Warren Buffett is arguably the greatest investor of all time.
But who taught Buffett?
After all, if Buffett is so great, the person who taught him much of what he knows must be really special.
Buffett’s teacher, early mentor, and even one-time employer was Benjamin Graham.
Graham created one of the greatest maxims in investing lore.
“In the short run, the market is a voting machine. But in the long run, the market is a weighing machine.”
Votes only require money.
Intelligence isn’t necessary, nor is rationality.
Eventually, though, a business’s results and qualities have to be weighed.
I’ve taken advantage of this myself over the years, which helped me to achieve FIRE (financial independence/retire early) at only 33 years old.
I describe how I accomplished this feat in my Early Retirement Blueprint.
A foundational pillar of the Blueprint is the investing strategy I’ve used.
That strategy is dividend growth investing.
This is all about investing in world-class businesses that pay reliable, rising dividends to shareholders.
You can find hundreds of examples of these stocks on the Dividend Champions, Contenders, and Challengers list.
I built the FIRE Fund using this strategy.
That’s my real-money dividend growth stock portfolio, and it produces enough five-figure passive dividend income for me to live off of.
The difference between votes and weight can create distortions in valuation.
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.
It’s protection against the possible downside.
Taking advantage of the market’s short-term voting machine traits by buying high-quality dividend growth stocks when they’re undervalued sets you up to benefit massively from the market’s long-term weighing machine traits.
Of course, spotting undervaluation requires one to first understand valuation.
Fortunately, this isn’t as difficult as you might think.
Fellow contributor Dave Van Knapp’s Lesson 11: Valuation, which is part of an overarching series of “lessons” on dividend growth investing, lays out a simple-to-follow valuation process that you can use as a template to estimate fair value on just about 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…
Magna International Inc. (MGA) is a multinational mobility solutions and technology company for automakers that designs, develops, and manufactures automotive systems, assemblies, modules, and components.
Founded in 1957, Magna is now an $18 billion (by market cap) automotive titan that employs more than 150,000 people.
FY 2021 revenue can be broken down by product category: Body Exteriors & Structures, 40%; Power & Vision, 31%; Complete Vehicles & Other, 15%; and Seating Systems, 14%.
Based out of Canada, Magna is one of the world’s largest manufacturers of OEM components for various automakers.
It’s not just a large company, either. There’s incredible breadth here.
Morningstar puts it this way: “Many suppliers focus on a particular area of the vehicle. In sharp contrast, Magna’s capabilities are so broad that the firm could nearly design, develop, supply, and assemble vehicles all on its own.”
Mobility is becoming more important. And autos are becoming more complex. This situates Magna well.
And since more companies are talking about getting into the self-driving/EV space, Magna’s breadth sets it up to be a great manufacturing partner.
In addition, because of pandemic-induced backups in the global supply chain, there’s pent-up demand for new auto supply.
Inventories have reached record lows. Thus, used car prices have also been breaking records.
This has created what appears to be a coiled spring.
And as that spring uncoils over the coming years, Magna’s tailwind could gust mightily.
That should result in increasing revenue, more profit, and bigger dividends for the company and its shareholders.
Dividend Growth, Growth Rate, Payout Ratio and Yield
As things stand now, Magna has increased its dividend for 13 consecutive years.
The 10-year dividend growth rate is a stout 13.2%.
However, I should point out that recent dividend increases have shown deceleration.
For instance, the most recent dividend increase was only 4.7%.
But I think that has less to do with Magna specifically and more to do with the general situation I just touched on.
I suspect that Magna’s dividend growth will return to a more normal level when the industry normalizes.
While you wait for the growth to pick back up, the stock yields 3.0%.
It’s also 60 basis points higher than the stock’s own five-year average yield.
The payout ratio is at only 36.0%.
Despite the company not necessarily firing on all cylinders, it’s still a well-covered dividend.
I always like dividend growth stocks in what I refer to as the “sweet spot” – that’s a yield of between 2.5% and 3.5%, paired with high-single-digit (or better) dividend growth.
This stock is basically dead center on the yield, and the long-term dividend growth rate is well over what I’d usually be looking for.
Great dividend metrics.
Revenue and Earnings Growth
As great as they are, though, they’re mostly looking at the past.
However, investors risk today’s capital for tomorrow’s rewards.
As such, I’ll build out a forward-looking growth trajectory for the business, which will later be of great aid when it comes time to estimate 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.
And then I’ll reveal a professional prognostication for near-term profit growth.
Amalgamating the proven past with a future forecast in this manner should give us a reasonable idea of what the company’s growth path on a go-forward basis might look like.
Magna has increased its revenue from $30.8 billion in FY 2012 to $36.2 billion in FY 2021.
That’s a compound annual growth rate of 1.8%.
At first glance, this is disappointing.
However, it’s important to keep in mind that this business has been severely impacted by pandemic-induced lockdowns and the corresponding kinks in the global supply chain.
Revenue has still not fully recovered from where it was in FY 2019.
