There are so many assets out there to choose from when the time comes to invest.
Real estate, artwork, collectibles, bonds, etc.
However, in my view, there’s one choice that stands far above the rest: stocks.
Stocks represent equity in businesses.
And businesses are basically designed to compound money over time.
Successful businesses reinvest growing profits back into the machine, creating a compounding effect, and it’s this compounding effect that separates stocks from the rest of the choices.
Nothing else compounds like stocks.
Yet, this can be taken to another level altogether by way of the dividend growth investing strategy, which involves buying and holding shares in high-quality businesses that reward shareholders with safe, growing dividends.
That’s because this strategy tends to funnel one right into some of the world’s best businesses, as only great businesses can generate the ever-larger profits necessary to fund ever-growing cash dividend payments.
As such, stocks that fit the strategy tend to represent equity in some of the world’s most well-known and most successful businesses, as evidenced by the Dividend Champions, Contenders, and Challengers list.
That list contains invaluable information on hundreds of US-listed stocks that have raised dividends each year for at least the last five consecutive years.
Investing in not just compounding machines but some of the best compounding machines – and collecting rising dividends along the way – is nearly a surefire way to build significant wealth and passive income over time.
This is why I’ve personally been using the dividend growth investing strategy for the last 15 years, letting it guide 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.
Actually, this has been enough for me to live off of since I quit my job and retired in my early 30s.
Of course, compounding machines aren’t worth infinite amounts of money, which is why valuation at the time of investment is so important.
While price is what you pay, it’s value that you end up getting.
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.
Buying undervalued high-quality dividend growth stocks sets you up with some of the world’s best compounding machines and can allow you to build enough wealth and passive income to become financially independent and even retire early (if you so wish).
The importance of valuation underscores why it’s so vital to understand it.
Toward this end, make sure to give Lesson 11: Valuation a read.
Written by fellow contributor Dave Van Knapp, it’s a primer on valuation that explains the concept in simple-to-understand terminology via a 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…
A. O. Smith Corp. (AOS) is a manufacturer of a broad range of residential and commercial water heaters and boilers, along with water and air purification systems.
Founded in 1874, A. O. Smith is now an $8 billion (by market cap) water technology leader.
Results are reported across two segments: North America, 75% of FY 2024 revenue; and Rest of World, 25%.
If a company can ride one secular growth wave, it’s in a great position.
Well, A. O. Smith is riding two secular growth waves.
First, let’s talk about water.
In my opinion, water will be the “liquid gold” of this century, much as how oil had that crown for the last century (and is, arguably, still wearing it).
Demand for clean, accessible water has unending demand.
There is no future in which humans will demand less of this.
Through its purification systems, A. O. Smith is in the business of catering to this enduring demand.
Second, let’s talk about efficiency.
The world, for a variety of reasons, is demanding more efficiency in almost everything being used.
Well, that’s precisely where A. O. Smith’s high-tech water heaters come in, putting the company in a prime position to capitalize on the rising demand for increasing efficiency.
So what we have here is a pure-play water technology company squarely positioned in two megatrends – simultaneously.
Moreover, the company’s core product – water heaters – are something that most households are unwilling to live without, creating very steady and reliable demand for A. O. Smith’s products over time.
This helps to explain why the company has been successfully in business for more than 150 years, and I think it clearly sets up the foundation for continued revenue, profit, and dividend growth for many years to come.
Dividend Growth, Growth Rate, Payout Ratio and Yield
To date, A. O. Smith has increased its dividend for 31 consecutive years.
It has earned its status as a vaunted Dividend Aristocrat, and I’m confident it’ll reach Dividend King status in 19 years.
Its 10-year dividend growth rate is 15.8%, which is impressive, but more recent dividend raises have been in a high-single-digit range.
Still, that kind of dividend growth is enough to make sense of the stock.
This market-beating yield, by the way, is 40 basis points higher than its own five-year average.
And with the payout ratio at 37.5%, the dividend has plenty of room to grow (even at a rate that exceeds the business itself, at least for a time).
This is a Dividend Aristocrat in a terrific space, growing its safe dividend fairly briskly.
Meantime, the stock offers a respectable yield.
It’s really in the sweet spot, where every box is getting a check.
Revenue and Earnings Growth
As sweet as it may be, though, many of the dividend metrics are looking backward.
However, investors must always be looking forward, as today’s capital is risked for tomorrow’s rewards.
As such, I’ll now build out a forward-looking growth trajectory for the business, which will come in handy when later attempting to estimate 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.
Lining up the proven past with a future forecast in this manner should give us the information necessary to judge where the business may be going from here.
A. O. Smith moved its revenue from $2.5 billion in FY 2015 to $3.8 billion in FY 2024.
That’s a compound annual growth rate of 4.8%.
I usually like to see a mid-single-digit (or better) top-line growth rate from a mature company, and A. O. Smith delivered.
Earnings per share grew from $1.58 to $3.63 over this period, which is a CAGR of 9.7%.
Very solid stuff from this Dividend Aristocrat.
Excess bottom-line growth was driven by a combination of share buybacks and margin expansion – both of which have been prolific.
