There’s a two-pronged approach to investing that almost guarantees success over the long run.
Invest in above-average companies.
And so at below-average valuations.
It’s a one-two punch that is tough to beat.
And it could very well lead to an outsized amount of wealth and passive income over the long run.
Finding above-average companies is, in my mind, straightforward.
I stick to high-quality dividend growth stocks that have longstanding track records of paying reliable, rising dividends.
You can find hundreds of them on the Dividend Champions, Contenders, and Challengers list.
A lengthy streak of rising dividends is a great initial litmus test of business quality.
It tells you that a company is likely producing the reliable, rising profit necessary to sustain those rising dividends.
Otherwise, a company wouldn’t be able to send out ever-larger cash payments.
Investing in these stocks for myself helped me to retire in my early 30s.
I lay out in my Early Retirement Blueprint how I accomplished that.
I bet my life and financial freedom on these stocks, which has worked out really well thus far.
Indeed, my FIRE Fund, which is my real-money personal portfolio, is filled with these stocks.
This portfolio now produces enough five-figure passive dividend income for me to live off of.
All that said, investing in above-average companies is only one part of the equation.
Valuation at the time of investment is also very important.
Price is simply what you pay. But value is what you actually get for your money.
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.
Investing in an above-average company at a below-average valuation can positively and dramatically change the financial outcome of your life.
Fortunately, estimating intrinsic value isn’t all that difficult.
Fellow contributor Dave Van Knapp’s Lesson 11: Valuation has greatly demystified the valuation process.
Part of a holistic series on dividend growth investing, it provides a valuation system that can be easily applied to most dividend growth stocks.
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…
Atmos Energy Corporation (ATO)
Atmos Energy Corporation (ATO) is an American natural gas utility business serving more than 3 million customers across eight different states.
Founded in 1906, Atmos Energy is now a $12 billion (by market cap) natural gas powerhouse that employs more than 4,000 people.
The company reports results across two segments: Distribution, 81% of FY 2020 revenue; and Pipeline and Storage, 19%.
A significant portion (~70%) of the company’s profit is derived from Texas. The company distributes natural gas to nearly 2 million Texans. And it has a 5,700-mile gas transmission pipeline in Texas that spans several important shale formations.
The company’s big bet on Texas could serve them very well over the coming years.
Texas is a business-friendly state that is attracting a lot of corporate relocations from regulation-heavy states such as California.
Simultaneously, and somewhat relatedly, Texas has been seeing a massive influx of new residents. Texas is one of the fastest-growing states in the US in terms of population growth.
More businesses and households consuming more energy naturally bodes well for Atmos Energy.
And that should translate to higher profits and dividends over the coming years.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Already, Atmos Energy has increased its dividend for 37 consecutive years.
They easily qualify for their status as a Dividend Aristocrat, which requires at least 25 consecutive years of dividend increases.
Their five-year dividend growth rate is 8.1%.
The stock’s current yield is 2.7%.
This is a compelling combination of yield and dividend growth here.
By the way, that market-beating yield is 50 basis points higher than the stock’s own five-year average yield.
And the dividend is protected by a moderate payout ratio of 47.3%.
I love 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.
Atmos Energy is right in that sweet spot.
Revenue and Earnings Growth
As good as these dividend metrics look, though, they’re focusing on the past.
But investors risk today’s capital for tomorrow’s rewards.
Thus, I’ll now build out a forward-looking growth trajectory, which will later help in the process of estimating the stock’s intrinsic value.
I’ll first show you what the company has done over the last decade in terms of top-line and bottom-line growth.
And then I’ll compare that up against a near-term professional prognostication for profit growth.
Blending the proven past with a future forecast in this manner should allow us to form a reasonably good idea as to where the business and its growth might be going.
Atmos Energy’s revenue dropped from $4.3 billion in FY 2011 to $2.8 billion in FY 2020.
A revenue shrinkage over a 10-year time frame isn’t what any investor typically wants to see; however, a number of business sales and restructurings makes this straight-line comparison impossible to make.
