One of my personal investing heroes, Terry Smith, has a simple, three-step framework he works with.
First, buy great businesses.
Second, don’t overpay.
Third, do nothing.
You know what this sounds like?
It sounds like dividend growth investing, which is the strategy I’ve been using for the last 15 years.
This is a long-term investment strategy that advocates buying and holding shares in world-class businesses that reward shareholders with safe, growing dividends.
So we’re talking about great businesses.
And you can see that by checking out the Dividend Champions, Contenders, and Challengers list, which has data on hundreds of US-listed stocks that have raised dividends each year for at least the last five consecutive years.
After all, it’s awfully difficult to not be a great business and somehow afford to write ever-larger checks to shareholders.
When one is collecting steadily rising dividends, it’s proof that the business is doing a lot of things right and generating the rising cash flow necessary to support this behavior.
And it makes it easy to hold for the long term, which is that third step.
I’ve been buying and holding high-quality dividend growth stocks for years as I’ve gone about building my FIRE Fund.
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 in the extremely fortunate position of being able to live off of dividends since I quit my job and retired in my early 30s.
My Early Retirement Blueprint has the details on exactly how that went down.
Now, there’s also that second step to contend with, which revolves around valuation.
Price is simply 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.
Buying high-quality dividend growth stocks when they’re undervalued and then holding for the long term is a very Terry Smith type of way to invest, and Terry Smith has been extremely successful over the years.
Valuation might seem like a very complex concept at first glance, but it’s really not.
And if you need any help regarding this concept, make sure to read Lesson 11: Valuation.
Written by fellow contributor Dave Van Knapp as part of a series of “lessons” designed to teach the dividend growth investing strategy, it spells out valuation using simple terminology and even provides a valuation template 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…
Allegion PLC (ALLE)
Allegion PLC (ALLE) is an American (but Irish-domiciled) provider of security products for homes and businesses globally.
Founded in 1908, but spun off from Ingersoll Rand Inc. (IR) in 2014, Allegion is now an $11 billion (by market cap) security competitor that employs more than 12,000 people.
Allegion reports results across two geographic segments: Allegion Americas, 80% of FY 2023 revenue; and Allegion International, 20%.
The company produces and sells a number of security-related products and accessories, including: access control systems, door closers, exit devices, electronic security products, locks, and key systems.
These products are sold under a range of leading brands, including: CISA, Interflex, LCN, Schlage, SimonsVoss, and Von Duprin.
Allegion is the right business model at the right time.
Why do I say that?
With social issues (such as crime, drugs, homelessness, and immigration) raging across the world, security has, perhaps, never been more important.
Whether threats are perceived or real is not the point; rather, it seems to me like a lot of people don’t feel extremely safe.
Well, Allegion seeks to alleviate its customers concerns by providing them with the right security tools to safeguard their businesses, homes, and lives.
In doing so, Allegion has been able to consistently generate rising revenue, profit, and dividends since its spin-off, and I fully believe that’ll continue for years to come.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Indeed, Allegion has increased its dividend for 11 consecutive years, dating back to the spin.
The 10-year dividend growth rate of 19.6% is incredible, but a lot of this came from sending the payout ratio higher off of a very low starting base.
Still, even the five-year dividend growth rate is 12.2%, and more recent dividend raises have been in a high-single-digit range.
And with the payout ratio at 31.4%, there’s plenty of fuel for sizable dividend raises over the years ahead – with or without the accompanying business growth.
Meantime, one gets this elevated dividend growth on top of the stock’s market-beating yield of 1.6%.
This yield, by the way, is 30 basis points higher than its own five-year average.
So one is looking at an above-average, above-market yield, backed by high growth and a low payout ratio.
It’s hard to dislike any of that.
Revenue and Earnings Growth
As likable as this all may be, though, many of these dividend metrics are based on the past.
However, investors must always be thinking about the future, as today’s capital ultimately gets risked for tomorrow’s rewards.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will come in handy when the time comes later to estimate the business’s fair 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.
And 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 enough to go off of as we judge where the business could be going from here.
Allegion advanced its revenue from $2.1 billion in FY 2014 to $3.7 billion in FY 2023.
That’s a compound annual growth rate of 6.5%.
Very solid top-line growth here.
Meanwhile, earnings per share increased from $1.80 to $6.12 over this period, which is a CAGR of 14.6%.
Excellent growth here.
Steady share repurchases, as well as a prolific expansion in margins, helped to drive excess bottom-line growth.
Regarding the former, the outstanding share count has been reduced by nearly 10% over the last decade.
Looking forward, CFRA believes that Allegion will compound its EPS at an annual rate of 12% over the next three years.
That’s not far off from what Allegion has done over the last decade, although it does include a modest slowdown.
