One of the hardest parts of investing is forecasting the future.

As Yogi Berra once put it: “It’s tough to make predictions, especially about the future.”

This is why it can be comforting to invest in businesses that are close to “sure things”.

Think companies that are providing the world with the products and/or services they practically cannot live without.

It’s difficult to imagine a future (at least a near-term future) without these companies.

Best of all, many of these companies are generously sharing their profits with shareholders in the form of dividends.

And since their profits are steadily rising (by selling more products and/or services at higher prices to more people), these dividends are also steadily rising.

You can see what I mean by taking a look at the Dividend Champions, Contenders, and Challengers list, which has compiled invaluable information on hundreds of US-listed stocks that have raised dividends each year for at least the last five consecutive years.

All of these stocks qualify for the dividend growth investing strategy – a long-term investment strategy that advocates buying and holding shares in high-quality businesses that pay safe, growing dividends to shareholders.

This strategy works so well because it tends to filter you right into some of the world’s best businesses, as evidenced by their ability to generate growing profits and willingness to share those growing profits with the shareholders.

I’ve been using this strategy for the last 15 years.

It’s been so powerful that it allowed me to quit my job and retire in my early 30s, which is something I lay out in my Early Retirement Blueprint.

That financial freedom emanates from the FIRE Fund – my real-money portfolio that throws off enough five-figure passive dividend income for me to live off of.

Now, as powerful as the strategy can be, one must be selective about not only what they invest in but the valuations at which they invest.

Price is only what you pay, but it’s 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.

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.

Investing in wonderful businesses that pay steadily rising dividends, and investing when valuations are favorable, simplifies investing and makes it so that you don’t have to actually do a lot of predicting about the future (which is impossible to do with 100% accuracy).

The whole idea of seeking out favorable valuations does, of course, mean that one already knows how valuation works.

If you need some help on that point, make sure to give Lesson 11: Valuation a read.

Put together by fellow contributor Dave Van Knapp, it spells out valuation using simple terminology.

It also includes a valuation template that you can use on your own.

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…

American Water Works Company Inc. (AWK)

American Water Works Company Inc. (AWK) is a utility company that provides water and wastewater services in the United States.

Founded in 1886, American Water Works is now a $24 billion (by market cap) water utility giant that employs 6,500 people.

American Water Works provides water and wastewater services to roughly 14 million people across 14 different states.

By customers, this is the largest publicly-traded water and wastewater utility in the US.

The company’s main segment is Regulated Businesses, which accounted for 93% of FY 2023 revenue and comprises the core water and wastewater utility operations.

A small component of the company (7% of FY 2023 revenue) is unregulated, serving 18 different military installations on long-term (usually 50 years) contracts.

American Water Works is, essentially, a regulated water and wastewater utility business that primarily serves residential and commercial customers.

It’s as simple as that.

And that’s what’s so great about this business.

It’s simple.

It provides something we cannot live without, and it’s been doing so since 1886.

That’s nearly 140 years.

And guess what?

I suspect it’ll be doing this for another 140 years.

While nothing is outright guaranteed in life or business (other than death), there’s great comfort in the near-certain future of this business and the services it offers.

I say that because water is our most precious resource.

As addictive as smartphones are, a person can live without one.

But one literally cannot survive without water.

However, because its customers are so heavily reliant on the services this company provides, American Water Works is heavily regulated.

Regulators are there to make sure that American Water Works doesn’t take advantage of this reliance and overcharge customers for necessary water and wastewater services.

The regulatory framework ensures that there’s a ceiling on the rates the company can charge for a resource with limitless demand.

Left totally uncapped, it would be easy to charge a captive customer base exorbitant rates.

But that’s not the situation at all.

To this point, the company estimates that its monthly water bill to its customers is less than 1% median household income.

This affordability point is important.

At first blush, the regulatory framework is a bummer, as it limits how well the business and stock can do (by putting a lid on rates).

However, this same regulatory framework puts a profit floor underneath the business, and that floor is further supported by the necessary-for-life nature of its services.

