Everything looks like a peak next to a trough.
Some stocks might look expensive after parabolic moves upward.
However, these parabolic moves came after steep drops during the spring of 2020.
A 100% run in one year is often extraordinary.
But it’s not so extraordinary if a 50% drop precipitated it.
It’s all relative.
Finding those relative deals is something I’ve always prided myself on.
And it’s greatly helped me as I’ve gone about building my FIRE Fund.
That’s my real-money stock portfolio, which produces enough five-figure passive dividend income for me to live off of.
Indeed, this portfolio, and the dividend income it produces, allowed me to retire in my early 30s.
I lay out in my Early Retirement Blueprint exactly how I was able to accomplish that.
A major feature of my success is investment strategy I’ve employed.
That strategy is dividend growth investing.
It’s a strategy that advocates buying and holding shares in world-class enterprises that pay reliable, rising dividends.
The Dividend Champions, Contenders, and Challengers list contains invaluable data on dividend growth stocks.
This list presents more than 700 US-listed stocks that have increased their dividends for at least the last five consecutive years.
Some of the world’s best businesses are on that list.
That’s not a surprise.
It takes a special kind of business to be able to reliably increase cash dividends to shareholders for decades on end.
But as great as many of these businesses are, investing at the right valuation is always important.
While price is what you pay, it’s value that 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.
If you can find the relative deals on high-quality dividend growth stocks by letting value be your guide, you’re setting yourself up for fantastic long-term investment performance.
Fortunately, the valuation process isn’t terribly complex.
Fellow contributor Dave Van Knapp has made that process a lot more simple with the introduction of Lesson 11: Valuation, which is part of a comprehensive series of “lessons” on dividend growth investing.
This module provides a valuation template that can be applied to almost any dividend growth stock.
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…
U.S. Bancorp (USB)
U.S. Bancorp (USB) is a bank holding company that offers a diversified mix of financial services, including traditional retail banking, wealth management, commercial banking, and payment services.
Founded in 1863, U.S. Bancorp is now an $83 billion (by market cap) banking juggernaut that employs nearly 70,000 people.
Operating as the fifth-largest American bank by deposits, U.S. Bancorp has branches in 26 different states (primarily in the Midwest and West).
U.S. Bancorp reports results across five business segments: Consumer & Business Banking, 41% of FY 2020 revenue; Payment Services, 24%; Corporate & Commercial Banking, 19%; Wealth Management & Investment Services, 12%; and Treasury and Corporate Support, 4%.
The banking business model is one of the oldest business models in existence.
The fact that banking has been around since ancient history tells you a lot about its staying power.
And that staying power is grounded in the necessity of banking within society.
That necessity and staying power makes a bank an attractive asset to invest in for any long-term investor.
But a bank is even more attractive because of its float – the low-cost, low-risk source of capital that’s built up by taking deposits and doing business, which can be used to earn a return on.
It’s making money from OPM – other people’s money.
And because bank assets tend to be very sticky, the returns can be highly lucrative and predictable.
Perhaps that’s why Warren Buffett has over $7 billion invested in U.S. Bancorp.
Another reason Buffett might be invested so heavily in U.S. Bancorp?
Growing dividends, which Buffett is known to have an affinity for (as do I).
Dividend Growth, Growth Rate, Payout Ratio and Yield
The bank has increased its dividend for 10 consecutive years.
That’s about to be 11 consecutive years, as they’ve already pre-announced a plan to increase the dividend by 10% starting in Q3.
That’s pretty much right in line with their five-year dividend growth rate of 10.9%.
And that double-digit dividend growth is layered on top of the stock’s current yield of 3.0%.
This market-beating yield, by the way, is 30 basis points higher than the stock’s own five-year average.
And with a low payout ratio of 39.5%, the dividend is easily protected and positioned to continue growing.
I like dividend growth stocks in what I refer to as the “sweet spot” – a yield of between 2.5% and 3.5%, paired with a high-single-digit (or better) dividend growth rate.
This stock is squarely in the sweet spot.
Revenue and Earnings Growth
As great as these dividend metrics are, though, they’re largely looking at the past.
The thing is, though, investors are risking today’s capital for tomorrow’s rewards.
It’s future dividends and dividend raises we care most about.
As such, I’ll now build out a forward-looking growth trajectory for the business, which will later aid in the valuation process for the stock.
I’ll first show you what the bank has done over the last decade in terms of top-line and bottom-line growth.
Then I will compare that to a near-term professional prognostication for profit growth.
Amalgamating the proven past with a future forecast in this way should give us a very good idea as to where the company is going from here.
U.S. Bancorp grew its revenue from $18.574 billion in FY 2011 to $23.226 billion in FY 2020.
