I grew up in Detroit, Michigan.
My childhood was one of abject poverty.
There were many days when I literally didn’t have anything to eat.
Yet, Warren Buffett is still right: I won the “ovarian lottery”.
Despite growing up in a very tough situation, I was born in the United States.
The US offers people unrivaled upward mobility in life.
There is no other country where you can go from the bottom of the bottom to the top of the top in one lifetime.
And a lot of this possibility is embodied in the US stock market.
The stock market allows everyday people to tap into the power of US capitalism and long-term compounding.
A highly, highly effective way to tap into this is through the dividend growth investing strategy.
This is a long-term investment strategy that advocates buying and holding shares in high-quality businesses which reward shareholders with safe, growing dividends.
Those safe, growing dividends can unlock the passive income necessary to become financially independent – something that is impossible for most people in most other countries.
You can find hundreds of businesses that qualify for the strategy by pulling up the Dividend Champions, Contenders, and Challengers list – a treasure trove of data on all US-listed stocks that have raised dividends each year for at least the last five consecutive years.
Building a portfolio chock-full of high-quality businesses from this list could be your ticket to wealth, passive dividend income, and financial independence.
I punched my ticket by following this strategy for 15 years, allowing it to help me build the FIRE Fund – my real-money portfolio that generates enough five-figure passive dividend income for me to live off of.
This has been enough for me to live off of since I was in the extremely fortunate position of being able to retire in my early 30s.
By the way, my Early Retirement Blueprint shares how such a thing is possible for almost anyone.
Now, the dividend growth investing strategy involves more than simply investing in the right businesses.
There’s also the matter of investing at the right valuations.
Price only tells you what you pay, but value tells you what 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.
Being born in America is winning the “ovarian lottery”, and it’s almost incumbent on oneself to take advantage of this by buying undervalued high-quality dividend growth stocks, building wealth and passive dividend income over time, and eventually unlocking financial independence.
Of course, recognizing undervaluation first requires one to understand how to go about valuing stocks.
No worries.
If you need some help on this, make sure to read Lesson 11: Valuation.
Written by fellow contributor Dave Van Knapp, it’s part of an overarching series of “lessons” on dividend growth investing, and it quickly explains how valuation works and how to go about quickly valuing almost any dividend growth stock you’ll run across.
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…
Xylem Inc. (XYL)
Xylem Inc. (XYL) is is a water technology company.
Founded in 2011, Xylem is now a $27 billion (by market cap) major player in water technology that employs approximately 23,000 people.
Xylem was technically founded in 2011 after being spun out from former parent company ITT Inc. (ITT), but its roots (under ITT) actually date back decades.
As an independent business, Xylem now focuses on providing water technology solutions for commercial and residential customers.
These solutions include the transport, treatment, testing, and more efficient usage of water.
FY 2023 revenue can be broken down across four business segments: Water Infrastructure, 30%; Water Solutions and Services, 27%; Measurement & Control Solutions, 22%; and Applied Water, 21%;
Roughly half of revenue is derived from the US.
Water Infrastructure, the largest segment by revenue, is where a range of Xylem products, such as wastewater pumps, filtration, treatment equipment, and controls are designed to help with the transportation and treatment of water.
The Water Solutions & Services segment, which was created after Xylem acquired Evoqua Water Technologies Corp., a leader in mission-critical water treatment solutions and services, in 2023 for $7.5 billion, specializes in mission-critical water treatment solutions and services.
Measurement & Control Solutions is where products, such as meters and sensors, are used to help with testing.
The Applied Water segment is where products including pumps and valves are instituted to increase water efficiency for customers.
Xylem has secular tailwinds blowing its way.
We’re talking about the transportation, treatment, testing, and more efficient usage of water here.
There is no world in which human beings will suddenly stop demanding clean water.
It’s our most precious resource, required to sustain life.
I think of water as the “liquid gold” of this coming century, much like how oil was for the last century.
Yet, all the water which currently exists is all that will ever exist.
Ever-increasing demand against a backdrop of finite supply means the efficient usage of this resource is vital, playing right into the hands of Xylem.
Moreover, ultra-pure water is necessary for all kinds of manufacturing processes, including semiconductor manufacturing.
Xylem doesn’t run the sexiest business model out there, but multiple layers of increasing demand and necessity on a resource with finite supply means the company’s offerings are only becoming more and more important.
