From the Fed’s faster taper to the spreading Omicron variant, the market’s had a lot to digest recently.
Well, it seems like we have a case of indigestion.
The market has not taken these developments in stride.
Volatility has picked up as a result.
But it’s during turbulent market environments such as this one that the strategy I espouse really shines.
That strategy is, of course, dividend growth investing.
It’s a strategy whereby you buy and hold shares in world-class enterprises that pay reliable, rising dividends.
You can find hundreds of these stocks listed on the Dividend Champions, Contenders, and Challengers list.
No matter what’s going on in the stock market, these dividends are consistently flowing directly from the companies to their shareholders – totally bypassing the market’s craziness.
That lack of volatility in one’s dividends, despite lots of volatility in one’s stocks, is why this strategy really shines during times like right now.
And what’s it done for me?
Well, quite a bit.
It’s radically changed my life.
For one, it helped me to retire in my early 30s.
My Early Retirement Blueprint describes exactly how I accomplished that, and why this strategy was instrumental toward that end.
I now manage the FIRE Fund.
That’s my real-money dividend growth stock portfolio.
It produces enough five-figure passive dividend income for me to live off of.
This strategy is so powerful.
And it’s so comforting during times of heightened market volatility.
As true as that is, valuation at the time of investment is critical.
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.
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.
Investing in a high-quality company that pays reliable, rising dividends, and doing so when it’s undervalued, sets you up to calmly ride out market volatility and experience excellent long-term total return.
Of course, Spotting undervaluation requires one to understand valuation.
Fortunately, this isn’t that difficult.
Fellow contributor Dave Van Knapp’s Lesson 11: Valuation, which is part of a larger series on dividend growth investing, deftly explains the ins and outs valuation and provides an easy-to-follow valuation system that can be applied toward most dividend growth stocks.
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 $43 billion (by market cap) investment management colossus that employs more than 7,000 people.
With approximately $1.6 trillion in assets under management, T. Rowe Price ranks as one of the largest US-based asset managers.
Asset management is an exceptional business model.
This is because of its structure.
See, T. Rowe Price charges fees to manage assets.
And there are multiple growth paths for the fees, one of which is exponential.
First, asset managers like T. Rowe Price naturally have a lot of exposure to global equities.
And since global equities are almost certainly headed higher over the long term, the company should benefit from the aggregate of the world’s growth. The fee base is exponentially rising.
Plus, clients and the associated assets tend to be “sticky”. This limits outflows, which helps the firm to ride out volatility.
Stimulative fiscal and monetary policies of late have created unprecedented levels of liquidity, intensifying the already favorable dynamics that T. Rowe Price enjoys.
Most asset classes have gone on huge runs, directly helping the likes of T. Rowe Price.
Simply put, the underlying business model is advantageously located in a rising tide (capital markets) that’s lifting all boats (participants in said capital markets).
Thus, fees have a built-in escalator – higher AUM, higher fees.
Then there’s the high performance, which improves the company’s reputation, keeps assets sticky, and provides a higher fee base.
Regarding T. Rowe Price’s performance, Morningstar states this: “At the end of 2020, 83%, 79%, and 77% of the company’s fund AUM were beating peers on a 3-, 5-, and 10-year basis, respectively, with 77% of AUM in the funds closing out the year with an overall rating of 4 or 5 stars, better than just about every other U.S.-based asset manager.”
In addition, T. Rowe Price has more ordinary growth paths in front of it, such as offering more products, more services, and acquiring more customers.
One product that’s been especially successful for the company is their target-date retirement offerings, which have generated just under $100 billion in net inflows over the last decade.
With such an exceptional business model, it shouldn’t be a surprise to see the company regularly growing its profit and dividend.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Indeed, T. Rowe Price has increased its dividend for 35 consecutive years.
That easily qualifies them for their status as a Dividend Aristocrat.
But what’s been really impressive is the recent acceleration in dividend growth – the most recent dividend increase was 20%.
I suspect that this trend will continue, as the payout ratio is a low 32.6%.
Meantime, you’re also able to lock in a market-beating 2.3% yield that’s within 30 basis points of its five-year average.
These dividend metrics are fantastic.
Revenue and Earnings Growth
As fantastic as they are, though, they’re largely looking at the past.
However, investors are risking today’s capital for tomorrow’s rewards.
And so I’ll now build out a forward-looking growth trajectory for the business, which will later help guide in the process to estimate the stock’s intrinsic value.
I’ll first show you what the company has done over the last decade in terms of its top-line and bottom-line growth.
Then I’ll reveal a near-term professional prognostication for profit growth.
