When we buy stock in a company, we’re making a bet on their future.
But this is far different than straight gambling.
Unlike what you’ll find at a casino, the house doesn’t always win.
If you make sure to stick to high-quality companies, the odds of doing very well in terms of growing your wealth and income are very high.
[ad#Google Adsense 336×280-IA]After all, a high-quality company becomes high quality by very virtue of its business.
I stick to businesses that routinely increase their revenue and profit, maintain appropriate debt levels, have great margins, and excel at maintaining high margins and returns on equity and invested capital.
Companies that provide ubiquitous products and/or services that consumers and/or other businesses consume regularly are high on my interest list.
And perhaps most importantly, I want to make sure that I’m collecting my rightful share of increasing profit via a growing dividend.
That means I solely buy stocks that not only pay dividends but also regularly increase those dividends.
These stocks – known as “dividend growth stocks” – tend to outperform the broader market over the long term because you’re basically looking at the crème de la crème.
The good news is that it’s not hard to find these stocks. You’ll find more than 700 US-listed stocks that have all increased their dividends for at least the last five consecutive years on David Fish’s Dividend Champions, Contenders, and Challengers list, for instance.
You can’t pay out an increasing dividend to shareholders for decades on end without the growing profit to support that behavior.
So by sticking to high-quality dividend growth stocks, you’re essentially kind of filtering out companies that can’t support regularly growing dividends via regularly growing profit.
And you’re also filtering out those companies that don’t have a penchant for sharing profit with shareholders, which is an automatic “no go” in my book.
Whether I own an entire company or part of a company, I want my share of the profit.
What’s really great about growing dividends, though, is that it’s basically passive income. You don’t have to do anything to collect your income. It just shows up in your brokerage account.
This is one major reason I’ve built a portfolio chock-full of high-quality dividend growth stocks: This portfolio will very likely generate enough growing dividend income for me to live off of by my 40th birthday, rendering me financially independent.
However, for all the important reasons we should stick to high-quality dividend growth stocks, it’s just as important that we try to pay as little as possible when acquiring stocks.
What do I mean by that?
Well, price is what you pay. Price tells you how much money you have to exchange for something in order to have it.
But value actually tells you whether or not you’re getting a good deal. Value tells you what you’re getting in return for the money you’re spending. Value gives context to price. Without that context, price means almost nothing.
Any time you go out and buy anything at all, you’re making a value call. You might not be aware of it. It might be subconscious. But you’re doing it, nonetheless.
“$1,000 for that laptop? That seems expensive.”
“Oh, this one is only $500. And it does most of the same stuff. This is a better deal.”
Or…
“Boy, $100 for this pair of jeans? What a ripoff! I’ll take the $30 jeans over on this rack.”
So on and so forth.
Almost everything in this world has a price. Equally so, almost everything in this world has value to it.
This is extremely important to remember when looking at stocks.
If we’re able to get a great deal on a high-quality dividend growth stock and buy it when it’s undervalued, we reduce our risk while simultaneously increasing our income and potential long-term total return.
I mentioned gambling earlier. Well, sometimes we make a call on a business and it goes the wrong way on us. Maybe the business doesn’t do what they’re supposed to. Maybe management makes a huge error. Maybe a scandal is announced. Maybe they just become less competitive over time.
Because there are so many things that can go wrong, we want to buy in as far below fair value as possible so that we reduce our risk of permanent capital destruction.
If you believe a stock is worth $50, you want to pay as far below that price as possible. And you certainly don’t want to pay more than that.
Paying $30 for a stock that you think is worth $50 builds in a 40% margin of safety. So the company could lose 40% of its intrinsic value and you’d still be even. Even if something goes very, very wrong, you’ve got that big cushion.
As such, you’re risking a lot less capital.
If you instead pay $50 or more, you’ve got little to protect you if things go awry.
Moreover, price and yield, all else equal, are inversely correlated. If that same stock pays a $1 annual dividend, a $30 share price gives you a 3.33% yield. A $50 share price, however, gives you just a 2% yield.
That spread of 133 basis points is just plain more money in your pocket.
And since yield is one component of total return (the other being capital gain), buying in cheaper gives you an automatic boost to the investment’s potential long-term total return.
Not only that, but as I mentioned earlier, the odds are on your side that things will go well when you’re sticking to high-quality companies that do right by shareholders.
As such, it’s likely that a high-quality company’s intrinsic value rises over the long run. But in the short run, you also get that potential boost to your investment if other investors pick up on the bargain, creating demand and lifting the stock’s price to where it should be.
With all that said, let’s take a look at an example of a dividend growth stock that is potentially significantly undervalued right now!
Qualcomm, Inc. (QCOM) develops and licenses products and services based on its advanced wireless broadband technology including semiconductors for mobile phones.
Qualcomm has long been hailed as being in a great position to capitalize on the revolution taking place in technology, as the world becomes more mobilized and connected, and as the Internet of Things becomes part of everyday life.
That’s because they’ve leveraged their technology and patents in CDMA and OFDMA via licensing deals, which has allowed them to collect lucrative royalties on the majority of all 3G and 4G mobile phones sold in the world. That’s because Qualcomm owns a huge portfolio of intellectual property, so much so that handsets are essentially unable to connect to 3G networks without Qualcomm collecting its royalty.
