If you want an average life, you do average things.
But what if you want an extraordinary life?
Well, you then have to do extraordinary things.
What if you want to be an extraordinary investor?
I’d argue that much of it comes down to investing in above-average businesses at below-average valuations.
If you can consistently do that, over and over again, you can achieve truly extraordinary results over the long run.
How to find above-average businesses?
Well, looking at businesses that routinely increase their profits and dividends is a great start.
I’m talking about high-quality dividend growth stocks here.
Stocks like those you’ll find on the Dividend Champions, Contenders, and Challengers list.
After all, only great enterprises can grow their profits and dividends, year in and year out, like clockwork.
It doesn’t work like that.
I’ve personally taken this to heart, putting my own hard-earned money to work with these stocks and building out my FIRE Fund in the process.
This Fund is my real-money portfolio, and it produces enough five-figure passive dividend income for me to live off of.
That’s even though I’m still in my 30s.
Indeed, I was actually able to retire at only 33 years old.
My Early Retirement Blueprint, which details how I accomplished this feat, explains why I bet my money, my future, and my life on these stocks.
It turned out to be a very good bet.
Regularly investing in above-average businesses has helped me to create and live an extraordinary life.
But, as pointed out earlier, valuation is the other big part of the equation.
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 above-average businesses at below-average valuations can help you to build extraordinary wealth and passive income over the long run, which can then allow you to live an extraordinary life.
Of course, finding below-average valuations does require one to have an understanding of valuation in the first place.
Fortunately, it’s not that difficult.
Fellow contributor Dave Van Knapp put together Lesson 11: Valuation in order to greatly simplify the valuation process.
Part of a comprehensive series of “lessons” on dividend growth investing, it lays out an easy-to-follow valuation system that can be applied 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…
Fifth Third Bancorp (FITB) is a diversified regional bank holding company that offers a range of financial services and products, such as deposits, lending, transaction processing, and advisory solutions.
Founded in 1858, Fifth Third Bancorp is now a $29 billion (by market cap) major financial player that employs 19,000 people.
Headquartered in Cincinnati, Ohio, the bank is mostly focused on its core Midwestern market that includes the states of Ohio, Michigan, Illinois, and Indiana.
With total assets of just over $210 billion, they are in the top-20 largest banks in the United States. For context, there are over 5,000 commercial banks and savings institutions in the US.
The bank operates four main businesses: Commercial Banking, 37% of FY 2021 revenue; Branch Banking, 27%; Consumer Lending, 10%; and Wealth and Asset Management, 9%. General Corporate and Other accounts for the remainder.
There are few business models more enduring than the banking business model. Banking as we know it can be traced back to 2000 BC.
It’s one of the oldest business models around because it’s one of the best business models around.
Thinking in very simple terms, a bank can take in deposits at one rate, then lend at a higher rate.
That’s a good business in and of itself, but it’s missing one of the most powerful aspects of the business model: the float.
A float shows up in a certain business models, including banks, insurance companies, and payroll processors.
Whenever a large amount of low-risk, low-cost capital accrues as a natural course of doing business, and whenever you have a time delay between capital being taken in and capital going out, you have the opportunity to take advantage of a float and earn a substantial amount of money on this capital while it’s in your charge.
Warren Buffett has repeatedly pointed to the float for why he’s so enamored with investing in banks and insurance companies.
But wait. There’s more.
In addition, modern-day banks have branched out into areas like wealth management, financial services, and payments.
This further diversifies banks, all while giving them access to more capital and recurring fees.
And all of that leads to increasing revenue, higher profits, and bigger dividends for the likes of Fifth Third.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Already, the bank has increased its dividend for 11 consecutive years.
They’re off to a great start, with a 10-year dividend growth rate of 14.8%.
Better yet, you’re pairing that double-digit dividend growth with the stock’s current yield of 2.9%.
While this yield is only right in line with its own five-year average, it blows away the broader market’s yield.
And since the payout ratio is just 32.2%, this is a well-covered dividend positioned for much more growth ahead.
I like dividend growth stocks in what I call the “sweet spot” – a yield of between 2.5% and 3.5%, paired with high-single-digit (or better) dividend growth.
This stock is squarely in the sweet spot.
Revenue and Earnings Growth
As sweet as they might be, these dividend metrics are largely looking backward.
However, investors have to risk today’s capital for tomorrow’s rewards.
Thus, I’ll build out a forward-looking growth trajectory for the business, which will later help when it comes time to estimate intrinsic value of the shares.
I’ll first show you what the company has done over the last decade in terms of top-line and bottom-line growth.
And then I’ll unveil a professional prognostication for near-term profit growth.
Comparing the proven past with a future forecast in this way should provide us with a reasonably clear picture of what the company’s future growth path might look like.
Fifth Third has advanced its revenue from $6.1 billion in FY 2012 to $7.6 billion in FY 2021.
