It’s fortunate that we have so many successful investors who came before us.
We can look up to them, see what worked, see what didn’t work, and use that information to our advantage.
I mean, investing isn’t some new idea that we have to navigate alone, in the dark.
No, we have lots of data to draw from, helping us to become more successful and wealthier than we’d otherwise be.
And when parsing this data, it’s clear to me that investing in great businesses almost always leads to great long-term results.
It’s intuitive, as taking the opposite approach – investing in terrible businesses – is obviously a poor proposition.
This is why I’m such a big fan (and personal practitioner) of dividend growth investing, a long-term investment strategy that advocates buying and holding shares in high-quality businesses that pay safe, growing dividends to shareholders.
Because growing profit is required to sustain a growing dividend for long, and because it requires a business to be of a certain level of greatness in order to earn a profit and routinely grow it, this strategy can almost automatically funnel an investor right into great businesses.
Moreover, growing dividend income is a fantastic source of totally passive investment income.
You can see examples of investment candidates that qualify for this strategy by pulling up the Dividend Champions, Contenders, and Challengers list.
This list has assembled 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 using this strategy for nearly 15 years, letting it inform me as I’ve gone about building the FIRE Fund.
That’s my real-money portfolio, and it generates enough five-figure passive dividend income for me to live off of.
It’s actually been enough for me to live off of since I quit my job and retired in my early 30s.
As my Early Retirement Blueprint discusses, a lot of that comes down to frugality and intelligent investing.
That latter point leads me to an important distinction.
While investing in great businesses can (and often does) lead to great results, intelligent investing also takes valuation into consideration.
That’s because price is only what you pay, but it’s value that you ultimately 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.
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.
If we’re able to learn from the successful investors who came before us, it’s likely that we simply end up buying undervalued high-quality dividend growth stocks.
Of course, this is all working under the assumption that one already understands how valuation works.
If you don’t, no worries.
Fellow contributor Dave Van Knapp’s Lesson 11: Valuation, which is part of an overarching series of “lessons” designed to teach the dividend growth investing strategy, lays out valuation in simple-to-understand terms and even provides a valuation template.
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…
EOG Resources Inc. (EOG)
EOG Resources Inc. (EOG) is an American energy company that engages in hydrocarbon exploration and production.
Founded in 1999, EOG Resources is now a $72 billion (by market cap) O&G player that employs approximately 3,000 people.
EOG Resources primarily operates across a number of US shale fields and basins, including Williston Basin, Powder River Basin, DJ Basin, Anadarko Basin, Barnett Shale, Permian Basin, Eagle Ford, Dorado, South Texas, Utica, and the Columbus Basin.
The company finished FY 2023 with net proved reserves at 4.5 billion barrels of oil equivalent (~13 years of production).
EOG Resources produced just over 984 thousand barrels of oil equivalent per day in FY 2023 (up 8.4% YOY), of which 71% was oil and natural gas liquids and 29% was natural gas.
Let’s get the bad news out of the way first.
EOG Resources is involved with commodities.
It’s not a price maker but rather a price taker, largely reliant on the volatile dynamics of energy markets for its ability to produce revenue and profit.
And since EOG Resources is relatively small in comparison to the fully integrated supermajors, EOG Resources has less control over those dynamics.
But there’s good news.
And lots of it.
EOG Resources provides society vital energy products which form part of the backbone of a modern-day standard of living in a developed country (i.e., electricity, transportation, technology, etc.).
There is no modern-day consumption without oil & gas consumption.
Consumerism, industry, and society set up a base level of demand for O&G.
While the world is slowly moving toward “cleaner” forms of energy that are more renewable, all of this is not yet close enough to meet basic needs – and may never be.
I say “may never be” because demand for energy broadly is rising.
Technology in developed countries is requiring much more energy than before (see: AI).
And developing countries need more energy as they develop, consume more, raise the general standard of living for inhabitants, and build industries out.
Beyond that built-in, rising demand, the supply side of the equation has never looked more favorable.
The industry used to have a “drill, baby, drill” mantra, where it was all about maximizing production in order to drive higher revenues.
That’s changed.
Major E&P companies are no longer focused on more production at all costs.
The focus is now on profitability and cash flow.
It’s now less about “hydrocarbon production”, more about “cash flow production”.
A prioritization of low costs, rational pricing, and the generation of free cash flow (which can be returned back to investors via buybacks and dividends) has been a boon to investors.
EOG Resources has been emblematic of this, hammering its costs down to the minimum.