CFRA cites a “…view of favorable nonresidential construction trends in 2024, steady trends in 2025 that will prioritize security upgrades, and positive growth with recent acquisitions.”
Allegion is acquisitive, focusing on portfolio expansion, emerging technologies, and growth of software and services.
CFRA again points out this acquisitive strategy, and the tilt toward digital, in this passage: “We think [Allegion] will see continued strong demand in its electronics business in nonresidential, with resilience coming from health care and education, as well as growth with acquisitions, but expect [Allegion]’s mechanical portfolio to show weakness.”
A recent example of this tilt toward digital/automated through inorganic growth is the acquisition of Stanley Access Technologies LLC, an automatic entrance solutions business, for $900 million in cash in 2022.
Perhaps the most impressive thing about Allegion is how well it’s managed its balance sheet and share float in light of the acquisitions.
In addition, we can obviously see an accretive strategy at work here, as EPS growth has easily outpaced revenue growth.
I’m willing to take CFRA’s number as the base case.
I really don’t see anything that would indicate it’s wildly off the mark.
And if Allegion can grow its EPS at 12% per year, that easily sets up the dividend for similar growth (by virtue of the low payout ratio).
That would line up almost perfectly with the five-year dividend growth rate, and it’d be coming on top of the very decent starting yield.
It puts the stock in the ballpark for a low-double-digit annualized total return.
This is a pretty compelling setup.
Financial Position
Moving over to the balance sheet, Allegion has a good financial position.
The long-term debt/equity ratio is 1.2, while the interest coverage ratio is nearly 8.
Allegion’s acquisitive nature does pressure the balance sheet.
I’m not wowed by Allegion’s financial position, but I’m also not overly concerned by it.
The company finished FY 2023 with $1.6 billion in long-term debt, which isn’t all that high against the market cap.
Profitability for the firm is excellent.
Return on equity has averaged 51.8% over the last five years, while net margin has averaged 14.3%.
ROE has been juiced by the leverage, but even ROIC is routinely over 20%.
Circling back to a point I made earlier on margin expansion, net margin was typically between 7% and 10% a decade ago.
With a world searching for more security and automation, Allegion has a lot to like with these tailwinds at its back.
And with economies of scale, brand recognition, a built-out distribution network, and a large installed base that promotes “stickiness”, 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.
Competition, in particular, is an issue, as Allegion competes with very capable players in this space (such as Assa Abloy AB (ASAZY)).
Something like half of the company’s revenue is connected to new construction, which exposes the company to the related risks (such as interest rates, macroeconomics, new construction demand, labor shortages, etc.).
Being an international company, Allegion faces geopolitics, supply chain concerns, and currency exchange rates (although it is mostly tied to the domestic market).
The industry is increasingly moving toward digital/automated solutions, which means Allegion must continually stay ahead of the tech curve in order to make sure it doesn’t get left behind.
While there are some risks present, the company’s long-term prospects appear to be very bright.
And with the valuation as low as it is, it doesn’t seem like these prospects are being properly reflected in the stock’s pricing…
Valuation
The P/E ratio on the stock is sitting at 20.2.
That’s a below-market multiple on a very good business, and it’s below the stock’s own five-year average P/E ratio of 22.4.
The cash flow multiple of 17.6, which is undemanding, is also below its own five-year average of 19.
And the yield, as noted earlier, is 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 two-stage dividend discount model analysis.
I factored in a 10% discount rate, a 10-year dividend growth rate of 12%, and a long-term dividend growth rate of 7.5%.
I’m basically assuming a continuation of the demonstrated five-year dividend growth rate out into the coming decade, which also happens to line up perfectly with the near-term forecast for EPS growth.
I just see that as an easy assumption to make.
From there, there’s nothing to indicate why Allegion can’t grow at a high-single-digit rate.
Nothing crazy here.
I’m mostly expecting more of the same out of Allegion.
The DDM analysis gives me a fair value of $127.59.
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.
From my vantage point, the stock is, 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 ALLE as a 4-star stock, with a fair value estimate of $152.00.
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 ALLE as a 4-star “BUY”, with a 12-month target price of $170.00.
I came out super low this time around, so I may have been too cautious. Averaging the three numbers out gives us a final valuation of $149.86, which would indicate the stock is possibly 12% undervalued.
Bottom line: Allegion PLC (ALLE) is a great business in a great space, benefiting from increasing desire for security in an increasingly volatile world. It’s growing rapidly, generating high returns on capital, and pursuing intelligent acquisitions. With a market-beating yield, a low payout ratio, double-digit dividend growth, more than 10 consecutive years of dividend increases, and the potential that shares are 12% undervalued, this is a very interesting idea for long-term dividend growth investors.
-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 ALLE’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 61. 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, ALLE’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
Disclosure: I have no position in ALLE.