That’s a compound annual growth rate of 2.5%.
It’s been a challenging decade for banks. I see this as a very acceptable top-line growth rate.
Meanwhile, earnings per share increased from $1.66 to $3.73 over this period, which is a CAGR of 9.4%.
That’s fairly impressive.
Better profitability has helped here. But a lot of excess bottom-line growth has been spurred by extensive buybacks – the outstanding share count is down by 25% over the last 10 years.
Looking forward, CFRA forecasts that Fifth Third will compound its EPS at an annual rate of 4% over the next three years.
What’s perplexing here is that CFRA had this three-year EPS CAGR forecast at 19% when I last looked at their report on Fifth Third back in August 2021.
CFRA has materially peeled back the growth forecast, despite no matching material change in Fifth Third’s business. So I find it inexplicable.
Even stranger, CFRA has simultaneously increased their 12-month target price on the stock by a material amount.
Admittedly, the macroeconomic backdrop has deteriorated since August 2021. A very high rate of inflation is forcing the US Federal Reserve to become aggressive with raising interest rates, which could run the US economy into a recession.
At the same time, higher rates generally benefit banks.
I think it’s important to keep in mind that the last decade has already been a tough stretch for banks: The US economy hobbled its way out of the Great Recession, interest rates have been kept at historic lows, the regulatory environment has been challenging, and then a global pandemic happened.
Yet Fifth Third still put up very respectable EPS and dividend growth over that stretch.
In addition, Fifth Third has put itself in a stronger competitive position in recent years by aggressively expanding into Florida. Florida, which is one of the fastest-growing states in the US, has become one of bank’s largest markets.
Even if the next decade is tougher than the last decade, I don’t see why Fifth Third can’t produce high-single-digit EPS growth.
With a low payout ratio, the dividend could grow at a level that’s at least in that same range.
And with a starting yield at almost 3%, it’s hard to complain about that.
Financial Position
Moving over to the balance sheet, the bank has a rock-solid financial position.
They have total assets of $206.3 billion against $183.5 billion in total liabilities.
Credit ratings for their senior debt are as follows: BBB+, S&P; Baa1, Moody’s; and A-, Fitch.
Profitability is fairly robust.
Over the last five years, the firm has averaged annual net margin of 30.9% and annual return on equity of 11.9%. Net interest margin came in at 2.6% for FY 2021.
This is a high-quality enterprise pretty much right across the board.
And the company does benefit from durable competitive advantages that include economies of scale, a large float, switching costs, and built-up relationships.
Of course, there are risks to consider.
Competition, regulation, and litigation are omnipresent risks in every industry.
In particular, regulation is a constant challenge in banking.
The US Federal Reserve is anticipated to aggressively increase rates throughout 2022, but rates are still low by historical standards.
All banks have direct exposure to economic cycles. The current cycle is especially uncertain, with unknown residual impacts from the pandemic and lockdowns.
With the US Federal Reserve embarking on a mission to curb demand, the near-term odds of a recession have risen. A recession can hurt the bank in two ways: Less economic activity reduces growth from deposits and loan demand, while loan losses harm the balance sheet.
These risks should be thoughtfully considered, but I still believe this bank can make for a great long-term investment.
With the stock down nearly 20% from its 52-week high, its undemanding valuation makes it even more enticing…
Stock Price Valuation
The stock’s P/E ratio is sitting at a lowly 11.0.
That’s substantially lower than the earnings multiple of the broader market.
Admittedly, it is right in line with the bank’s own five-year average P/E ratio. But with rates rising and the prescient expansion into Florida, the bank arguably deserves a higher multiple than its long-term average.
Banks are also often valued on a P/B ratio, with most banks commanding a P/B ratio that ranges from 1.0 to 2.0.
The stock’s P/B ratio is 1.4, which is on the lower end of that range.
And the yield, as noted earlier, is right 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 7%.
The 7% mark is well below the bank’s demonstrated EPS and dividend growth rates, respectively, over the last decade.
Rates are rising to the bank’s benefit. And the payout ratio is low.
However, I think some caution is warranted.
The near-term EPS growth forecast is below this number.
The current economic cycle is fraught with uncertainty.
And near-term odds of a recession are seemingly rising.
Overall, I think this is a fair assessment of the bank’s long-term dividend growth power, even if it might be a bit bumpy from year to year.
The DDM analysis gives me a fair value of $42.80.
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 overly aggressive at all, yet the stock still looks at least modestly undervalued.
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 FITB as a 3-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 FITB as a 4-star “BUY”, with a 12-month target price of $56.00.
I came out within pennies of where Morningstar landed. Averaging the three numbers out gives us a final valuation of $47.27, 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 D&I: How safe is FITB’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 50. 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, FITB’s dividend appears Borderline Safe with a moderate risk of being cut. Learn more about Dividend Safety Scores here.
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