The path to significant and sustainable wealth is wonderful for many reasons.
One of those reasons is, the path is pretty straightforward.
There are a lot of ways you can go broke.
However, there are really only a few proven long-term strategies out there for becoming very wealthy.
My favorite strategy is about as simple as it gets.
Dividend growth investing is the strategy I’ve personally used to become relatively wealthy at a fairly young age.
This strategy involves buying shares in world-class businesses that are paying their shareholders reliable and growing cash dividend payments.
Increasing dividends are funded by that increasing profit.
It’s that simple.
The beauty is in the simplicity.
Furthermore, those growing dividend payments can add up quickly.
In fact, one could even live off of their dividends at a young age.
I’m a perfect example of this.
I built my FIRE Fund by following this strategy.
That real-life and real-money stock portfolio generates five-figure and growing passive dividend income for me.
It’s actually enough to cover my essential expenses in life, rendering me financially independent.
By following the Early Retirement Blueprint, which I wrote, I was able to retire in my early 30s.
The Blueprint involves a heavy dose of dividend growth investing.
It’s pretty easy to understand why.
An element of the strategy’s simplicity is in the ease of finding suitable dividend growth stocks for long-term investment.
The Dividend Champions, Contenders, and Challengers list features more than 800 US-listed stocks that have raised their dividends each year for at least the last five consecutive years.
Ideas are everywhere.
However, 800+ stocks is a lot to take in.
And that’s why I’m taking the time today to feature one particular high-quality dividend growth stock that appears to be undervalued.
Quality matters for an investor.
The best businesses are built to survive and thrive over the long run. Ensuring growing dividend payments means ensuring growing profit.
But valuation is also critical.
The price is what something costs, but the value is what something is worth.
An undervalued dividend growth stock should offer a higher yield, greater long-term total return prospects, and reduced risk.
That’s all relative to what the same stock would otherwise offer 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.
Total return is comprised of capital gain and investment income.
A higher yield boosts possible investment income, thereby leading to greater long-term total return potential.
That’s before factoring in the “upside” to capital gain, influenced by the favorable gap between price and value.
That gap tends to close over time as pricing becomes more rational, leading to additional capital gain.
This is on top of the capital gain that plays out as a quality company naturally becomes worth more over time.
An investor should also see reduced risk with undervaluation.
A margin of safety is introduced when price is well below estimated intrinsic value.
This protects an investor’s downside against unforeseen events that could negatively affect value.
These dynamics should obviously be taken advantage of at every turn.
Fortunately, it’s far from impossible to spot undervalued dividend growth stocks.
Fellow contributor Dave Van Knapp put together a fantastic piece on valuation, making it easier than ever to spot these stocks.
Lesson 11: Valuation is part of an overarching series of “lessons” on DGI, and it’s very much worth a read (and a re-read).
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…
FedEx Corporation (FDX)
FedEx Corporation (FDX)FedEx Corporation (FDX) is a multinational courier delivery company that provides domestic and international air express services, as well as residential and business ground package delivery, heavy freight, and logistics services.
The company operates across four primary business segments: FedEx Express, 55% of FY 2018 revenue; FedEx Ground, 28%; FedEx Freight, 10%; and FedEx Services, 3%. Other and eliminations account for the remainder.
Founded in 1971, the company’s network reaches more than 220 countries and territories, linking more than 99% of the world’s GDP.
There are a number of large “themes” playing out across the world’s stage. These themes are impacting the way people fundamentally go about their lives.
One major theme is the increasing shift to e-commerce.
Now, there are a number of ways to play that theme.
But investing in a major logistics company is a fairly obvious approach.
FedEx Corporation is one of the largest logistics companies in the world. And they’re perfectly positioned to capitalize on the growing e-commerce theme.
Their fleet of over 670 aircraft and approximately 90,000 ground vehicles gives them the scale needed to efficiently operate a global delivery company.
It’s scale that would be nearly impossible for a competitor to quickly and cost-effectively replicate, creating a huge barrier to entry.
This is part of why there are only three major players in the global delivery space. It’s an oligopoly that appears unlikely to change or break anytime soon.
Dividend Growth, Growth Rate, Payout Ratio and Yield
That bodes well for FedEx Corporation’s ability to grow its profit and pay its shareholders increasing dividends.
Speaking of which, the company has increased its dividend for 17 consecutive years.
These aren’t minor dividend increases, either.
The 10-year dividend growth rate is a monstrous 18.3%.
Even more impressive, that DGR hasn’t slowed down.
The most recent increase came in at an incredible 30.0%!
With a payout ratio of just 18.0% on adjusted TTM EPS (which factors out a tax gain for Q3 FY 2018), the dividend clearly has plenty of room to run.
However, that high DGR is offset by the low yield.
The stock only yields 1.44% right now.
As such, this stock is better suited for younger dividend growth investors with a long time horizon.
Double-digit dividend growth on a payout ratio this low offers a lot to like. If you can be patient and allow that growth to unfold, this could be a phenomenal long-term investment.
Moreover, the current yield is more than 60 basis points higher than its five-year average. That speaks on what I noted earlier.
And the dividend is due an increase with the next dividend declaration.
There’s no other way to put it: these are excellent dividend metrics.
Revenue and Earnings Growth
But in order to estimate future dividend growth, we’ll have to estimate future earnings growth. The latter will largely dictate the former over the very long run.
Getting a feel for earnings power will later help us value the stock.
I’ll first reveal what the company has done over the last decade in terms of top-line and bottom-line growth.
Then I’ll compare the historical results to a near-term professional forecast for EPS growth.
Blending the known past with what the company might do going forward should give us plenty to work with when it comes to building out a growth trajectory.
