Successfully investing over the long term shouldn’t be that difficult.
But it can be difficult.
It’s as easy or as difficult as you make it out to be.
What do I mean by that?
Well, it depends largely on the quality of the businesses you invest in.
If you invest in low-quality businesses, you should expect low-quality results over the long run.
And vice versa, of course.
Investing in great businesses sets you up for great results and an easier, more enjoyable path.
It’s as simple as that.
And I’d argue the best investment strategy for this straightforward logic is dividend growth investing.
That’s because, by its very nature, it filters out most low-quality businesses right off the bat.
It requires reliable, rising profits to fund reliable, rising dividends.
Typically, only great businesses can consistently produce that.
You can find hundreds of these stocks on the Dividend Champions, Contenders, and Challengers list.
It shouldn’t be a surprise to see many household names on that list.
Now, I’m not just writing about this.
I’m putting my money where my mouth (or keyboard) is.
I’ve personally used this strategy over the last 10+ years to build up the FIRE Fund.
That’s my real-money portfolio, which produces enough five-figure passive dividend income for me to live off of.
Indeed, I’ve been able to live off of dividends for many years now.
I actually retired in my early 30s using this strategy, as I share in my Early Retirement Blueprint.
As important as quality is, there’s another factor that’s arguably just as important.
It’s valuation.
While price is what you pay, it’s value that you end up getting.
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.
Combining the best of both quality and valuation within the framework of the dividend growth investing strategy positions you for truly spectacular results over the long run.
Of course, it’s necessary to understand valuation in order to do this.
Fortunately, this isn’t as complex as you might think.
Fellow contributor Dave Van Knapp has made it even easier, via Lesson 11: Valuation.
This is part of an overarching series of “lessons” on dividend growth investing, and it lays out a simple-to-understand valuation process that can be applied toward 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 $30 billion (by market cap) investment management colossus that employs more than 7,000 people.
With approximately $1.4 trillion in assets under management, T. Rowe Price ranks as one of the largest US-based asset managers.
Asset management is one of the best and most lucrative business models in the entire world.
That’s because of its basic structure.
T. Rowe Price charges fees to manage assets.
Well, these fees have two huge built-in advantages.
First, the fees are subject to exponential growth.
That’s because asset managers like T. Rowe Price have tremendous exposure to global equities.
As the world’s economic output continues to grow, global equities should continue to compound. The base upon which fees are levied is exponentially rising.
Second, these fees are incredibly “sticky”.
Once assets are in place and being properly managed, the path of least resistance is to simply leave them in place.
Stickiness is reinforced by performance.
Regarding performance, Morningstar states this: “At the end of March 2022, 69%, 68%, and 79% of the company’s fund AUM were beating the Morningstar category median on a 3-, 5-, and 10-year basis, respectively, with 50% of fund assets closing out 2021 with an overall rating of 4 or 5 stars, better than just about every other U.S.-based asset manager we cover.”
Stickiness is further bolstered by specific account types.
Morningstar adds : “T. Rowe Price has historically had a stickier set of clients than its peers as well, with two thirds of its assets under management derived from retirement-based accounts.”
This stickiness limits outflows, which helps the firm to ride out volatility.
And it also creates an environment for relatively smooth, upward business results across revenue, profit, and the dividend over the long term – despite volatile asset pricing in the short term.
Dividend Growth, Growth Rate, Payout Ratio and Yield
In fact, T. Rowe Price has increased its dividend for 36 consecutive years.
That makes the asset manager a vaunted Dividend Aristocrat.
No volatility in that impressive track record.
The 10-year dividend growth rate is 13.3%.
On top of the double-digit dividend growth, the stock offers an appealing yield of 3.9%.
This yield easily beats the market, and it’s a stunning 140 basis points higher than its own five-year average.
With a payout ratio of only 38.8%, the dividend is highly secure.
I like dividend growth stocks in what I call the “sweet spot” – a yield of between 2.5% and 3.5%, paired with a high-single-digit (or better) dividend growth rate.
This stock offers both a higher yield and a higher dividend growth rate than the upper bounds of that sweet spot.
It might be one of the best combinations of yield and growth in the whole market.
Revenue and Earnings Growth
As great as these dividend metrics are, though, they’re mostly looking at the past.
However, investors have to risk present capital for future rewards.
As such, I’ll now build out a forward-looking growth trajectory for the business, which will later be helpful when it comes time to estimate the stock’s intrinsic value.
I’ll first show you what this company has done over the last decade in terms of its top-line and bottom-line growth.
And then I’ll reveal a professional prognostication for near-term profit growth.
Blending the proven past with a future forecast in this manner should allow us to determine what the prospective growth path might look like.
T. Rowe Price advanced its revenue from $3.0 billion in FY 2012 to $7.7 billion in FY 2021.
That’s a compound annual growth rate of 11.0%.
