With AI coming on strong, it’s never been more important to invest in durable business models.
Durability is where it’s at now.
AI is likely going to disrupt a number of industries out there.
But businesses that have true durability will almost surely survive.
In fact, with a reset playing field, they may very well thrive.
This is why the dividend growth investing strategy has never been more relevant.
This strategy, which involves buying and holding shares in high-quality businesses paying out steadily growing dividends, is built for this environment.
And that’s because the only way a company can steadily generate enough growing profit necessary to sustain ever-larger cash dividend payouts is to be durable in the first place.
A longstanding track record of growing dividends is in and of itself evidence of durability.
You can see what I mean by pulling up 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.
Many of these companies have been around for more than a century already.
I’ve been using the dividend growth investing strategy for more than 15 years now.
What’s it done?
Well, it guided me as I went about building the FIRE Fund.
That’s my real-money portfolio that generates enough five-figure passive dividend income for me to live off of.
This strategy was so effective, it allowed me to retire in my early 30s.
My Early Retirement Blueprint does a deep dive into all of that.
Now, while durability and quality are vital considerations when making any long-term investment, so is valuation.
See, 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.
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.
Combining durability, quality, and value within the dividend growth framework is nearly a bulletproof way to sustainably build wealth, passive income, and financial freedom over time.
The big thing with valuation, though, is that it seems complicated at first glance.
Well, this is where Lesson 11: Valuation comes in.
Written by fellow contributor Dave Van Knapp, it uses simple terminology to explain what valuation is all about and how to go about estimating the fair value of 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) is a US-based global water technology company.
Founded in 2011, Xylem is now a $26 billion (by market cap) major water tech provider employing more than 20,000 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 2025 revenue can be broken down across four business segments: Water Infrastructure, 29%; Water Solutions and Services, 27%; Measurement & Control Solutions, 23%; and Applied Water, 21%;
Roughly half of revenue is derived from the US.
A quick sampling of some of Xylem’s products include filters, meters, pumps, sensors, treatment equipment, and valves.
Water is our most precious resource; we literally cannot live without it.
Demand for clean water is increasing, but the supply of it is finite.
This need for water security is why I view water as the “liquid gold” of the coming century, much in the way that oil had that designation during the preceding century.
Access to, and efficient usage of, clean water is becoming increasingly important, playing right into the hands of Xylem.
Its range of products are specifically designed to facilitate access to clean water – something that is virtually guaranteed to have purpose and value for as long as humans are around.
All of this positions Xylem extremely favorably for the decades ahead, setting it up for sustained revenue, profit, and dividend growth.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Already, Xylem has increased its dividend for 16 consecutive years.
Its 10-year dividend growth rate of 11% is fairly impressive, and Xylem has been quite consistent in terms of handing out low-double-digit dividend raises almost every year.
That’s a great combination of yield and growth, creating the framework for a low-teens type of annualized total return over time.
Those who have an immediate need for income in the here and now might not find a lot of solace in that longer-term compounding profile, but I would note this yield is 40 basis points higher than its own five-year average.
This is a stock that has typically offered a below-market yield, but that’s been totally flipped.
The payout ratio, which is at just 42.8%, indicates a very healthy dividend poised for much more growth ahead.
A healthy, market-beating yield with double-digit growth, backed by the enduring need for clean water, offers a lot to like for long-term dividend growth investors.
Revenue and Earnings Growth
As likable as it may be, though, much of this is based on what’s happened in the past.
However, investors must always be considering what could happen in the future, as the capital of today gets put on the line for the rewards of tomorrow.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will be instrumental for valuation purposes.
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.
Blending the proven past with a future forecast in this way should give us confidence in the ability to judge where the business might be going from here.
Xylem escalated its revenue from $3.8 billion in FY 2016 to $9 billion in FY 2025.
That’s a compound annual growth rate of 10.1%.
Strong top-line growth, but this isn’t totally accurate.
Revenue jumped in a big way after the 2023 acquisition of Evoqua Water Technologies Corp. for $7.5 billion.