FedEx Corporation increased its revenue from $35.497 billion in FY 2009 to $65.450 billion in FY 2018. That’s a compound annual growth rate of 7.03%.
A stellar growth rate for revenue, especially on a fairly large company like this.
FedEx Corporation’s $4.8 billion acquisition of TNT Express N.V., a large European mail and courier services company, in 2016 certainly has something to say about this top-line growth rate, but revenue was growing briskly even before the acquisition closed.
This acquisition, by the way, gave FedEx Corporation a larger foothold in Europe, improving their operations there and making the entire enterprise more robust.
Earnings per share, meanwhile, advanced from $3.76 to $15.31 over this period, which is a CAGR of 16.88%.
I used adjusted EPS for both fiscal years. That’s because both FY 2009 and FY 2018 were heavily skewed by one-time issues. Both fiscal years had impairment charges (unrelated to each other), while FY 2018 saw its GAAP EPS boosted by a tax gain.
FedEx Corporation is growing rapidly. It’s quite stunning. This is why the dividend was able to grow like it has, even while the payout ratio has remained so low.
Looking forward, CFRA is predicting that FedEx Corporation will compound its EPS at an annual rate of 11%.
Volume growth and raised prices, underpinned by strong e-commerce demand, are part of the thesis here. Indeed, recent quarters have reflected all of this.
However, continued investment into the company’s infrastructure, in order to handle volume growth, will limit some of their near-term potential.
This forecast is below what FedEx Corporation produced over the last decade, but it would still easily be enough for like dividend growth.
With the payout ratio being so low, 11% EPS growth could translate into 15% dividend growth with no issues whatsoever.
Dividend growth could actually outpace earnings growth for many years to come due to how healthy the payout ratio is. We saw that play out with the most recent dividend increase of 30%.
Financial Position
The company’s health carries over to the balance sheet, too.
This is an asset-heavy and capital-intensive business, yet the balance sheet is relatively flexible.
The long-term debt/equity ratio is 0.79, while the interest coverage ratio is almost 9.
Good numbers here, but there has been some deterioration in recent years. Notably, the company took on considerable debt to fund their acquisition of TNT Express N.V. in 2016.
Profitability is robust, but margins do trail major competitor United Parcel Service, Inc. (UPS).
Over the last five years, the firm has averaged annual net margin of 4.47% and annual return on equity of 15.63%.
When I think about risks here, regulation, competition, and litigation are omnipresent for any industry.
Specific to FedEx Corporation, though, there’s a lot of exposure to economic cycles. Any major recession would naturally cause a dip in global commerce and thus shipment volumes.
In addition, it’s a capital-intensive business running a global fleet of vehicles and aircraft. Also, technology continues to change and improve, requiring investment. It’s a competitive advantage in the sense that there’s a huge barrier to entry, but it can weigh on the results.
Indeed, one strike against the company, in my view, is the free cash flow situation.
Constant infrastructure investments, along with pension contributions, have left FCF thin, or even negative, in recent years. The thought here is that these temporary constraints on FCF leave a runway for growth and higher FCF in the future, especially in the sense of a modern fleet having many years of usage.
One question mark surrounding major logistics players has been the entry of Amazon.com, Inc. (AMZN) as a competitor, but it’s worth noting that Amazon.Com represented less than 1.5% of FedEx Corporation’s revenue in 2018. So the loss of that customer wouldn’t be a major impact.
Otherwise, there’s really a lot to like about this company as a long-term investment.
As always, a lot comes down to the valuation.
Well, the stock looks quite cheap right now…
Stock Price Valuation
The stock is trading hands for a P/E ratio of 12.30.
That’s using adjusted TTM EPS, factoring out the one-time gain for Q3 FY 2018.
This is silly low for a company that’s supposed to grow at 11% annually. The PEG ratio is near 1.
That P/E ratio compares quite favorably to both the broader market and the stock’s own five-year average P/E ratio of 25.8.
Every basic valuation metric I look at is below its respective recent historical average.
The P/CF ratio, at 9.0, is much lower than its three-year average of 11.9.
And the yield, as discussed earlier, is significantly higher than its own five-year average.
The stock clearly looks undervalued. But how undervalued might it be? What would a reasonable estimate of intrinsic value look like?
I factored in a 10% discount rate.
Then I assumed a dividend growth rate of 15% for the first 10 years.
Finally, I assumed a long-term dividend growth rate of 7.5%.
That initial DGR is below what the company has demonstrated over the last 10 years.
Since the most recent dividend increase was much higher than this, and seeing as how the payout ratio is so low, it appears reasonable.
That’s slightly in excess of the near-term expectation of EPS growth, but the payout ratio can easily expand.
The long-term dividend growth rate is roughly in line with what I see as their long-term earnings power. I view their long-term growth potential as being similar to UPS.
The DDM analysis gives me a fair value of $207.85.
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.
My analysis reveals a stock that looks at least moderately undervalued.
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 FDX as a 4-star stock, with a fair value estimate of $210.00.
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 FDX as a 5-star “STRONG BUY”, with a 12-month target price of $245.00.
I came out on the low end. Averaging the three numbers out gives us a final valuation of $220.95, which would indicate the stock is possibly 24% undervalued right now.
Bottom line: FedEx Corporation (FDX) is a high-quality company that operates as part of a global oligopoly with huge barriers to entry. The growing theme of e-commerce could present this company with a massive tailwind for years to come. 19 consecutive years of dividend increases, a recent dividend increase of 30%, an extremely low payout ratio, and the potential that shares are 24% undervalued are all good reasons why dividend growth investors may want to ship this stock into their portfolios.
— Jason Fieber
Note from DTA: How safe is FDX’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, FDX’s dividend appears safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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