Fantastic top-line growth here.
Not a total surprise, as the last decade has been great for US equities.
Meanwhile, earnings per share grew from $3.36 to $13.12 over this period, which is a CAGR of 16.3%.
Whenever you see double-digit long-term growth across both the top line and bottom line, you know you’ve got a special business on your hands.
We can also see where double-digit dividend growth has been coming from all this time – it’s been supported by underlying EPS growth.
A combination of margin expansion and share buybacks helped to drive excess bottom-line growth. Regarding the latter point, the outstanding share count is down by approximately 12% over the last 10 years.
Looking forward, CFRA currently has no growth forecast for T. Rowe Price’s EPS over the next three years.
It’s unusual that CFRA has no forecast here.
In late December 2021, which is when I last analyzed and valued the business, CFRA believed that T. Rowe Price was going to compound its EPS at an annual rate of 14% over the next three years.
It would be fair to scale that expectation back quite a bit, as 2022 has produced extreme volatility and big pricing drops across global assets.
This has caused asset depreciation, outflows in assets under management, and lowered fee revenue.
Indeed, the company ended FY 2021 with $1.7 trillion in AUM.
T. Rowe Price finished Q1 FY 2022 with less than $1.6 trillion.
And a recent filing by the company showed slightly over $1.4 trillion in AUM as of April 30, 2022.
As great as the asset management business model is, it’s not perfect. Volatility will affect AUM.
The good news is that there doesn’t appear to be an issue with client-driven outflows.
Of the $136 billion decrease in AUM for Q1 FY 2022, more than $130 billion was due to market depreciation. Less than $6 billion was due to client net outflows. This relates back to the “stickiness” I touched on earlier.
On one hand, the near-term picture looks suboptimal in terms of AUM, fee, revenue, and EPS growth.
The company’s Q1 FY 2022 report showed a 24% contraction in YOY EPS.
On the other hand, the lowered earnings base makes it easier to put up a higher growth rate in relative terms on a go-forward basis. But this only happens after a painful “reset” in that base.
I still believe T. Rowe Price is positioned for strong EPS and dividend growth over the long term, but I do acknowledge that the near term looks a bit ugly.
I also think it’s important to remember that the stock yields nearly 4% here.
That’s well above its norm, which compensates today’s investors for some of this bumpiness.
With the yield so far above what it usually is, the company has some breathing room in terms of dividend growth. They simply don’t have to grow the dividend at the same high rate as when the yield was closer to 2%.
Either way, with a solid business and a low payout ratio, I would expect T. Rowe Price to grow the dividend at a high-single-digit rate over the long run.
It’s hard to dislike the long-term setup here in terms of both yield and growth.
Financial Position
Moving over to the balance sheet, T. Rowe Price has an outstanding financial position.
The company has no long-term debt.
That’s right.
It’s a flawless balance sheet.
Profitability is terrific.
Over the last five years, the firm has averaged annual net margin of 35.6% and annual return on equity of 31.7%.
Circling back around to a point I made earlier, net margin has noticeably expanded over the last few years. Net margin was routinely below 30% in the earlier part of the last decade.
I find almost nothing to fault about T. Rowe Price.
This is a debt-free Dividend Aristocrat with sky-high margins that has grown at a double-digit rate for a long time.
I’m not sure what else you’d really want out of a 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 direct exposure to 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, it’s difficult to grow at a high rate in percentage terms.
I think these risks should be carefully weighed, but the quality of the business strikes me as far more weighty than the risks.
And with the valuation severely compressed after the stock’s 50% drop from its 52-week high, the business looks particularly buyable at this point in time…
Stock Price Valuation
The stock is trading hands for a P/E ratio of 10.0.
That’s well below the broader market’s earnings multiple.
It’s also much lower than the stock’s own five-year average P/E ratio of 15.2.
There’s an even bigger disconnect in the cash flow multiple.
The P/CF ratio of 8.0 is less than half that of its own five-year average of 31.0.
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%.
I’m being super careful with the dividend growth rate here.
The company’s demonstrated EPS growth and dividend growth over the last decade are both about double this mark.
And the payout ratio remains low, even after factoring in a recent hit to earnings.
I understand the near-term picture doesn’t look great, and the recent 24% YOY contraction in EPS shows that.
However, the 50% drop in the stock’s price more than reflects this.
That said, because of an unusually high amount of uncertainty and volatility, it’s appropriate to be conservative.
I think it’s highly likely that T. Rowe Price does better than this expectation over the long run, but I’d rather err on the side of caution.
The DDM analysis gives me a fair value of $171.20.
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 feel like my valuation model was very cautious, yet the stock still looks remarkably 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 4-star stock, with a fair value estimate of $155.00.
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 $140.00.
I came out high, which surprises me. Averaging the three numbers out gives us a final valuation of $155.40, which would indicate the stock is possibly 25% 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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