An interesting phenomenon often plays out in the stock market.
When it rallies higher, like it did on October 21st, people tend to cheer.
This is very odd to me.
It’s like cheering for higher prices at the grocery store because you have a half-full pantry at home.
Assuming you still have to buy merchandise at some point in the future, you should always cheer for lower prices.
This is especially true for quality merchandise.
And when speaking about the stock market, high-quality dividend growth stocks are regarded as some of the best merchandise you’ll find.
These stocks represent equity in world-class businesses that pay reliable, rising dividends to their shareholders.
Reliable, rising dividends are, of course, funded by reliable, rising profits.
And reliable, rising profits come about as a result of running great businesses and selling more and more of what the world demands.
Want to see what I mean?
Take a look at the Dividend Champions, Contenders, and Challengers list.
This list contains invaluable information on hundreds of US-listed stocks that have raised dividends each year for at least the last five consecutive years.
I’ve been buying high-quality dividend growth stocks for more than a decade.
I built my FIRE Fund in the process of that buying.
That’s my real-money portfolio, and it produces enough five-figure passive dividend income for me to live off of.
That’s right.
I live off of dividends.
In fact, I’ve been living off of dividends for years.
I was actually able to retire in my early 30s.
And my Early Retirement Blueprint explains how.
A major part of my success comes down to the type of stocks I’ve been buying.
Whereas price tells you what you pay, value tells you what you 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.
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.
Cheering for market downturns, and taking advantage of these downturns by buying up high-quality dividend growth stocks at lower valuations sets dividend growth investors up for marvelous returns, wealth, and passive income over the years to come.
Of course, taking advantage of lower valuations first requires one to understand valuation.
Good news.
It’s not terribly difficult.
Fellow contributor Dave Van Knapp put out Lesson 11: Valuation in order to make it even less difficult.
Part of a comprehensive series of “lessons” designed to teach the ins and outs of dividend growth investing, it explicitly lays out a valuation process that can be easily understood and applied.
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 $23 billion (by market cap) banking powerhouse 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.
To give that scale some 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 two powerful pillars of the banking business model that make it so attractive for long-term investors.
First, endurance.
There are few business models that have proved to be as enduring as banking.
Banking dates back to antiquity.
Why has it persisted for thousands of years?
Well, our society basically cannot function without the proper flow of capital.
That’s particularly true for a free-market economy, like the US has now.
Banks are integral to the flow of capital and the growth of a free-market economy.
The second pillar is the float.
A float shows up in a certain business models, such as banks, insurance companies, and payroll processors.
It’s the low-cost capital that accrues as a natural course of doing business, due to a time delay between capital being taken in and capital going out.
Banks can, and do, take advantage of the float, earning a substantial amount of money on it while it’s in their charge.
Warren Buffett has repeatedly explained the genius of the float, using it himself (through insurance operations) to build a massive fortune.
Beyond his own company’s float, Buffett has invested heavily in other businesses that have a float (such as banks).
If all of this weren’t already attractive enough, many modern-day banks have upped the ante by branching out into areas like wealth management, financial services, and payments.
This further diversifies banks, all while giving them access to more capital and – more importantly – recurring fees.
Recurring fees reduces the volatility of a bank’s operating results by providing smooth income across the economic cycles.
Put simply, modern-day banks have taken a wonderful and enduring business model and made it even more wonderful and enduring.
This should translate into growth across Fifth Third’s revenue, profit, and dividend for many years to come.
Dividend Growth, Growth Rate, Payout Ratio and Yield
As things stand, the bank has increased its dividend for 12 consecutive years.
In fact, the bank just increased its dividend by 10% only weeks ago.
Now, that raise does trail the 10-year dividend growth rate of 14.1%.
That’s particularly true when you consider the stock’s yield of 3.8%.
This yield smokes the broader market’s yield.
It’s also 70 basis points higher than its own five-year average.
And with a low payout ratio of 40%, we have what appears to be a well-covered dividend with plenty of cushion.
I see nothing to dislike about the dividend metrics.
You get a fairly high yield and a fairly high dividend growth rate, protected by a low payout ratio.
It’s the best of all worlds.
Revenue and Earnings Growth
As likable as these metrics might be, though, they’re mostly looking in the rearview mirror.
Investors know that they’re risking today’s capital for tomorrow’s rewards.
That’s why I’ll now build out a forward-looking growth trajectory for the business, which will be extremely useful 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.
I’ll then reveal a professional prognostication for near-term profit growth.
Deftly amalgamating the proven past with a future forecast should give us a reasonable idea about where the business might be going from here.
Fifth Third moved 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%.