Evoqua specializes in mission-critical water treatment solutions and services, making it a highly complementary addition to Xylem.
Meanwhile, earnings per share grew from $1.45 to $3.92 over this period, which is a CAGR of 11.7%.
Bottom-line growth coming in even better than top-line growth – the latter of which was heavily affected by a major acquisition – goes to show how great this business is and how accretive Evoqua has been thus far.
Looking forward, CFRA believes that Xylem will deliver a 9% CAGR in its EPS over the next three years.
While this would represent a modest step down from what Xylem did over the prior decade, it would still be a great rate of growth.
CFRA cites global water scarcity as a structural growth theme for Xylem, touching on what I discussed earlier.
There’s almost no imaginable future in which Xylem’s products are not necessary.
To the contrary, global population growth against a finite supply of water only creates upward pressure on demand.
In addition, data centers are now providing secular tailwinds for Xylem, as these centers are very thirsty (pun intended) for extremely pure water within controlled ecosystems.
If we take CFRA’s number as our base case, that sets up the dividend to continue on with the status quo of low-double-digit growth.
That could be easily achieved through a slow, steady expansion of the payout ratio.
Again, when you layer that on top of the starting yield, that paints a picture of a low-teens annualized total return profile over the coming years.
When that’s based on something as easy to understand and underwrite as clean water, it’s awfully appealing.
Financial Position
Moving over to the balance sheet, Xylem has a fantastic financial position.
Its long-term debt/equity ratio is 0.2, while the interest coverage ratio is over 40.
Notably, Xylem’s long-term debt load has actually been steadily decreasing for years, and cash offsets more than half of all long-term debt.
Xylem does have investment-grade credit ratings of Baa2 from Moody’s and BBB from S&P, but I’m surprised these aren’t even higher.
Profitability is good, but I’d like to see improvements.
Return on equity has averaged 10.1% over the last five years, while net margin has averaged 8.8%.
ROIC is typically in a HSD range.
Overall, if one is looking for exposure to the secular growth themes within clean water, Xylem strikes me as one of the best and most obvious ways to play that.
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.
Being an international company, Xylem has exposure to geopolitics and currency exchange rates,.
Also, since Xylem is focused on water infrastructure globally, Xylem is exposed to sovereign budgets and debt loads, as large infrastructure projects (water or otherwise) often stem from government entities and public spending.
Input costs can be volatile.
Xylem has become quite large, which may start to introduce the law of large numbers.
I’m seeing a very modest risk profile for Xylem, particularly when weighed against the immense opportunity in front of the business.
And after a 25% slide in the stock, the valuation also seems quite modest…
Valuation
The P/E ratio is now at 27.4.
While that actually seems high, I’d point to two things.
First, that’s way lower than its own five-year average of 41.8.
Second, GAAP EPS is skewed by all kinds of impacts.
If we look at the cash flow multiple, for instance, which is probably the more accurate metric, that’s at just 17.3 right now (compared to its five-year average 24.6).
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 11%, and a long-term dividend growth rate of 8%.
I’m basically extrapolating out the demonstrated 10-year dividend growth rate into the next decade.
Seeing as how the near-term expectation for EPS growth is 9% per year, and with the payout ratio being as low as it is, I don’t think a continuation of the status quo is unrealistic.
Xylem seems very capable of low-double-digit dividend growth over the foreseeable future, and then a natural slowdown into a high-single-digit rate of growth as the business matures is a reasonable expectation to have.
The DDM analysis gives me a fair value of $119.76.
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.
This stock appears to be slightly undervalued to me after a large drawdown.
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 4-star stock, with a fair value estimate of $124.00.
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 4-star “BUY”, with a 12-month target price of $140.00.
I’m on the low side, although I’m not far off from Morningstar. Averaging the three numbers out gives us a final valuation of $127.92, which would indicate the stock is possibly 14% undervalued.
-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.
Disclosure: I’m long XYL.
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.