for tomorrow’s rewards.
It’s the future growth and dividends that are most relevant.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will later help with the estimation of the stock’s intrinsic value.
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.
Amalgamating the proven past with a future forecast in this manner should give us a very good idea as to where the business might be going from here.
Pinnacle West has increased its revenue from $3.241 billion in FY 2011 to $3.587 billion in FY 2020.
That’s a compound annual growth rate of 1.13%.
Meantime, earnings per share grew from $3.09 to $4.87 over this period, which is a CAGR of 5.18%.
These are fairly standard numbers for a utility business, in my view.
I see them as neither excellent nor subpar.
However, there’s been a very recent explosion of demand for Arizona in general and Phoenix specifically. Migration to this area bodes well for the utility, with a good chance of growth acceleration off of this solid base.
Looking forward, CFRA believes that Pinnacle West will compound its EPS at an annual rate of 5% over the next three years.
So CFRA is basically assuming the status quo here, which is fair.
I’m a bit more sanguine, owing to what I just noted about Arizona’s recent in-migration.
Even if CFRA’s growth forecast were to materialize, which would be in line with Pinnacle West has historically delivered, that would be enough bottom-line growth to fuel similar dividend growth.
And when you pair that kind of dividend growth with the 4%, yield, I think that’s right in the wheelhouse for a utility investor.
That said, I do believe there’s a good chance that both EPS and the dividend will eclipse this 5% growth level when peering into the near future.
Financial Position
Moving over to the balance sheet, Pinnacle West has a pretty standard financial position for a utility business.
The long-term debt/equity ratio is 1.12, while the interest coverage ratio is near 4.
Profitability is robust, with margins standing out as a strong suit.
Over the last five years, the firm has averaged annual net margin of 14.31% and annual return on equity of 9.96%.
I see Pinnacle West as a very good utility business across the board.
What’s particularly exciting about it, in my opinion, is the area in which it operates. I’m enthusiastic about Arizona in general, and Pinnacle West should see that rising tide lifting its boat.
The utility also benefits from competitive advantages that include economies of scale, geographic monopoly, and a regulatory structure that nearly guarantees profit.
Of course, there are risks to consider.
Litigation, regulation, and competition are omnipresent risks in every industry.
Regulation is a double-edged sword.
On one hand, regulators allow for utilities to make a reasonable profit, factoring in things like capex. Profit tends to scale with costs. This puts a profit floor in place.
On the other hand, there’s also a ceiling. Because power is necessary and there’s often only one power provider in any one geographic area, regulators limit the rates a utility can charge.
Since a geographic monopoly is often in place, competition in the traditional sense is usually nil.
However, customers could become greater competition in the future through the generation of power at the site of consumption.
There’s geographic risk here. Utilities don’t have the ability to expand their coverage areas very much, so they largely rely on the underlying population growth of those areas.
I also see pricing risk. The company purchases some of their power. This leaves them vulnerable to swings in natural gas prices.
Lastly, there’s nuclear risk. Pinnacle West has an interest in the Palo Verde nuclear plant, the largest nuclear plant in the US.
Even with these issues out in the open, I still believe that the potential long-term reward easily outweighs the long-term risks.
At the right valuation, that equation skews even more to the investor’s favor.
With the stock priced below where it was before the pandemic, despite all of the growth over the last 18 months, I see the valuation as attractive…
Stock Price Valuation
The stock’s P/E ratio is 16.95.
That compares very favorably to the market’s earnings multiple.
It’s also well below the stock’s own five-year average P/E ratio of 18.7.
And the yield, as noted earlier, is measurably 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 9% discount rate (to account for the higher yield) and a long-term dividend growth rate of 5%.
This is extra conservative.
I’m basically assuming, like CFRA, more of the same. It’s status quo.
This DGR is right in the same neighborhood as the company’s 10-year EPS CAGR and 10-year DGR. And it matches CFRA’s near-term EPS growth forecast.
I think Pinnacle West could easily outperform this expectation.
As always, though, I do prefer to err on the side of caution when extrapolating projections out over a very long period of time.
The DDM analysis gives me a fair value of $87.15.
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 put together a cautious valuation, yet the stock still looks 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 PNW as a 3-star stock, with a fair value estimate of $88.00.
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 PNW as a 4-star “BUY”, with a 12-month target price of $92.00.
We’re all in the same ballpark. Averaging the three numbers out gives us a final valuation of $89.05, which would indicate the stock is possibly 7% 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 PNW’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 92. 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, PNW’s dividend appears Very Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
It's the brainchild of one of the smartest investment managers alive and it pays you every single month. Even better, this fund trades at a discount to NAV, so there's near-certain price gains ahead! All the details are waiting for you, along with 2 other incredible picks from my full "7% Monthly Payer Portfolio."