Meanwhile, earnings per share increased from $2.27 to $4.89 over this period, which is a CAGR of 8.9%.
We can see that Atmos Energy has been doing more with less, which is a sign of prudent management.
We can also see where the high-single-digit dividend growth has been coming from – it’s been a result of like EPS growth.
Looking forward, CFRA is forecasting that Atmos Energy will compound its EPS at an annual rate of 8% over the next three years.
This forecast is more or less in line with what the last decade has proven out, so I don’t see anything unreasonable or shocking here.
A utility company’s regulatory environment is always an important consideration for long-term investment.
In this area, Atmos Energy shines.
CFRA states this: “We see positive developments related to regulatory outcomes as increasing investments for grid modernization (pipeline repairs, service line updates, etc.) continue to push the rate base higher.”
Moreover, CFRA cites “favorable gas-jurisdictions” to likely support growth moving forward.
In addition, the company’s reliance on and exposure to the fast-growing Texas market is almost certainly a boon for long-term business.
I see nothing in the company’s financial results or overall positioning that would lead me to question this base expectation for EPS growth.
And this high-single-digit EPS growth would support similar dividend growth, which is basically a continuation of the status quo.
With a starting yield near 3%, I think there’s a lot to like about that.
Financial Position
Moving over to the balance sheet, Atmos Energy has a strong financial position.
The long-term debt/equity ratio is 0.7, while the interest coverage ratio is almost 10.
These are great numbers for a utility.
Profitability is robust, with defined and steady improvement.
Over the last five years, the firm has averaged annual net margin of 17.4% and annual return on equity of 10.8%.
For perspective, net margin was in the mid-single-digit range a decade ago.
In my view, this Dividend Aristocrat has a lot to offer.
And with local service territory monopolies, economies of scale, and difficult-to-replicate physical infrastructure, 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.
A regulated utility business like this one has limited competition by its nature; however, the regulation is in and of itself heightened as a result.
There is interest rate risk here. Rising interest rates could hurt in two ways. It makes the debt servicing more expensive. And it makes the stock’s yield less attractive on a relative basis, which could put downward pressure on the stock.
The continued push toward renewable and clean energy sources is a long-range risk for the business model.
Their regulatory environment is currently apparently favorable. Any changes in that relationship could be detrimental to the growth outlook, however.
The business model also has black swan risks, including explosions and spills.
With these risks stated, I still think this could be a great long-term investment for dividend growth investors.
After correcting from its 52-week high of nearly $105/share, the valuation only serves to reinforce my view…
Stock Price Valuation
The stock is trading hands for a P/E ratio of 17.7.
That’s well below where the broader market is at.
It’s also significantly lower than the stock’s own five-year average P/E ratio of 21.3.
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 7.5%.
This is a rational long-term dividend growth expectation from the business, in my opinion.
This DGR is lower than the company’s long-term demonstrated EPS and dividend growth.
It’s also lower than the near-term expectation for EPS growth.
And with the payout ratio moderate, the company should be able to maintain high-single-digit dividend growth for the foreseeable future and beyond.
The DDM analysis gives me a fair value of $107.50.
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.
Even with what was arguably a cautious valuation model, the stock still looks 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 ATO as a 4-star stock, with a fair value estimate of $98.00.
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 ATO as a 3-star “HOLD”, with a 12-month target price of $115.00.
I came out roughly in the middle. Averaging the three numbers out gives us a final valuation of $106.83, which would indicate the stock is possibly 15% undervalued.
Bottom line: Atmos Energy Corporation (ATO) is a high-quality Dividend Aristocrat that is operating in a favorable environment for long-term growth. With a market-beating yield, more than 35 consecutive years of dividend raises, a moderate payout ratio, high-single-digit dividend growth, and the potential that shares are 15% undervalued, this is a name that dividend growth investors ought to consider for their portfolios.
-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 ATO’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 97. 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, ATO’s dividend appears Very Safe with a very unlikely 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