However, the tech space is brutally competitive and changes quite fast. Recent troubles in China regarding the enforcement of proper license payments as challenges to Qualcomm’s intellectual property arises just serves to prove out how dynamic the technology space really is.
But recent troubles may have served up an opportunity – QCOM has dropped 19% in less than a month.
First, let’s consider the dividend pedigree here.
The company has increased its dividend for the past 13 consecutive years. That’s still a budding record, sure, but it’s impressive considering how fast the landscape changes in tech. So Qualcomm has proven its staying power.
And this company isn’t just handing out small raises to keep a streak alive.
They’ve increased the dividend by an annual rate of 21.7% over the last decade.
However, much of that dividend growth was fueled by an increasing payout ratio. That ratio now sits at 60%. Not particularly worrisome since that meas the company is retaining the other 40% of earnings it’s not paying out as a dividend, but that ratio is more than twice as high as it was a decade ago.
I mentioned a potential spread in yield earlier when you buy a stock for less than it’s worth, which can immediately increase your income.
Well, we see that in real-time here. QCOM yields 3.96% right now. That’s not only almost twice the broader market, it’s also almost 230 basis points higher than the stock’s five-year average yield of 1.7%.
Big spread there!
So you’ve got a very attractive yield, big dividend growth, and a payout ratio that still allows some room for future raises.
But how does the rest of the business stack up?
I like to look at top-line and bottom-line growth over the course of a decade (which is long enough to smooth out economic and business cycles), which tells me a lot about a company. Gives me a great idea about growth trajectory, which can also tell me a lot about what the business might be worth.
Qualcomm’s revenue is up from $7.526 billion to $25.281 billion from fiscal years 2006 to 2015. That’s a compound annual growth rate of 14.41%.
Mighty impressive top-line growth here.
Meanwhile, earnings per share improved from $1.44 to $3.22 over this stretch, which is a CAGR of 9.35%.
Not often I see the profit growth trail revenue growth. But Qualcomm’s profitability has deteriorated over this period, which speaks to the dynamics I mentioned earlier. This is a worrisome trend, but this is still a very profitable company that’s growing at an attractive clip.
S&P Capital IQ is calling for 10% compound annual growth for Qualcomm’s EPS over the next three years, believing that the historical trend will continue. This would obviously be in line with what the company has done over the last decade, but recent troubles in Asia could upend that.
One aspect of this company that is simply fantastic is the balance sheet. Qualcomm has long had a stellar balance sheet, with plenty of cash and no debt. But like a lot of other companies in this space (and other industries), they’ve taken on some debt recently.
However, they still maintain a long-term debt/equity ratio of 0.32 and the interest coverage ratio is well over 60. Moreover, cash and short-term investments add up to over $17 billion, which could swiftly pay off all long-term debt.
Profitability, as mentioned earlier, is a sore spot, though.
Over the last five years, Qulacomm has averaged net margin of 27.07% and return on equity of 18.28%.
These numbers in absolute terms are great, and they also compare well to other players in this industry. But there has been some marked deterioration here over the last five and ten years. That’s something to keep an eye on.
This appears to be a bit high on the risk-reward scale simply because they’re experiencing some troubles relating to their intellectual property in key markets around the world.
But sometimes you need to deal with short-term pain for long-term gain.
Those recent troubles have brought the stock’s valuation way down…
The P/E ratio for QCOM is 15.15 right now. That’s about 30% lower than the five-year average P/E ratio of 21.1. It’s also quite a bit lower than the broader market. And as noted above, the current yield is significantly higher than its recent historical norm. The stock wasn’t this cheap even during the financial crisis.
But what’s the stock actually worth?
I valued shares using a dividend discount model analysis with a 10% discount rate and a conservative 6.5% long-term dividend growth rate. I’ve brought that growth rate down since I last looked at QCOM to reflect very real near-term challenges. In addition, the payout ratio is moderately high. But the company is still growing at a rapid clip. They could lower the payout ratio while simultaneously increasing the dividend at that rate if the forecast for underlying EPS growth pans out. The DDM analysis gives me a fair value of $58.42.
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.
I valued the stock quite conservatively and still came up with a price well above what the stock is available for right now. However, I’m not the only one who believes this stock is undervalued right now.
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 QCOM as a 4-star stock, with a fair value estimate of $68.00.
S&P Capital IQ 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.
S&P Capital IQ rates QCOM as a 4-star “buy”, with a fair value calculation of $69.00.
I came in the light side, but I tend to be pretty conservative when looking at tech plays due to the inherent risks. Averaging out the three numbers gives us $65.14, which appears to be a very reasonable assumption when looking at everything across the board. That would indicate this stock is possibly 34% undervalued right now.
Bottom line: Qualcomm, Inc. (QCOM) owns substantial intellectual property relating to 3G and 4G handsets, so much so that most of these phones cannot connect to networks without royalty fees being paid to Qualcomm. Recent challenges in key markets have brought this stock down to historically cheap levels, pushing the yield to an all-time high. There’s the potential for 34% upside on top of that. The risk is high, but so is the reward. If this is a space you’re comfortable with, take a very good look here.
— Jason Fieber, Dividend Mantra
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