Accumulating wealth can be mindless, endless, and almost even pointless if there are no boundaries and goals put forth at the start of the process.
Without targets in mind, it’s akin to getting in your car and driving without a known destination.
In that situation, arrival is impossible.
Like Seneca said: “If a man knows not to which port he sails, no wind is favorable.”
This is why I think financial independence is such a beloved universal goal among investors.
It’s a clear port to sail to, and it’s a lovely place to arrive to.
I set this goal for myself more than 15 years ago, using the dividend growth investing strategy to achieve it.
This is a long-term investment strategy involving the buying and holding of shares in high-quality businesses paying out safe, growing dividends to shareholders.
These growing dividend payments, once enough to cover bills, can form the bedrock of one’s financial independence.
You can find hundreds of businesses reliably paying out ever-larger cash dividend payments by pulling up the Dividend Champions, Contenders, and Challengers list.
This list has compiled invaluable information on US-listed stocks that have raised dividends each year for at least the last five consecutive years.
As you might imagine, a growing dividend is a great initial litmus test for business quality, as a business almost has to attain a certain level of quality in order to afford the financial commitment of ever-larger cash payments to shareholders.
I’ve used dividend growth investing over the last 15+ years to build the FIRE Fund.
That’s my real-money portfolio which generates enough five-figure passive dividend income for me to live off of.
I’ve been in this fortunate position since I quit my job and retired in my early 30s.
Yes, I set out for the “port” of financial independence, and I arrived there years ago.
If you’re curious about how such an early retirement is possible, be sure to give my Early Retirement Blueprint a read.
There’s also the matter of getting valuation right.
That’s because price is simply what you pay, but value is what you actually 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.
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.
While the preceding points regarding valuation might seem complex, they’re really not.
Lesson 11: Valuation, written by fellow contributor Dave Van Knapp, succinctly explains the ins and outs of valuation, even providing an easy-to-use template you can apply 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…
CMS Energy Group (CMS) is an American energy holding company.
Founded in 1886, CMS is now a $22 billion (by market cap) energy player employing more than 8,000 people.
Almost all of CMS Energy’s revenue comes from Consumers Energy, a regulated electric and gas utility serving nearly 2 million customers in Michigan’s lower peninsula.
CMS Energy also has a small independent power production business called NorthStar Clean Energy, but its revenue is fairly immaterial to the group.
About half of Consumers Energy’s customers are residential, and the rest are commercial/industrial.
Power utilities are one of my favorite areas for long-term investment.
The investment thesis is simple but powerful: A power utility is providing captive customers with services they cannot live without, and this provision occurs within a monopolistic framework due to the fact that only one power utility tends to exist within any one geographic area.
CMS owns essential infrastructure providing critical and necessary energy services to customers who almost have no choice but to use what CMS is providing them.
Hard to beat that.
Plus, energy demand is rising, generally, exacerbated by power-hungry innovations in technology (e.g., AI, data centers, etc.), providing an extra tailwind to incumbent utilities.
Of course, because of the power (pun intended) CMS holds over its area, regulators step in and limit how much it can charge.
That’s the trade-off for investing in a business model that almost cannot lose over time.
But because regulatory-allowed rates scale with investment, CMS has an easy path toward higher rates, more revenue, bigger profit, and larger dividends for years into the future.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Already, CMS has increased its dividend for 20 consecutive years.
Its 10-year dividend growth rate of 6.5% is very solid for a power utility.
A lot of power utilities tend to feature mid-single-digit dividend growth, so CMS pushing it toward a high-single-digit area sets it apart.
This yield, by the way, is 20 basis points higher than its own five-year average.
And with a payout ratio of 63%, which is pretty on brand for a power utility, indicates no issues whatsoever with the health and continued growth of the dividend.
Moreover, dividend security is given an additional boost by the basic necessity of what the business is providing.
I couldn’t imagine a future in which this company’s customers stop demanding and paying for power, which provides a very healthy floor underneath the business and dividend.
This strikes me as a really balanced dividend profile, offering a nice mix of income, growth, and safety.
A lot to like.
Revenue and Earnings Growth
As likable as it may be, though, much of this is based on past information.
However, investors must always have the future in mind, as the capital of today is ultimately risked for the rewards of tomorrow.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will be of great use when the time comes later to estimate intrinsic value.
I’ll first show you what the business has done over the last ten years in terms of its top-line and bottom-line growth.
And 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 the ability to judge where the business could be going from here.
CMS grew its revenue from $6.4 billion in FY 2016 to $8.5 billion in FY 2025.