That’s a compound annual growth rate of 2.51%.
Meanwhile, the company increased EPS from $2.46 to $3.06 over this period, which is a CAGR of 2.45%.
Ordinarily, these would not be good numbers.
However, we know that banks were greatly impacted by the pandemic during 2020.
Economic shutdowns and loan loss reserves combined to crater results for the year.
If we were to back things up just one year, the nine-year CAGR for EPS (ending in FY 2019) would be nearly 7%.
In my view, that’s really a far more accurate picture of the company’s true bottom-line growth profile.
Looking forward, CFRA is projecting that U.S. Bancorp will compound its EPS at an annual rate of 5% over the next three years.
That looks conservative to me, especially when compared against a more normal growth environment for U.S. Bancorp, which would seem to lend itself to high-single-digit EPS growth.
That said, we’re in anything but a “normal” environment right now.
There is still much uncertainty as it relates to the recovery and post-pandemic economy.
I think it makes sense to be conservative in that sense, but this would be more of a low-end expectation in my mind.
A lot of U.S. Bancorp’s near-term and long-term growth trajectory will, of course, depend on interest rates. And on that front, it does appear likely that rates will rise from here, even if at a modest level.
U.S. Bancorp has long benefited from rather stable earnings on the back of a large mortgage business. Payments (up 39.5% YOY for Q2) gives them a nice growth kicker to balance things out.
With the payout ratio being so low and the recovery off to a strong start, I believe the bank will deliver at least high-single-digit dividend raises for the foreseeable future.
Financial Position
Moving over to the balance sheet, the bank has a fantastic financial position.
They have $554 billion in total assets against $500 billion in total liabilities.
Their senior unsecured debt has the following credit ratings: A2, Moody’s; A+, S&P; A+, Fitch.
These ratings are well into investment-grade territory.
U.S. Bancorp’s profitability is quite robust, going head-to-head with some of the best banks out there.
Over the last five years, the firm has averaged annual net margin of 26.96% and annual return on equity of 13.57%. Net interest margin came in at 2.68% last year.
This is a great bank across the board, which is surely why Buffett is so keen to put billions of dollars to work here.
And with economies of scale, switching costs, established relationships, and the built-up float, 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.
Banks are highly exposed to economic cycles. Recessions hurt the bank through reduced deposits and loan demand, as well as higher credit losses.
If there are lasting economic scars from the pandemic, this could create long-term growth headwinds for the company.
Persistently low interest rates continue to challenge banks, although the prospects for rates to continue rising over the near term are good.
With these risks out in the open, I still believe that U.S. Bancorp can make for a great long-term investment.
That’s particularly true with the valuation being as attractive as it is right now…
Stock Price Valuation
The stock is trading hands for a P/E ratio of 12.2.
That’s less than half that of the broader market’s earnings multiple.
It’s also lower than the stock’s own five-year average P/E ratio of 13.8.
The P/B ratio of 1.8 is precisely in line with the stock’s average P/B ratio over the last five years.
And the yield, as noted earlier, is materially 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%.
This DGR is well below the demonstrated long-term dividend growth rate from the company. It’s also very close to the pre-pandemic long-term EPS growth rate.
Keep in mind, the most recent dividend increase, which will be realized this quarter, is 10%.
And the payout ratio is rather low.
While EPS growth over the next year or two could be a bit sluggish, as CFRA hints at, the long-term dividend growth story here looks strong.
The DDM analysis gives me a fair value of $65.63.
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 don’t see my valuation model as overly aggressive, yet the stock still comes out looking cheap.
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 USB as a 3-star stock, with a fair value estimate of $55.00.
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 USB as a 4-star “BUY”, with a 12-month target price of $64.00.
I came out slightly high this go around. Averaging the three numbers out gives us a final valuation of $61.54, which would indicate the stock is possibly 8% undervalued.
Bottom line: U.S. Bancorp (USB) is a high-quality bank benefiting from durable competitive advantages. It has the Warren Buffett “seal of approval” for good reason. With a market-beating yield, double-digit dividend growth, a low payout ratio, 10 consecutive years of dividend increases, and the potential that shares are 8% undervalued, long-term dividend growth investors would be wise to consider investing alongside Warren Buffett in this company.
-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.
Note from DTA: How safe is USB’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 55. 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, USB’s dividend appears Borderline Safe with a moderate risk of being cut. Learn more about Dividend Safety Scores here.
The goal? To build a reliable, growing income stream by making regular investments in high-quality dividend-paying companies. Click here to access our Income Builder Portfolio and see what we’re buying this month.
Source: DividendsAndIncome.com