Morningstar highlights this: “These efforts have led the firm to boast materially lower well costs than its peer average. Lower costs bring better operating margins, as does EOG’s access to key US oil markets, which has helped push better price realization relative to peers across all three hydrocarbons.”
Renewed focus and less waste has led to shareholders being richly rewarded.
Morningstar adds: “Finally, we like EOG’s organic focus. While the rest of the US shale industry has long since pivoted toward a return on capital model, we have even higher confidence in EOG’s model given that it eschews the expensive mergers and acquisitions often pursued by peers. In contrast to its peers that we think are leaning too heavily into share repurchases given prices relative to intrinsic valuations, roughly 75% of EOG’s cash returns come from its regular dividend.”
That last part is music to my ears.
Indeed, EOG Resources has been relentless when it comes to revenue, profit, and dividend growth.
Dividend Growth, Growth Rate, Payout Ratio and Yield
The company has now increased its dividend for seven consecutive years.
While that’s a shorter track record than I’d like to see, it appears to be the start of something beautiful.
That emerging beauty can be seen in the five-year dividend growth rate of 34.2%.
That is massive dividend growth.
It’s tech-like growth out of an O&G company, which is pretty remarkable.
Moreover, this doesn’t fully do justice to this company’s dividend commitment.
The company has 26 years of a stable and growing dividend.
Yes, some years were “just” stable, but there have been no dividend cuts across nearly three decades.
I think that speaks volumes.
Plus, when growth comes, it comes big.
And on top of that big dividend growth, the stock yields a respectable 2.9%.
This market-beating yield is 70 basis points higher than its own five-year average.
Yet again, though, things are even better than they look.
I say that because EOG Resources regularly pays out special dividends.
The company paid two special dividends in 2023, adding up to an additional $2.50/share.
That’s an extra 2% in yield (using 2023’s special dividends against today’s stock price) – bringing the all-in yield up to 4.9%.
While there have been no special dividends in 2024 (special dividends should never be expected in regular intervals), the regular dividend profile is already great enough on its own.
Possible specials are icing on dividend cake.
Furthermore, starting this year, management plans to distribute a minimum of 70% of free cash flow back to shareholders, which could portend more special dividends on top of share buybacks (unless commodity prices drop precipitously).
The payout ratio on the regular dividend is only 28.1%, giving a cushion that’s very nice to have for a business model so captive to volatile commodity pricing.
We can also see that EOG Resources generated $1.4 billion in FCF last quarter (Q2 FY 2024), which covered the ~$530 million in regular quarterly dividends nearly three times over.
This is a well-covered, fast-growing dividend, and the already-healthy yield is boosted by intermittent special dividends.
What a lovely dividend profile.
Revenue and Earnings Growth
As lovely as it may be, though, a lot of dividend metrics are looking at the past.
However, investors must always attempt to peer into the future, as the capital of today gets risked for the rewards of tomorrow.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will be of use when the time comes later to estimate the business’s intrinsic value.
I’ll first show you what the business 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.
Amalgamating the proven past with a future forecast in this way should give us what we need to draw some reasonable conclusions about where the business could be going from here.
EOG Resources grew its revenue from $18 billion in FY 2014 to $24.2 billion in FY 2023.
That’s a compound annual growth rate of 3.3%.
Pretty decent top-line growth.
Meanwhile, earnings per share increased from $5.32 to $13.00 over this period, which is a CAGR of 10.4%.
Improved profitability, stemming from the changing industry dynamics that I discussed earlier, helped to drive a lot of excess bottom-line growth.
The last decade looks so much better than the prior decade, it’s almost like looking at two different businesses.
Looking forward, CFRA is forecasting EOG Resources will compound its EPS at an annual rate of 2% over the next three years.
CFRA’s commentary is largely glowingly positive, so I’m not sure why there’s such a modest growth forecast in place.
For example, CFRA states: “EOG’s Q2 unit costs beat its internal target, and we think management’s penchant for achieving high returns as well as low costs will persist. We see growth catalysts from the Permian, the Utica, and Dorado.”
Persistence from a 10%+ growth base, along with growth catalysts, doesn’t seem to add up to a 2% CAGR.
Circling back around to the company’s most recent quarter – the one in which that $1.4 billion in FCF was generated – EOG Resources printed 8.3% YOY revenue growth and 10.9% YOY EPS growth.
Looking pretty “persistent” to me.
Due to those better industry dynamics, encouraging tighter supply and a focus on profitability, I don’t see why EOG Resources can’t keep this up – even under less auspicious commodity pricing.
