When you spend a dollar, you’re not really spending a dollar.
You’re actually spending $2, $5, or even $10.
How?
Opportunity cost.
When you spend a dollar instead of investing it, you’re losing out on the long-term power of compounding.
That’s right.
And it’s not something that you only get to enjoy decades down the road.
No, you can enjoy it all the way along.
That happens via the growing cash dividend payments that high-quality dividend growth stocks pay out.
Growing cash dividend payments keep the long-term journey interesting, and nobody dislikes cold, hard cash (which keeps increasing).
You can find hundreds of examples of these stocks on the Dividend Champions, Contenders, and Challengers list.
This list features invaluable information on US-listed stocks that have raised dividends each year for at least the last five consecutive years.
I’ve been personally buying these stocks with my own hard-earned savings over the years.
In the process of doing so, I built the FIRE Fund.
That’s my real-money portfolio, and it produces enough five-figure passive dividend income for me to live off of.
Indeed, I’ve been in the fortunate position to be able to live purely off of dividends for years now.
In fact, I was able to retire in my early 30s.
My Early Retirement Blueprint explains how I was able to accomplish that.
As you might be able to surmise by now, consistently buying high-quality dividend growth stocks with my savings (i.e., money not spent) is a key part of the Blueprint.
But there’s more to it than that.
Valuation at the time of investment has also been very important.
Whereas price tells you what you pay, value tells you what 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.
Avoiding unnecessary spending and allocating that capital toward undervalued high-quality dividend growth stocks instead can allow you to massively benefit from the long-term power of compounding, while also getting paid safe, growing dividend income along the way.
Of course, this idea does require one to have a basic understanding of valuation.
Fear not.
Fellow contributor Dave Van Knapp’s Lesson 11: Valuation, which is part and parcel of a comprehensive series of “lessons” on dividend growth investing, is here to help.
It was written in order to demystify valuation and provide an easy-to-use valuation guide that can be applied toward just about any dividend growth stock out there.
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…
Intercontinental Exchange Inc. (ICE)
Intercontinental Exchange Inc. (ICE) is an operator of global financial exchanges and clearing houses, and also provides mortgage technology, data, and listing services.
Founded in 2000, but with certain roots dating back to the late 1700s, Intercontinental Exchange is now a $63 billion (by market cap) financial powerhouse that employs over 9,000 people.
The company reports results across the following three segments: Exchanges, 56% of FY 2022 revenue; Fixed Income and Data Services, 29%; and Mortgage Technology, 16%.
The company’s most well-known offering is the New York Stock Exchange, which is the largest stock exchange in the world.
It’s sometimes hard for me to spend money.
And that’s because I’m aware of the fact that when I spend a dollar, I’m not really spending just a dollar.
I’m spending more like $5 or $10, due to the opportunity cost of that money.
If I spend $1, it can’t be compounded into many more dollars.
On the other hand, I do shop a lot and spend a lot of money on specific merchandise.
That merchandise is high-quality dividend growth stocks.
This is why the stock market is my favorite store.
And that leads me right to the major exchanges, like the NYSE.
It’s also what leads all other investors to the exchanges.
But that’s not all.
Whereas many different types of merchandise can be simultaneously found at many different competing stores, this company has a lock on what it sells.
The NYSE is basically a monopoly unto itself, which is why it’s an irreplaceable asset and a crown jewel.
If you want to buy any stock that is listed on the NYSE, that leads you straight to this company.
And then you’ve got the futures contracts and clearing on top of it.
As compelling as the story is already, Intercontinental Exchange has also bolted on high-margin data and technology services – leveraging their tremendous scale and built-in information.
The recently completed $11.9 billion acquisition of Black Knight Inc., a premier provider of integrated technology, data, and analytics in the mortgage industry, only strengthens this aspect of Intercontinental Exchange.
Intercontinental Exchange is, in many ways, dominant.
And it’s becoming even more dominant.
This is why the company has such a long and clear runway ahead for more revenue, profit, and dividend growth.
Dividend Growth, Growth Rate, Payout Ratio and Yield
To date, the company has increased its dividend for 11 consecutive years.
The five-year dividend growth rate of 13.7% easily beats inflation, even in the current environment.
And you get the stock’s 1.6% yield to start off with.
That yield, by the way, is 40 basis points higher than its own five-year average.
The dividend is protected by a low payout ratio of 31.1%, based on TTM adjusted EPS.
Because of the low payout ratio, as well as the growth of the underlying business (which I’ll get into shortly), the dividend should continue to grow at a brisk rate for years to come.
For dividend growth investors who prefer long-term compounding over immediate income, these metrics are highly desirable.
Revenue and Earnings Growth
As desirable as the metrics could be, we’re mostly looking backward here.
But investors must constantly look forward, as the capital of today is being risked for the rewards of tomorrow.
As such, I’ll now build out a forward-looking growth trajectory for the business, which will be of great aid when the time comes to estimate fair value.
I’ll first show you what the business has done over the last decade in terms of its top-line and bottom-line growth.
I’ll then reveal a professional prognostication for near-term profit growth.
Amalgamating the proven past with a future forecast in this way should allow us to competently judge where the business may be going from here.
Intercontinental Exchange moved its revenue from $1.6 billion in FY 2013 to $7.3 billion in FY 2022.
That’s a compound annual growth rate of 18.4%.
Very strong.
Meanwhile, earnings per share grew from $0.64 to $5.30 (adjusted) over this 10-year period, which is a CAGR of 26.5%.
Extremely impressive growth here.
However, I think we have to take both numbers with a grain of salt.
Regarding top-line growth, the company has been actively acquisitive, which bolsters growth in absolute terms.