Moreover, I think the low price and affordable nature of what American Water Works provides its customers puts a very high value proposition on these services, and I also believe it adds a sense of goodwill among the customer base.

All of this helps to explain why the company has been prospering for nearly 140 years, and I think it’s also why the company should continue to prosper and grow its revenue, profit, and dividend for many decades to come.

Dividend Growth, Growth Rate, Payout Ratio and Yield

American Water Works has already increased its dividend for 17 consecutive years.

The 10-year dividend growth rate is 9.5%, which is actually quite impressive for a utility.

Most power utilities that I follow tend to grow dividends at a mid-single-digit (say, 4% to 6%) rate.

American Water Works is well above that level, showing the allure of this type of utility (relative to alternatives across power).

The trade-off to the higher dividend growth rate is the yield, as evidenced by the stock’s 2.4% yield.

Now, this yield does beat what the broader market offers.

This yield is also 70 basis points higher than its own five-year average.

That means the market has typically been willing to accept a much lower yield from this stock, due to the near-certain stream of revenue, profit, and dividends (and higher growth rate in comparison to other utilities).

On the other hand, if one is more oriented around yield and income, power utilities that offer higher yields might be more appealing.

In my view, American Water Works could excellently accentuate one’s utility holdings, offsetting the lower growth rates and total return profiles among power utilities (in exchange for giving up some current income).

With a payout ratio of 60.7%, this is one of the safer dividends I’ve run across in the utility space.

This stock doesn’t offer the kind of yield that one can find across power utilities, but this growth and safety could be argued to be well worth giving up some yield.

Overall, I like this dividend profile a lot.

Revenue and Earnings Growth

As likable as the dividend metrics may be, though, many of these numbers are looking backward.

However, investors must always be thinking about what is likely to happen going forward, as today’s capital gets risked for tomorrow’s rewards.

Thus, I’ll now build out a forward-looking growth trajectory for the business, which will be instrumental in the valuation process.

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.

Blending the proven past with a future forecast in this way should give us the ability to reasonably judge where the business could be going from here.

American Water Works increased its revenue from $3 billion to $4.2 billion in FY 2023.

That’s a compound annual growth rate of 3.8%.

Not bad for a utility.

Meanwhile, earnings per share grew from $2.35 to $4.90 over this period, which is a CAGR of 8.5%.

That’s strong EPS growth for any utility, regardless of what it’s providing.

We can also see how well dividend growth and EPS growth line up over the last decade, indicating a sustainable dividend and deft control by management (i.e., the high dividend growth rate hasn’t been purely fueled by payout ratio expansion).

Looking forward, CFRA believes that American Water Works will compound its EPS at an annual rate of 7% over the next three years.

This growth will be underpinned by CapEx, as utilities are guaranteed a rate of return on its spending/investments by regulators (part of the aforementioned regulatory framework).

CFRA opines on this point: “…A strong capex pipeline and federal support for upgrading U.S. water infrastructure underscore [American Water Works]’s above-peer EPS and dividend growth trajectories, which we anticipate near 7% and 8% CAGRs, respectively, from 2024 to 2027.”

Sounds good to me.

These growth trajectories would be pretty close to what American Water Works has made good on over the last decade, seemingly indicating more of the same.

One very important thing to know about American Water Works is that it isn’t so limited on its geographic footprint.

This differentiates it from a power utility, as power utilities are generally limited to one geographic area.

American Water Works employs the serial acquirer playbook to slowly consolidate the industry, expand its reach, and build out a water and wastewater empire.

This is a huge growth driver that a lot of other utilities don’t have access to.

American Water Works routinely acquires smaller municipal water and wastewater systems.

It completed 26 acquisitions in 2022, and it completed another 23 acquisitions across eight states in 2023.

The company takes what is already a powerful business model (providing a resource people literally can’t live without), and then it adds the powerful serial acquirer model on top of it.

Being able to spread out, geographically, while still maintaining its local monopolies, is what makes this business so much more interesting and productive than a typical power utility business to me.

There’s also less disruption risk here, as centralized power is slowly being displaced by alternative sources at the point of use (such as solar panels); water is very difficult to disrupt.