Thanks to its low-cost framework, EOG Resources has a breakeven price of less than $35 per barrel (~25% lower than peer average), giving it lots of cover in an environment where WTI crude is sitting at about $75 per barrel.
I’d be inclined to give EOG Resources the benefit of the doubt.
Expecting the company to continue doing what it’s been doing seems like a reasonable thing to do, which would put the dividend in a position to continue growing at a double-digit rate – especially with the payout ratio being as low as it is.
And that’s before adding in those occasional special dividends.
A situation where you’re getting a near-3% yield, double-digit dividend growth, and some special dividends?
Fantastic!
Financial Position
Moving over to the balance sheet, EOG Resources has a stellar financial position.
The long-term debt/equity ratio is 0.1, while the interest coverage ratio is nearly 70.
Moreover, EOG Resources is sitting on net cash.
A large O&G company sitting on net cash would have been practically unheard of a decade ago.
This speaks even more on just how much healthier this industry and many of its major players are now.
If we compare the current situation to 10 years ago, EOG Resources has almost halved its long-term debt load, and cash has more than doubled.
Very impressive.
Profitability is also impressive, not just in absolute terms but also in terms of improvement.
Return on equity has averaged 19.2% over the last five years, and net margin has averaged 19.3%.
Again, if we zoom out, both of these numbers have both improved and become more consistent.
Also, that ROE is coming in without a lot of leverage.
Management has noted that 10% ROCE can now be maintained at $44 oil.
The floor for double-digit ROCE a decade ago was $85 oil.
Over the last 10 years, EOG Resources has transformed from a good business to a terrific one.
And with economies of scale, low-cost operations, barriers to entry, and favorable acreage, the company does benefit from durable competitive advantages.
Of course, there are risks to consider.
Litigation, regulation, and competition are omnipresent risks in every industry.
Regulation, in particular, is a thorny issue in this industry, but more regulation can actually counterintuitively be a boon (by suppressing supply, thereby increasing commodity prices).
While the world still requires hydrocarbons for energy, there’s a risk over the very long run that renewable forms of energy will eventually displace oil & gas.
It’s a capital-intensive business model which is simultaneously highly cyclical.
EOG Resources is a price taker, not a price maker, and so it is highly dependent on commodity pricing.
The company’s reserves must continually be added to so as not to risk running out of supply.
Fields naturally get depleted over time, and there is uncertainty regarding how much supply is left in the world.
The industry sees constant pressure from some environmental groups, which may result in negative goodwill across some parts of society.
Overall, I see most of these risks as pretty standard for the industry, yet the fundamentals here are anything but standard.
However, the valuation doesn’t seem to be accounting for very much excellence at all…
Valuation
The P/E ratio is only 9.9.
A single-digit earnings multiple, in this market, on a business growing at a double-digit rate?
I like that.
For perspective, even though this stock is never very expensive, the current earnings multiple is below its own five-year average of 12.6.
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%.
This is obviously very conservative when compared against the clear trend of double-digit EPS and dividend growth that has been playing out for years (and continues to play out).
However, because this industry is so cyclical, and because EOG Resources is so reliant on commodity pricing, I think erring well on the side of caution is wise.
That said, this DDM analysis does not account for the special dividends that EOG Resources sometimes pays out, so this analysis is doubly conservative.
I believe the dividend can, and will, grow at a rate that exceeds 7% over the next 10+ years, but tempering expectations and taking a cautious approach when it comes to O&G is something that’s served me well over the years.
The DDM analysis gives me a fair value of $129.83.
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.
Even after a careful approach to valuation, the stock comes out looking, at worst, fairly priced.
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 EOG as a 3-star stock, with a fair value estimate of $124.00.
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 EOG as a 4-star “BUY”, with a 12-month target price of $146.00.
I think we’re all being a bit wary here, and this business could be worth quite a bit more than these numbers indicate. Averaging the three numbers out gives us a final valuation of $133.27, which would indicate the stock is possibly 4% undervalued.
Bottom line: EOG Resources Inc. (EOG) is a high-quality O&G company that has drastically improved over the last decade alongside its wider industry. It now generates high returns on capital and lots of growth, even while running with net cash on the balance sheet. With a market-beating yield, a low payout ratio, double-digit dividend growth, more than five consecutive years of dividend increases, and the potential that shares are 4% undervalued (under a conservative scenario that doesn’t factor in special dividends), long-term dividend growth investors looking to up their exposure to energy have a prime candidate on their hands with this one.
-Jason Fieber
Note from D&I: How safe is EOG’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 82. 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, EOG’s dividend appears Very Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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.
Disclosure: I’m long EOG.