That’s a compound annual growth rate of 3.2%.
This top-line growth is right in line with what I’d expect from a power utility.
Meanwhile, earnings per share increased from $1.98 to $3.53 over this period, which is a CAGR of 6.6%.
Very solid.
Amazingly, EPS growth and dividend growth over the last decade line up almost precisely with one another, showing that management has been very prudent and exacting.
Looking forward, CFRA believes that CMS will compound its EPS at an annual rate of 8% over the next three years.
According to CFRA, this acceleration is underpinned by a large CapEx plan, a friendly regulatory environment, data center buildouts in Michigan, and rising energy usage generally.
Supporting this 8% mark is CMS’s $24 billion five-year CapEx plan, which gives way to CMS guiding for 6% to 8% long-term adjusted EPS growth (with confidence toward the high end).
We’re looking at a 10.5% rate base CAGR from CapEx, and CMS recently received a 9.9% authorized ROE (above industry trends, speaking on the friendliness of the regulatory environment).
Putting it all together, I think CFRA is right on the mark here.
And that would fuel HSD (say, 7%+) dividend growth over the coming years.
Layering that on top of the 3%+ starting yield adds up to a 10%+ annualized total return out of a stable power utility providing a basic necessity to millions of captive customers within a monopolistic framework.
That strikes me as quite appealing.
Financial Position
Moving over to the balance sheet, CMS has a fairly standard financial position for a power utility.
Its long-term debt/equity ratio is 1.8, while the interest coverage ratio is over 2.
While these numbers would be tough to swallow in most cases, they are really only slightly on the weak side relative to what I’ve seen across this specific space.
Moreover, CMS has investment-grade credit ratings: BBB, Fitch; BBB+, S&P.
I’m certainly not in love with the balance sheet, but it’s not totally out of whack for a power utility.
Profitability is quite strong and skewed toward the higher side for the industry.
Return on equity has averaged 14.6% over the last five years, while net margin has averaged 10.9%.
The ROE for CMS is excellent, and it speaks on the friendliness of regulation.
Overall, I think CMS is one of the better power utilities in the US.
And with economies of scale, a monopoly over its territories, extremely high barriers to entry, a supportive regulatory environment, and a captive customer base, the company does benefit from durable competitive advantages.
Of course, there are risks to consider.
Competition, regulation, and litigation are omnipresent risks in every industry.
While competition is basically non-existent, regulation is a constant overhang.
And that regulation is a double-edged sword: Regulators allow for utilities to make a reasonable profit, where profit scales with costs, putting a profit floor in place; however, because electricity is a basic necessity and there’s often only one power provider in any one geographic area, regulators put a profit ceiling in place by limiting the rates a utility can charge.
Also, although competition at a local level doesn’t exist, it’s possible that customers will increasingly become competitors by generating power at the site of consumption (via solar installations).
CMS is dependent on the evolving regulatory structure and population growth of Michigan, but Michigan’s current regulatory situation is constructive.
There is limited natural disaster risk present, although Michigan does experience occasional blizzards and tornadoes.
The balance sheet is stretched, but this is offset by highly steady and visible revenue.
These risks are pretty typical for a power utility.
But I see a valuation that is atypical after a recent correction in the stock…
Valuation
The P/E ratio has compressed to 19.5.
That compares favorably to its own five-year average of 21.8.
The cash flow multiple of 9.2 is also decently lower than its own five-year average of 9.5.
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 dividend discount model analysis.
I factored in a 10% discount rate and a long-term dividend growth rate of 7%.
I’m basically extrapolating out the 10-year dividend growth rate into the future, albeit with the inclusion of a modest acceleration.
A modest acceleration in dividend growth should be easily supported by the EPS growth acceleration that’s being projected by both CFRA and CMS itself.
In fact, I’m building in a slight gap between the two, which could accommodate a slow payout ratio compression even as dividend growth actually picks up.
The DDM analysis gives me a fair value of $81.32.
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.
A recent 10%+ correction has pushed this stock from a fair level into undervaluation, in my view.
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 CMS as a 2-star stock, with a fair value estimate of $66.00.
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 CMS as a 4-star “BUY”, with a 12-month target price of $87.00.
We have a spread here, although I think Morningstar is being too conservative on this one. Averaging the the three numbers out gives us a final valuation of $78.11, which would indicate the stock is possibly 10% undervalued.
-Jason Fieber
Note from D&I: How safe is CMS‘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, CMS’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 have no position in CMS.