I’m willing to take CFRA’s number as the base case on a go-forward basis.

That would set up the dividend for growth that’s similar or better (due to the healthy payout ratio).

If one can get a ~2.5% yield and high-single-digit dividend growth, that’s putting together a picture for a low-double-digit total return profile.

When you’re getting that from an ultra reliable and predictable water utility business with locked-in customers that need these services and have no viable alternatives, that’s very nice.

Financial Position

Moving over to the balance sheet, American Water Works has an acceptable financial position.

The long-term debt/equity ratio is 1.2, while the interest coverage ratio is nearly 4.

For a utility, these are fairly standard numbers.

If this were any other kind of business, I’d be concerned.

But utilities have revenues that are practically 100% recurring, and investments are backed by the regulatory framework.

There is no future in which its customers will suddenly stop using water and wastewater services.

This is the basis for its investment-grade credit ratings for its senior unsecured debt: A, S&P Global; Baa1, Moody’s.

This is why I think American Water Works has an acceptable, rather than a worrisome, financial position.

Profitability is quite decent, particularly for a utility.

Return on equity has averaged 12.4% over the last five years, while net margin has averaged 22.4%.

ROE is aided by the debt, however.

I would note that net margin was in the 15% range a decade ago, so there’s been a nice improvement here.

American Water Works has a lot to like, and it has multiple growth levers to pull over the coming years: upgrading aging infrastructure, slowly increasing fees, and adding inorganic growth through acquisitions.

And with economies of scale, local monopolies across service territories, high barriers to entry, regulatory support for profit recovery, and entrenched infrastructure, 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.

There is essentially no competition across local territories, giving American Water Works a rare leg up on a lot of other business models.

Regulation is a double-edged sword; regulation puts a ceiling on profit (in order to eliminate the possibility of price gouging), but regulators also put a profit floor under the business by allowing a recouping of investments through higher service fees to customers.

The company’s acquisitive nature requires introduces risks regarding capital allocation, execution, and integration.

Accessing source water, due to natural changes, may become increasingly challenging and difficult for the company over time.

While I do see some risks present, which is true for any business, this company’s specific risk profile seems to be low relative to a lot of alternatives across the marketplace.

Yet, with the stock down 35% from recent highs, the valuation seems to be pricing in a lot more risk than normal…

Valuation

The P/E ratio on the stock is 24.7.

That is well below its own five-year average of 30.

The market has often allowed this stock to command a healthy premium, but that premium has severely dissipated.

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 is lower than the demonstrated dividend growth over the last decade, but it’s also slightly in excess of the near-term forecast for EPS growth.

Also, EPS growth over the last decade hasn’t been much higher than this mark.

And the payout ratio is elevated (but not overly so for a utility).

It’s quite possible, maybe even likely, that American Water Works can do a bit better than this over the long run, but I also find it unlikely that it’ll land well short of this, and I’d rather err on the side of caution.

The DDM analysis gives me a fair value of $131.58.

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.

My view is that this stock is priced slightly cheaper than it ought to be.

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 AWK as a 4-star stock, with a fair value estimate of $137.00.

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 AWK as a 4-star “BUY”, with a 12-month target price of $162.00.

I landed very closely to where Morningstar is at, and I think CFRA is aggressive. Averaging the three numbers out gives us a final valuation of $143.53, which would indicate the stock is possibly 13% undervalued.

Bottom line: American Water Works Company Inc. (AWK) is in the business of providing its customers with the world’s most precious resource. This is the largest publicly-traded water and wastewater utility in the US, backed by a necessary-for-life service and nearly 140 years of operation. It’s as close to a sleep-well-at-night investment as it gets. With a market-beating yield, a reasonable payout ratio, a high-single-digit dividend growth rate, nearly 20 consecutive years of dividend increases, and the potential that shares are 13% undervalued, this could be a compelling buying opportunity for dividend growth investors looking for a conservative long-term investment.

-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 AWK’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, AWK’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.

Disclosure: I’m long AWK.