There’s a lot of craziness going on out there.
We have extreme volatility in the US stock market, a sudden collapse of a very large crypto exchange, and ongoing uncertainty about the US midterm elections.
Periods of irrationality is when it’s extra helpful to remain rational.
If there’s one thing I pride myself on, it’s my rationality.
And I think this quote by Paul Samuelson will help you to remain rational: “Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.”
When I think about rational investing, the dividend growth investing strategy immediately comes to mind.
Why?
Well, it’s awfully hard to successfully invest over the long run by avoiding great businesses.
And dividend growth investing funnels you right into great businesses.
High-quality dividend growth stocks represent equity in high-quality businesses that pay reliable, rising dividends to their shareholders.
Take a look at the Dividend Champions, Contenders, and Challengers list to see what I mean.
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.
Some of the world’s very best businesses are on this list.
I think not.
A business almost has to be great in order to produce the reliable, rising profit necessary to sustain reliable, rising dividend payments.
I’ve been using the dividend growth investing strategy for myself to great effect for more than 10 years now, building my FIRE Fund in the process.
That’s my real-money portfolio, and it produces enough five-figure passive dividend income for me to live off of.
In fact, I’ve been living off of dividends since retiring in my early 30s.
And my Early Retirement Blueprint explains how I was able to retire so early in life.
It’s at the heart of my success.
But another key factor here is valuation at the time of any investment.
Whereas price is what you pay, it’s ultimately value that 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.
And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.
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.
Staying rational through periods of widespread irrationality, and sticking to undervalued high-quality dividend growth stocks through the ups and downs, will almost guarantee long-term investment success.
Now, taking advantage of undervaluation would first mean that one understands valuation.
Good news.
It’s not that hard.
Fellow contributor Dave Van Knapp has made it even easier, via Lesson 11: Valuation.
One of his comprehensive “lessons” on dividend growth investing, it spells out valuation in a very easy-to-understand manner.
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…
Broadcom Inc. (AVGO) is a leading designer, developer, and supplier of analog and digital semiconductor devices.
With a history dating back to 1961, Broadcom is now a $220 billion (by market cap) semiconductor behemoth that employs 20,000 people.
The company reports revenue in two primary segments: Semiconductor Solutions, 74% of FY 2021 sales; Infrastructure Software, 26%.
While Broadcom’s roots can be traced back to semiconductors, the company has, over the years, broadened out into areas like software through strategic mergers and acquisitions.
Broadcom’s still-pending $61 billion acquisition of VMware, Inc. (VMW), a cloud computing company, is something that will further diversify Broadcom across various aspects of technology.
Broadcom’s current technology offerings can be found in the likes of smartphones, servers, set-top boxes, storage systems, and controllers.
The company is exposed to exciting, high-growth areas like data centers, broadband, wireless connectivity, and automation.
It’s actually difficult to name a major theme in technology that Broadcom isn’t exposed to.
And I do hesitate to use the word “theme” here.
After all, we’re talking about real-life, large-scale changes in the way our society has worked and will work.
This is about the past, present, and future of tech and life.
That’s what sets up Broadcom to continue growing its revenue, profit, and dividend for years into the future.
Dividend Growth, Growth Rate, Payout Ratio and Yield
To date, the company has increased its dividend for 13 consecutive years.
The 10-year dividend growth rate is a jaw-dropping 40.2%.
Now, more recent dividend raises have been in the low-double-digit range.
And you’re pairing that with the stock’s current market-beating yield of 3.2%.
While this yield is only 10 basis points higher its own five-year average, it’s rare to see a 3%+ yield with a dividend growth rate this high.
With a payout ratio of 46.9%, based on TTM adjusted EPS, this dividend looks secure and poised for continued outsized growth.
I like dividend growth stocks in what I refer to as 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’s yield is at the higher end of the range, while the dividend growth rate is much higher than what I’d typically look for.
Phenomenal dividend metrics here.
Revenue and Earnings Growth
As phenomenal as the metrics may be, though, they’re largely looking backward.
However, investors have to face the reality of 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 later be of great use when estimating intrinsic value.
I’ll first show you what this company has done in terms of its top-line and bottom-line growth.
I’ll then reveal a professional prognostication for near-term profit growth.
Carefully blending the proven past with a future forecast in this way should allow us to come to a reasonable conclusion about where the business might be going from here.
Broadcom advanced its revenue from $2.4 billion in FY 2012 to $27.5 billion in FY 2021.
That’s a compound annual growth rate of 31.1%.
Truly stunning top-line growth, but it’s been far from totally organic.
A lot of this growth has been the result of serial M&A activity.
A string of large mergers and acquisitions built Broadcom into what it is.
The $18.9 billion acquisition of CA Technologies in 2018 is a prime example.
CA Technologies was, at the time, one of the largest independent software companies in the world.
The aforementioned move on VMware is yet another example.
Looking at bottom-line growth on a per-share basis should give us a better sense of the company’s true growth profile, as we’ll be able to see if there’s been growth accretion to EPS (or not).
Broadcom grew its EPS from $2.25 to $28.01 (adjusted) over this period, which is a CAGR of 32.3%.
EPS growth has slightly exceeded revenue growth, indicating some modest level of accretive growth.