Regarding the former, the outstanding share count was reduced by approximately 18% over this 10-year period.
Looking forward, CFRA is projecting a 5% CAGR for A. O. Smith’s EPS over the next three years.
This kind of EPS growth would be about half as fast as what the last decade produced.
The modest pessimism is curious considering CFRA’s mostly ebullient language regarding A. O. Smith’s prospects.
For instance, this passage from CFRA stands out: “…We calculate shares as having attractive upside potential. We also think that [A. O. Smith] is well positioned to benefit from growth related to emerging markets, particularly in India, and its water treatment segment due to the increasing need for water filtration systems to filter out contaminants, such as pesticides and PFAs.”
That said, the residential market in the US, which A. O. Smith is heavily exposed to, has been tight because of elevated interest rates and high housing costs.
Those with locked-in mortgages at lower rates don’t want to sell, and US homebuilders are having a challenging time with keeping up with demand for new supply.
This naturally limits sales for A. O. Smith.
On the other hand, these are temporary headwinds, as the massive shortage of homes in the US (estimated to be as high as seven million) will need to be corrected over the coming years.
In addition, mortgage rates are unlikely to stay this high forever, and lower rates would encourage more movement across existing inventory.
And since water heaters are related to basic quality of life, it’s unlikely that households in need of a water heater will not buy one when the time comes.
There’s also the fact that A. O. Smith has broadened its business out into adjacencies across water, including water treatment (which should smooth out some of the bumps that the US housing market can dish out).
While I fully acknowledge that CFRA’s near-term caution may be warranted, my analyses are always based on what’s prudent to expect over the long term.
With that in mind, I don’t see any reason to believe that A. O. Smith cannot continue to grow its EPS and dividend at high-single-digit rates, respectively, over the coming years.
The next year or two may be below average, but I fully anticipate this company to put up very good numbers past that point.
With a 2%+ starting yield, that easily puts those buying in today in a great position to possibly earn a 10%+ annualized total return over time.
Coming from a Dividend Aristocrat providing extremely consistent dividends and dividend raises, that’s not bad.
Financial Position
Moving over to the balance sheet, the company has a stellar financial position.
A. O. Smith is sitting on net cash.
What little long-term debt is on the balance sheet (which doesn’t exceed cash) is so immaterial that the interest coverage ratio is over 100.
Love the balance sheet.
Profitability is outstanding.
Return on equity has averaged 23.8% over the last five years, while net margin has averaged 12.1%.
The company’s returns on capital are routinely high; ROIC is typically coming in at well over 20%.
Circling back around to the margin expansion story I touched on earlier, net margin was closer to 10% a decade ago (and logging in at north of 14% in more recent years).
Overall, this is a fantastic business, and it’s not surprising to see that it’s a Dividend Aristocrat.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
The company’s heavy ties to the US housing market means A. O. Smith has direct exposure to interest rates and the broader US economy cycles.
Input costs are volatile.
The international footprint introduces exposure to geopolitics and currency exchange rates.
A trend toward tankless water heaters may result in more sales for Chinese competitors, as A. O. Smith isn’t as entrenched in this area of the market (yet).
The company’s expanding reach into water treatment, while exciting and promising, is relatively new and fairly unproven.
The company’s TAMs are somewhat small, limiting its growth and size, which is evidenced by how it’s taken more than 150 years for the company to reach the somewhat small market cap of $8 billion.
Relative to all other business models out there, I see A. O. Smith as featuring a pretty muted risk profile.
Yet, with the stock down more than 20% over the last year, the valuation seems to be pricing in plenty of risk…
Valuation
The stock is trading hands for a P/E ratio of 18.3.
For a reliable Dividend Aristocrat growing at almost 10%/year, that’s not egregious at all.
It’s far lower than the broader market’s earnings multiple.
It’s also quite a bit lower than the stock’s own five-year average P/E ratio of 24.6.
In fact, every basic multiple I look at is lower than its respective recent historical average.
And the yield, as noted earlier, is notably 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 8%.
While this dividend growth rate is at the high end of what I allow for in a model, it’s actually far lower than A. O. Smith’s demonstrated EPS and dividend growth over the last decade.
I’m baking in a lower number because of the near-term caution around growth, as well as the fact that more recent dividend raises have been in a high-single-digit range (not far off from where I’m at).
I don’t think the next decade will be as good as the last one was in terms of dividend growth; expecting 15%+ dividend growth from here would be unwise.
However, again, I see nothing to indicate how or why A. O. Smith can’t continue to put up high-single-digit business and dividend growth over time.
The business is just too good, and it’s in markets that are just too good.
The DDM analysis gives me a fair value of $73.44.
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, based on the quality and growth prospects, this stock isn’t fully priced right now.
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 AOS as a 4-star stock, with a fair value estimate of $77.00.
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 AOS as a 4-star “BUY”, with a 12-month target price of $84.00.
I ended up on the low end this time around. Averaging the three numbers out gives us a final valuation of $78.15, which would indicate the stock is possibly 13% undervalued.
-Jason Fieber
Note from D&I: How safe is AOS’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 99. 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, AOS’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 AOS.