Comparing the proven past with a future forecast in this way should give us a fairly clear picture on where the business might be going from here.
T. Rowe Price grew its revenue from $2.7 billion in FY 2011 to $6.2 billion in FY 2020.
That’s good for a compound annual growth rate of 9.5%.
Tremendous.
I usually look for a mid-single-digit top-line growth rate from a mature business like this.
T. Rowe Price blew my expectations 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 14.6%.
Excellent growth here, which speaks on everything I noted earlier about the exceptionality of the business model.
A combination of margin expansion and share repurchases helped to produce excess bottom-line growth. Regarding the latter, the outstanding share count is down by ~12% over the last 10 years.
Looking forward, CFRA is predicting that T. Rowe Price will compound its EPS at an annual rate of 14% over the next three years.
CFRA highlights T. Rowe Price’s “strong market share, better-than-peer-average ability to attract new investment, and relatively better-than-average investment performance”.
Also noted by CFRA is the fact that T. Rowe Price routinely repurchases its shares. This provides a base level of EPS growth, as there are simply less shares upon which to calculate net income.
I see CFRA’s forecast as safe and reasonable. It’s right in line with the demonstrated 10-year EPS growth rate, so we’re assuming a continuation of the status quo.
For perspective, T. Rowe Price’s Q3 report for FY 2021 showed 21.2% YOY growth.
Admittedly, it was a great 12-month period for US stocks. And T. Rowe Price has felt the gusting of this tailwind. But I think this Q3 report goes to show that there’s no evidence of a slowdown, which means there’s no reason to expect one.
In addition, T. Rowe Price already announced that it agreed to buy alternative credit manager Oak Hill Advisors LP and related entities for $4.2 billion.
This bolt-on acquisition, which will be funded by a combination of cash and stock, diversifies the company’s offerings.
More importantly, the company stated that the acquisition is expected to be accretive to FY 2022 EPS “by a low-to-mid single digit percentage”. That’s meaningful.
Overall, I see T. Rowe Price’s future looking a lot like its past. Which is to say, the future looks very bright.
And so I’d expect dividend growth to remain at least in the high-single-digit range for the foreseeable future.
Financial Position
Moving over to the balance sheet, the company has a magnificent financial position.
T. Rowe Price has no long-term debt.
The balance sheet is flawless.
Profitability is outstanding.
Over the last five years, the firm has averaged annual net margin of 34.7% and annual return on equity of 30.8%.
Net margin has expanded significantly over the last decade.
There is usually something to complain about when analyzing a business.
Be it a shaky balance sheet or underwhelming growth, one can almost always point to a fault or two.
However, I find nothing to fault here. It’s almost a perfect business.
And with economies of scale, performance-oriented brand value, and switching costs that keep assets “sticky”, the company does benefit from durable competitive advantages.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
The very business model is a risk, due to the exposure to so much volatility from global capital markets.
There’s cyclical risk here. A recession would hurt asset valuations, AUM, fees, and profits.
There has been a pronounced shift to passive funds throughout the industry, which reduces demand for active management and the associated fees.
I view the company’s size as somewhat of a risk. Their AUM base is so large at this point, it’s difficult to grow at a material rate in percentage terms.
While I think it’s important to consider these risks, I see the overall quality of the business as very high and easily able to overcome the risks.
And with the stock 14% off of its 52-week high, the valuation makes this a particularly compelling long-term idea right now…
Stock Price Valuation
The stock is trading hands for a P/E ratio of 14.5.
That’s much lower than the broader market’s earnings multiple.
It’s also slightly discounted compared to the stock’s own five-year average P/E ratio of 15.5.
For a company growing at ~14% per year, the current P/E ratio implies a PEG ratio of just 1 – that’s ludicrously low.
And the yield, as noted earlier, is close to 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 DGR is at the highest end of what I will allow for.
But if there’s any company that deserves this designation, it’s this one.
As high as it might be, it’s still lower than the company’s demonstrated EPS and dividend growth over the last decade. It’s also lower than the near-term forecast for EPS growth.
With the payout ratio being so low, there’s flexibility on top of the underlying high growth rate of the business.
I think this is a reasonable long-term dividend growth expectation. If anything, they may very well exceed it over the next few years.
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.
This stock looks cheap, even after a valuation that probably doesn’t factor in all of their true earnings power over the coming years.
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 3-star stock, with a fair value estimate of $212.00.
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 3-star “HOLD”, with a 12-month target price of $220.00.
I came out a bit high, but the range here is fairly tight. Averaging the three numbers out gives us a final valuation of $221.76, which would indicate the stock is possibly 15% 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 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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