Meanwhile, earnings per share moved up from $3.04 to $5.00 over this time period, which is a CAGR of 5.7%.
Again, I think this result doesn’t accurately represent the company’s true growth profile. Earnings power has been temporarily, but heavily, curtailed.
If, for instance, we back things up and look at the five-year period from FY 2012 to FY 2016, EPS sported a CAGR of over 14%.
I expect the company’s EPS to increase meaningfully as the world starts to fully recover over the next 24-36 months.
I will quickly add that excess bottom-line growth has been aided by extensive share buybacks: The outstanding share count is down by an enormous 36% over this 10-year time frame.
Looking forward, CFRA believes that Magna will compound its EPS at an annual rate of 25% over the next three years.
I just stated that I expect a meaningful increase in the company’s EPS over the next few years. Well, that is meaningful.
I would ordinarily scoff at this kind of eye-popping growth forecast.
However, this is not an ordinary situation.
I see Magna’s business as a coiled spring. They’ve been forced to operate at subpar levels for two years now. As the supply chain kinks start to unwind, the coiled spring should explosively uncoil.
Record-low inventories for new autos are coming at a time when demand is at all-time highs, leading to very high prices.
Supply doesn’t have to just catch up to 2022’s demand but also make up for the losses over the course of two years. There’s a huge gap to fill.
There’s simply not enough supply to meet demand.
CFRA states it best here: “Sales would be stronger if not for the record-low inventory levels and parts shortages (particularly semiconductors) which have plagued the market in recent months and we expect to persist well into 2022 and possibly beyond. In 2020, U.S. light vehicle sales posted their weakest total since coming in at 14.44 million units in 2012.”
However, that simply creates a need for a catch-up in supply. The compression has to uncompress.
CFRA adds this: “On the positive side, strong consumer fundamentals, economic growth, low unemployment rates, and relatively low (but rising) interest rates should help support sales volumes. We think margins will benefit from a combination of record-high new vehicle price realizations (now over $47,000 in the U.S.) and cost cuts implemented during the course of the Covid-19 pandemic.”
Now, Magna does have some idiosyncratic challenges, including six idled plants in Russia.
Overall, however, I think Magna could be entering into one of the best stretches the company’s ever seen.
With a low payout ratio and the projection for near-term double-digit EPS growth, dividend growth should be outstanding.
Pairing that with a 3% yield offers a very nice combination of yield and growth.
Financial Position
Moving over to the balance sheet, the company has a solid financial position.
The long-term debt/equity ratio is 0.3, while the interest coverage ratio is at 17.
The latter number is already very good, but it’ll get even better when EBIT rises.
Furthermore, there’s a healthy cash balance – almost enough to pay off all long-term debt in one fell swoop.
Profitability is fine, and I think it’ll improve quite a bit over the coming years.
Over the last five years, the firm has averaged annual net margin of 4.5% and annual return on equity of 16.3%.
Magna is a great business, with recent headwinds poised to transform into powerful tailwinds.
And the company does benefit from durable competitive advantages, including economies of scale, barriers to entry, and switching costs.
Of course, there are risks to consider.
Competition, regulation, and litigation are omnipresent risks in every industry.
The company does have exposure to Russia, and they’ve had to idle six plants.
Input costs are volatile.
Customer concentration risk is present. Magna’s six largest customers account for nearly 80% of the company’s annual sales.
Magna has direct exposure to economic cycles. This risk is amplified by the fact that the company runs a capital-intensive business model.
The global supply chain is still in disarray. This could drag on longer than expected.
There’s risk around technology. Technological changes in mobility could happen in a way or at a speed that Magna is unable to adapt to.
It’s certainly valid to be concerned about the risks, but I still think long-term dividend growth investors have a great case for buying shares in the business.
That investment case has been made even stronger by the stock’s 41% drop from its 52-week high, which has created an attractive valuation…
Stock Price Valuation
The stock is trading hands for a P/E ratio of 12.3.
That’s well below the broader market’s earnings multiple.
It’s also measurably off of the stock’s own five-year average P/E ratio of 13.8.
Plus, the E in the P/E ratio is temporarily depressed, making this ratio even lower than it appears to be.
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 a 10% discount rate and a long-term dividend growth rate of 7.5%.
This dividend growth rate looks awfully conservative when we consider the company’s own demonstrated dividend growth rate over the last decade. The payout ratio is low. And the near-term EPS growth forecast is well into the double digits.
However, Magna’s 10-year EPS growth rate is lower than this mark. And there’s still a lot of global uncertainty.
Overall, I think Magna will exceed this mark over the long run.
I’m being fairly cautious here, but I’d rather err on the side of caution.
The DDM analysis gives me a fair value of $77.40.
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 see anything irrational about my valuation model, yet the stock still looks very 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 MGA as a 4-star stock, with a fair value estimate of $81.00.
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 MGA as a 4-star “BUY”, with a 12-month target price of $90.00.
I came out a bit low this time around. Averaging the three numbers out gives us a final valuation of $82.80, which would indicate the stock is possibly 34% 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 MGA’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 70. 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, MGA’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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