And this is what sets Xylem up for revenue, profit, and dividend growth over the decades to come.
Dividend Growth, Growth Rate, Payout Ratio and Yield
To date, Xylem has increased its dividend for 15 consecutive years.
Its 10-year dividend growth rate is 10.9%, which is very solid.
Making the dividend profile even more solid is the consistency: Xylem has been consistent about handing out dividend raises in a high-single-digit to low-double-digit range.
In fact, the most recent dividend raise, which was announced by the company in February, came in at 11.1%.
Low-double-digit dividend growth is right about where we’re at with Xylem, which is obviously nice – especially if you’re a younger dividend growth investor interested in high-quality compounders.
The trade-off, however, is the stock’s lowish yield of 1.4%.
You’re rarely going to get a high yield when there’s double-digit dividend growth present, and I do think the elevated growth offsets the low starting yield, but this kind of yield is not optimal for income-oriented investors.
That said, this yield is 30 basis points higher than its own five-year average, so there is more income juice to squeeze than normal here.
With the payout ratio sitting at 43.8%, Xylem has plenty of dividend firepower in order to keep that low-double-digit dividend growth coming.
This stock probably isn’t suited all that well for older investors seeking income.
But for those who have time for the compounding process to play out as those dividend raises add up, Xylem’s dividend profile could be quite alluring.
Revenue and Earnings Growth
As alluring as it may be, though, this profile is largely based on backward-looking dividend metrics.
However, investors must base decisions on forward-looking numbers, as the capital of today ultimately gets risked for the rewards of tomorrow.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will be super useful when it comes time 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.
And I’ll then reveal a professional prognostication for near-term profit growth.
Lining up the proven past with a future forecast in this way should allow us to build a model on where the business might be going from here.
Xylem advanced its revenue from $3.7 billion in FY 2015 to $8.6 billion in FY 2024.
That’s a compound annual growth rate of 9.8%.
Strong top-line growth out of Xylem; however, revenue growth was boosted in a major way after the 2023 acquisition of Evoqua Water Technologies Corp.
If we look at earnings per share growth, we can see that EPS grew from $1.87 to $3.65 over this period, which is a CAGR of 7.7%.
Seeing as how the outstanding share count was driven higher after the acquisition (the all-stock transaction was funded by Xylem equity), this EPS growth rate could be seen as a more accurate reflection of the company’s true growth path (since it includes the dilution effects).
On the other hand, the pivotal acquisition has seemingly improved upon Xylem’s prior growth trajectory.
FY 2024 alone resulted in 30.8% YOY EPS growth.
So the short-term pain of dilution appears to be very much worth the long-term gain of more growth.
Balancing things out, I really do think the post-acquisition Xylem is built for low-double-digit EPS growth (which would fuel the low-double-digit dividend growth shareholders have become accustomed to).
Looking forward, CFRA is anticipating that Xylem will compound its EPS at a 10% annual rate over the next three years.
This is corroborating what I just mentioned.
CFRA sees: “…robust demand in utility end markets, multiyear tailwinds stemming from federal infrastructure stimulus, and portfolio optimization efforts that we see enhancing the firm’s margin profile. [Xylem] is actively reviewing its market exposures and product lines with the goal of exiting unprofitable businesses and better aligning capital with profitable growth, a move that we see as prudent following the integration of Evoqua. [Xylem] is benefiting from the digital transformation of the water business, with accelerating industry adoption of digital solutions. Updated EPA rules on PFAS and other contaminants in drinking water present an additional demand catalyst as [Xylem] utilizes its recent Evoqua acquisition to capture pollutants and develop innovative technologies that enable the detection and destruction of harmful substances.”
I mean, that says it all.
This captures much of the thesis.
Put simply, Xylem has multiple levers to pull and ways to win.
Efficiency, technology, and purity are all major growth drivers for water/Xylem on a go-forward basis.
It’s almost impossible to imagine Xylem not doing well over the next decade or so.
I am in full agreement with CFRA’s viewpoint here regarding Xylem’s near-term EPS growth.
I actually think that near-term growth forecast is a reasonable expectation for longer-term growth out of Xylem – and that goes for both EPS and the dividend (with some faster growth out of the latter possible through modest payout ratio expansion).