During a very challenging decade for banks, Fifth Third managed to put up respectable growth.
Meantime, earnings per share grew from $1.66 to $3.73 over this period, which is a CAGR of 9.4%.
That’s a bit more like it.
Really strong bottom-line growth.
Profitability improvement and prolific share buybacks both helped to spur excess bottom line-growth.
Regarding the buybacks, the outstanding share count is down by 25% over the last 10 years.
Looking forward, CFRA is projecting that Fifth Third will compound its EPS at an annual rate of 4% over the next three years.
This would represent a material slowdown in growth for the bank.
I think some caution is warranted.
There are fears that aggressive interest rate hikes from the US Federal Reserve could drive the US into a recession next year.
It’s even possible that the US is in a recession right now.
A recession hurts a bank on both the income statement and the balance sheet – it’s a simultaneous decrease in loan demand and increase in loan losses.
At the same time, however, CFRA’s forecast does seem overly cautious to me.
After all, the very same aggressive rate hikes that are designed to reduce economic activity are beneficial for banks.
Indeed, Fifth Third’s recent Q3 report for FY 2022 showed sizable jumps in both NIM and NII – NIM came in at a remarkable 3.2%.
Following the earnings release, CEO Tim Spence said this on CBNC: “We’ve been around for about 164 years now. And we’re having our best year ever in the history of the company.”
A lot of this comes down to the new rate regime, which is helping the bank to print some outstanding results.
Also, it should be noted that Fifth Third has been rapidly expanding across Florida, one of the fastest-growing states in the USA, which broadens and improves the bank’s geographic footprint.
In my view, it’s tough to imagine a decade that’s more challenging for banks than the last one, yet Fifth Third still grew its dividend at a double-digit rate.
The bank is now operating and situated better than ever.
I struggle to explain how or why the dividend should grow at a much slower pace over the next decade, even if the next year or two is tough.
That would set investors up for at least high-single-digit dividend growth from here.
Pairing that with a near-4% yield is extremely compelling, in my view.
Financial Position
Moving over to the balance sheet, Fifth Third has a very good financial position.
They have total assets of $206.3 billion against $183.5 billion in total liabilities.
The bank sports the following investment-grade credit ratings for their senior debt: BBB+, S&P; Baa1, Moody’s; and A-, Fitch.
Profitability is robust.
Over the last five years, the firm has averaged annual net margin of 31.4% and annual return on equity of 12.2%. Net interest margin came in at 2.6% for FY 2021.
Fifth Third is running a great operation here.
And with economies of scale, a large float, switching costs, and built-up relationships, the company does benefit from durable competitive advantages.
Of course, there are risks to consider.
Competition, regulation, and litigation are omnipresent risks in every industry.
In particular, regulation is a constant thorn for any bank.
The US Federal Reserve has been aggressively increasing interest rates, but rates are actually still low by historical standards.
The company has substantial exposure to economic cycles, and the current cycle is unusually uncertain and concerning.
Recessionary risks loom, and a recession can hurt a bank in two ways: Less economic activity reduces growth from deposits and loan demand, while loan losses harm the balance sheet.
While these risks are worth carefully thinking over, I believe the bank’s overall quality outweighs the risks.
And with the stock’s price down 30% from its 52-week high, the valuation really tilts the scales in favor of the long-term investor…
Stock Price Valuation
The P/E ratio is 10.9.
We’re nearly at a single-digit P/E ratio here.
This is well off of the market’s earnings multiple, which itself has become quite compressed.
That said, this is pretty much right in line with its own five-year average.
The P/B ratio of 1.6 is right about what I’d expect, since most banks oscillate in a range of between 1 and 2 times book.
But 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%.
This high-single-digit dividend growth threshold strikes a balance.
It’s measurably lower than what the bank has been able to compound its EPS and dividend at over the last decade.
And with higher rates and a modest payout ratio, a severe reduction in dividend growth seems unlikely.
On the other hand, CFRA’s near-term EPS growth forecast is much lower than this mark.
Also, recessionary risks are higher than they’ve been in some time.
Putting it all together, I see the bank as highly capable of producing at least high-single-digit dividend growth.
It’s possible they exceed this expectation, but I’d rather err on the side of caution.
The DDM analysis gives me a fair value of $47.08.
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 was measured with my analysis and valuation, yet the stock still comes out looking 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 FITB as a 4-star stock, with a fair value estimate of $45.00.
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 3-star “HOLD”, with a 12-month target price of $33.00.
I came out slightly high, but CFRA’s number strikes me as too pessimistic. Averaging the three numbers out gives us a final valuation of $41.69, which would indicate the stock is possibly 17% 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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