To be fair, I did use adjusted EPS for FY 2021.
This is due to Broadcom’s frequent and sizable discrepancies between GAAP EPS and non-GAAP EPS.
I’m not always a big fan of using adjusted numbers, but Broadcom’s FCF does line up a lot better with adjusted EPS than GAAP EPS.
I view the adjusted EPS as being a much more accurate representation of this company’s earnings power.
Looking forward, CFRA is forecasting that Broadcom will compound its EPS at an annual rate of 17% over the next three years.
This kind of bottom-line growth, while strong, would mark a material step-down in comparison to what Broadcom has produced over the last decade.
However, I don’t see this as unreasonable at all.
If anything, it would be unreasonable to expect a company of this size to continue compounding its EPS at 30%+ annually indefinitely.
That’s simply not realistic.
I actually see CFRA’s forecast as something that shareholders or prospective investors ought to celebrate.
A lot of companies out there would love to grow at 17% per year.
Giving everyone more to celebrate, CFRA states the following: “We have high confidence in management execution and expect [Broadcom] to benefit from higher spending from cloud customers looking to upgrade their infrastructure and networks. We think visibility remains extremely high near term across all core markets.”
This lines up well with what Hock Tan, Broadcom’s CEO, stated in the company’s Q3 FY 2022 earnings release: “Broadcom’s record third quarter results were driven by robust demand across cloud, service providers, and enterprise.”
Tan also added this: “We expect solid demand across our end markets to continue in the fourth quarter, reflecting continued investment by our customers of next generation technologies in data centers, broadband, and wireless.”
This Q3 report, by the way, showed 39.8% YOY adjusted EPS growth.
Simply put, this high-speed locomotive of a business isn’t stopping at all, even if it may slow a bit over the coming years.
If we take CFRA’s EPS growth forecast as our base case, that still positions Broadcom’s dividend to grow at least at a high-single digit rate over the foreseeable future.
And it’s very possible, perhaps even likely, that low-double-digit dividend raises keep coming for the next few years.
Meantime, the stock also yields north of 3%.
That’s a very attractive setup, in my view.
Financial Position
Moving over to the balance sheet, Broadcom has a solid financial position.
The long-term debt/equity ratio is 1.6, while the interest coverage ratio is slightly over 9.
Broadcom’s elevated debt load, a result of so much M&A activity, might be the only chink in the company’s armor.
However, Hock Tan has been wise with his M&A choices, which greatly reduces my concerns here.
Profitability is extremely robust.
Over the last five years, the firm has averaged annual net margin of 25% and annual return on equity of 24.5%.
Broadcom is a terrific business.
Its diversified exposure to almost every exciting, high-growth area of technology bodes well for the firm and its shareholders.
I must also add, Hock Tan has been a masterful manager.
And the company does benefit from durable competitive advantages, including scale, established relationships, IP, entrenched infrastructure, and technological expertise.
Of course, there are risks to consider.
Litigation, regulation, and competition are omnipresent risks in every industry.
Broadcom’s elevated debt load will become more expensive with interest rates on the rise.
Hock Tan has been an M&A wizard, but there’s always the risk that a deal turns out to be a bad deal for shareholders.
The company’s highly successful M&A strategy could also become limited by Broadcom’s size, as it takes ever-larger deals to move the needle.
Customer concentration is a risk, with approximately 20% of the company’s revenue coming from Apple Inc. (AAPL).
As diversified as Broadcom has become, about 1/4 of the business is exposed to smartphones.
Demand for electronics is economically cyclical.
Broadcom must constantly work to stay ahead of the tech curve in order to not fall behind competitors.
These risks are worth seriously considering, but I also see the positive facets of the business as being far more considerable.
And with the stock down 25% from its recent high, the attractive valuation is also considerable…
Stock Price Valuation
The P/E ratio is 14.6, based on TTM adjusted EPS.
For a company growing this fast, that’s an absurdly low earnings multiple.
We’re talking about a PEG ratio well below 1, even after factoring in a growth slowdown.
For perspective, the stock’s own five-year average P/E ratio is 40.3.
That ratio is skewed by lumpy GAAP results, but I think the disconnect here is still clear.
And the yield, as noted earlier, is slightly 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 dividend growth rate looks suspiciously low in comparison to Broadcom’s demonstrated EPS and dividend growth rate over the last decade.
But I think it’s important to point out that the last decade was a special one for the business.
It’s nearly impossible for it to be repeated, especially with M&A being such a focal point.
Both the debt load and the size of the business work against Hock Tan in this regard, and even a great manager can only do so much.
Indeed, CFRA sees a pretty serious drop in bottom-line growth ahead.
I concur.
That said, we’re still talking about a terrific business growing at a high rate.
Broadcom could, and likely will, exceed this dividend growth rate over the next few years, but I expect a moderation over the longer term.
The DDM analysis gives me a fair value of $584.93.
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 put together a thoughtful valuation, yet the stock 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 AVGO as a 4-star stock, with a fair value estimate of $624.00.
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 AVGO as a 4-star “BUY”, with a 12-month target price of $580.00.
Boy, I’m almost right there with CFRA on this one, but we’re all pretty close. Averaging the three numbers out gives us a final valuation of $596.31, 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 AVGO’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 67. 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, AVGO’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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