This is all to say, Xylem’s dividend growth over the next several years seems likely to match its 10-year mark (say, 10%+/year).
When you put that on top of the yield, assuming no major change in valuation, it sets investors up for a low-teens annualized total return.
For perspective on that, this stock’s 10-year total return (including reinvested dividends) annualizes out to nearly 14%/year.
Again, for younger dividend growth investors who prefer high-quality compounders with enduring tailwinds, Xylem is a compelling idea.
Financial Position
Moving over to the balance sheet, Xylem has a rock-solid financial position.
The long-term debt/equity ratio is 0.2, while the interest coverage ratio is over 25.
Notably, the balance sheet has improved sharply over the last decade, with long-term debt mostly flat but shareholders’ equity up markedly (due to the Evoqua acquisition).
Since Xylem used equity to fund its big acquisition, the balance sheet’s integrity has been maintained.
There’s a lot of financial resiliency here, reinforced by the nature of the steady business model, which is reassuring.
Profitability is good, but there’s room for improvement.
Return on equity has averaged 10.1% over the last five years, while net margin has averaged 7.7%.
I’d like, and even expect, to see higher returns on capital here, and I think Xylem has put itself in a good position to generate better profitability over the coming years.
As a leading company providing products designed to improve usage of our most precious resource, Xylem is in the driver’s seat as it pertains to the world’s increasing thirst (pun intended) for access to clean water.
And with economies of scale, industry know-how, switching costs, IP, R&D, brand power, and an installed base that’s entrenched, 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.
Litigation and regulation both seem to be somewhat limited for Xylem relative to many other business models, but competition in this space is fierce.
The company has exposure to geopolitics, currency exchange rates, and sovereign debt loads, as large infrastructure projects (water or otherwise) often stem from government entities and public spending.
The Evoqua acquisition is now fully absorbed, limiting near-term execution risks, but only time will determine whether or not the acquisition was worth the price paid.
Input costs can be volatile, and recent inflationary pressures could be a near-term headwind.
Overall, I don’t see Xylem as being a high-risk business model.
And with the valuation not being overly demanding, I also don’t see a lot of valuation risk…
Valuation
The stock’s P/E ratio is sitting at 31.7.
While that might seem high in absolute terms, it’s actually well below the stock’s own five-year average P/E ratio of 45.9.
This is the kind of business model that commands – and deserves, in my opinion – premium multiples.
I say that because of the numerous tailwinds and incredible visibility around revenue and long-term growth.
The P/CF ratio of 20.1 is really not that high, even in absolute terms, and it’s also well below its own five-year average of 25.4.
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 15-year dividend growth rate of 12%, and a long-term dividend growth rate of 8%.
This is the same model I used the last time I analyzed and valued Xylem, and I feel confident enough to stick with it.
The 15-year dividend growth rate I’m factoring in is only slightly higher than Xylem’s demonstrated dividend growth rate over the last decade, and this accounts for Xylem’s better growth profile.
With the near-term forecast for Xylem’s EPS growth being at 10%, the moderate payout ratio allows for 12% dividend growth.
Since my last analysis was completed, which included these same assumptions, Xylem handed out an 11.1% dividend increase – in the midst of a lot of uncertainty.
Any improvement in that uncertainty could easily open things up for even higher dividend raises.
I don’t think any of this is all that ambitious for the likes of Xylem and what this business is capable of.
The DDM analysis gives me a fair value of $141.02.
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 market is undervaluing this business.
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 XYL as a 3-star stock, with a fair value estimate of $116.00.
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 XYL as a 5-star “STRONG BUY”, with a 12-month target price of $155.00.
I’m somewhere in the middle on this one, although I’m closer to CFRA. Averaging the three numbers out gives us a final valuation of $137.34, which would indicate the stock is possibly 16% undervalued.
Bottom line: Xylem Inc. (XYL) is a great business in a great space. Providing many products designed to improve water, our most precious resource, the business has multiple ways to win and almost can’t lose over the long run. With a market-beating yield, a moderate payout ratio, double-digit dividend growth, 15 consecutive years of dividend increases, and the potential that shares are 16% undervalued, long-term dividend growth investors looking for a high-quality compounder with lots of revenue visibility should take a peek at this name.
-Jason Fieber
Note from D&I: How safe is XYL’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 66. 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, XYL’s dividend appears Safe with an 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 XYL.