In addition, that bottom-line CAGR is shown in its best possible light.
FY 2013 GAAP EPS was unusually soft.
In addition, I used adjusted FY 2022 EPS (which is more indicative of the company’s true earnings power).
So the starting point and ending point is as favorable as it gets for the business.
That’s not to say that Intercontinental Exchange isn’t putting up strong numbers; rather, I wouldn’t use the last decade as the most realistic baseline for building long-term growth expectations.
Looking forward, CFRA is projecting that Intercontinental Exchange will compound its EPS at an annual rate of 7% over the next three years.
In my view, that’s fairly realistic, if a bit cautious.
It’s simply a better baseline for expectations on a go-forward basis.
We can see that Intercontinental Exchange produced 8% YOY adjusted EPS growth in its Q2 FY 2023 earnings report.
That’s just slightly ahead of what CFRA is putting forth.
CFRA really hits home with this passage: “In a world full of uncertainty, we view shares of [Intercontinental Exchange] favorably as the company has an unprecedented ability to perform in all market environments. Not only was [Intercontinental Exchange] able to grow earnings before, during, and after the pandemic, but [Intercontinental Exchange] has seen earnings growth in each year since it went public in 2005. Furthermore, we forecast its mortgage technology business will continue to gain market share and create cross-sell opportunities. With the acquisition of Black Knight, [Intercontinental Exchange] has the opportunity to take a stranglehold on the industry by offering both standardized and customized products to its customers. Additionally, we are encouraged by [Intercontinental Exchange’s] recurring revenue growth, which decreases the firm’s reliance on trading volumes.”
That’s a very good high-level, long-term look at business dynamics.
If we put it all together, a high-single-digit bottom-line growth rate over the next few years would still allow for a low-double-digit dividend growth rate.
That’s by virtue of the low payout ratio, which could easily but slowly expand at a very modest annual clip.
What I see is a high rate of dividend compounding over the coming years, which is perfect for investors who can give those dividend raises time to pile up.
Financial Position
Moving over to the balance sheet, Intercontinental Exchange has a good financial position.
The long-term debt/equity ratio is 0.8, while the interest coverage ratio is nearly 4.
The latter number looks troublesome at first glance, but that’s mostly because GAAP EPS for FY 2022 was artificially low.
However, what I do find somewhat troublesome is how the company’s long-term debt load has been climbing in recent years – it’s basically tripled over the last five years alone, far outpacing the growth of anything else in the business.
In my view, the balance sheet is becoming the weakest part of the business.
Profitability is robust.
Net margin has averaged 29.9% over the last five years, while return on equity has averaged 12.4%.
GAAP EPS has been a bit lumpy over the last few years, which has negatively affected net margin, but this business consistently pumps out fat margins.
That said, I’m surprised to see ROE so low in light of balance sheet deterioration.
What I see here is a great business with monopolistic economics.
And with proprietary assets, exclusive data ownership, and nearly infinite scalability of markets, 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.
The very business model lends itself to extra regulatory pressure.
And the exchanges are very competitive with another for new listings.
The exchanges are global, introducing the company to currency exchange rates and geopolitical risks.
The balance sheet is starting to show some signs of stress, and the Black Knight acquisition will only add further pressure to this situation, so it is incumbent upon management to ensure growth is worth the debt.
The company’s acquisitive nature exposes it to integration and execution risks.
Any broad slowdown in the US housing market could reduce demand for the company’s mortgage offerings.
A global economic slowdown would also negatively impact volumes across the exchanges, although the recurring nature of that revenue would blunt some of the impact.
These risks are worth bearing in mind, but the quality and growth potential of the business should also be part of the picture.
Also, with the stock correcting in price since late August, the valuation should be part of that same picture…
Stock Price Valuation
The P/E ratio is 20.1.
That’s based on TTM adjusted EPS.
Is that an egregious earnings multiple for a company with world-class assets?
I don’t think so.
We can also see how disconnected multiples are to their own respective recent historical averages.
For instance, the P/S ratio of 6.3 is well off of its own five-year average of 7.3.
The P/CF ratio of 16.7 is also quite a bit below its own five-year average of 19.8.
And the yield, as noted earlier, is significantly 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 12%, and a long-term dividend growth rate of 8%.
That initial dividend growth rate leans on the idea of slowly expanding the low payout ratio, as the near-term earnings growth forecast falls short.
I don’t think it’s an unreasonable expectation.
After all, the company’s demonstrated five-year dividend growth rate is above this level.
And there’s not a huge gap between underlying business growth and this level of dividend growth.
It’s not a lot of ground for the business to cover.
The one issue that does give me some pause is the balance sheet.
Beyond that, there’s plenty of quality and growth here.
The DDM analysis gives me a fair value of $127.21.
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 reasonable model shows a stock that appears to be at least mildly 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 ICE as a 4-star stock, with a fair value estimate of $137.00.
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 ICE as a 4-star “BUY”, with a 12-month target price of 135.00.
I came out low, but we’re all in the same general direction. Averaging the three numbers out gives us a final valuation of $133.07, which would indicate the stock is possibly 19% undervalued.
Bottom line: Intercontinental Exchange Inc. (ICE) is a great business with a crown jewel of an asset that every investor is familiar with. And the higher-margin data services stand to make the business even greater. With a market-like yield, double-digit long-term dividend growth, a low payout ratio, more than 10 consecutive years of dividend increases, and the potential that shares are 19% undervalued, long-term dividend growth investors could be looking at a great chance to own equity in a business that they almost certainly interact with frequently.
-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 D&I: How safe is ICE’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 89. 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, ICE’s dividend appears Very Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
Source: Dividends & Income