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3 Reasons This Hidden Gem Dividend Aristocrat Is Likely To Smash The Market Over The Next Decade

Posted On July 30, 2018 10:55 am
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Dividend Profile: Safe And Fast Growing Payout Means Market Beating Return Potential

The most important part of any income investment is the dividend profile which consists of three parts: yield, payout safety, and long-term growth prospects.

Company Yield TTM FCF Payout Ratio Projected 10 Year Annual Dividend Growth 10 Year Annual Potential Total Return
Roper Technologies 0.6% 14% 12% to 13% 12.6% to 13.6%
S&P 500 1.8% 40% 6.20% 2% to 8%

Sources: Gurufocus, FastGraphs, Morningstar, Yardeni Research, Gordon Dividend Growth Model, Vanguard, Blackrock

Now it’s true that Roper’s paltry yield means that it’s not a good source of immediate income. But what Roper lacks in current yield it more than makes up for in dividend safety and long-term growth prospects. That’s because the company’s FCF payout ratio is a rock bottom 14%, meaning it retains 86% of its free cash flow after paying its rapidly rising dividend. In the past 12 months that amounted to $936 million which the company continues to employ into highly profitable and disciplined bolt on acquisitions. This high amount of retained FCF also means that the dividend has a very wide safety buffer to protect it during industry or economic downturns.

Of course there is more to a safe dividend than just a low payout ratio. The balance sheet is important, especially given the company’s penchant for M&A.

  • Debt/EBITDA: 2.9 (industry average 2.2)
  • Interest coverage ratio: 9.0 (industry average 39.1)
  • S&P Credit Rating: BBB+
  • Average borrowing cost: 3.9%

Recently Roper made a $1.2 billion acquisition that pushed up its debt levels considerably. This is why its leverage ratio appears higher than its industry rivals’ and its interest coverage ratio appears much lower. However, the company continues to enjoy a strong investment grade credit rating and low borrowing costs (which are far below its phenomenal returns on capital). That’s because its river of retained FCF is enough to pay off all its net debt in just 4.5 years. In other words, Roper’s balance sheet is rock solid, and further adds to its dividend security.

Most importantly for Roper investors is the fact that with EPS expected to grow about 12.5% annually for the next 10 years, the stock should appreciate at about the same pace (since share prices are a function of EPs and FCF growth). Meanwhile the dividend might grow slightly faster, given that the FCF payout ratio has plenty of room to expand without threatening the safety of the dividend.

According to the Gordon Dividend Growth Model (highly accurate since 1956 for companies like this) Roper is likely to generate about 13% total returns over the next decade. That’s not just far superior to the market’s historical 9.2% total return since 1871 but far greater than the 2% to 4% total returns Vanguard and Blackrock expect the market to return on an annual basis from its historically elevated current valuations. Note the Gordon Dividend Growth Model predicts the S&P 500 will generate about 8% total returns, which is closer to its historical norm. However, even in that more bullish scenario Roper is likely to still outperform the broader market by an impressive 5% per year over the next decade.

Valuation: An Industry Leading Blue Chip Worth Buying At Fair Price

Even the best company can be a terrible investment if you overpay. This is why I live by the Buffett mantra that “It’s better to buy a wonderful company at a fair price, then a fair company at a wonderful price”. Roper Tech is certainly a wonderful company but what’s a fair price for it? There are dozens of approaches to valuing a company and none are 100% correct. This is why I use a combination of valuation models to maximize the chances of not overpaying for a company.

The first value screen is the Gordon Dividend Growth Model’s total return potential from the dividend profile. I only want to recommend companies that can realistically beat the market’s historical returns. With strong double digit return potential Roper passes with flying colors. Another approach I use is  a formula pioneered by Benjamin Graham, Buffett’s mentor and the father of modern value investing. This formula looks at a company’s PE ratio to determine what growth rate is baked in and what PE ratio would represent a “fair price”.

Forward PE Ratio 20 Year Average PE Ratio Implied 10 Year EPS Growth Rate Yield 5 Year Average Yield 13 Year Median Yield
26.6 24.4 9.1% 0.6% 0.6% 0.5%

Sources: Benjamin Graham, Gurufocus, Fastgraphs, Simply Safe Dividends

At first glance Roper’s forward PE of 26.6 doesn’t make it look like a good value stock. After all it’s slightly above the 20 year average PE ratio of 24.4. However, we have to remember that Roper didn’t really start transforming itself into a tech company until 2011, so it’s higher profitability and faster growth rate means that it probably deserves a higher multiple. How high is reasonable? Well according to the Ben Graham fair value PE formula (2X long-term growth rate + 8.5)/discount rate)) Assuming you are targeting market beating total returns of 10% (discount rate) then a fair PE for Roper is 30.5. That’s because the stock is currently pricing in just 9.1% long-term EPS growth, about 33% below what analysts expect it to realistically accomplish.

Finally, being a dividend investor I like to compare the yield to its historical norms, both the five year average and 13 year median. That’s because yields tend to be mean reverting over time (assuming a stable business model which Roper has), and cycle around a relatively fixed value approximates fair value. Based on its five year average and 13 year median yields Roper appears about 7% overvalued, and 20% undervalued respectively.

Factoring all these methods together I estimate that Roper Tech is worth about $310 today, representing a 4% discount to fair value. That might not be a screaming bargain but for a Grade A industry leader such as this, I’m more than happy to recommend buying this hidden gem of a dividend aristocrat today. That is assuming you’re comfortable with its risk profile.

About author

Dividend Sensei
Dividend Sensei

I'm an Army veteran and former energy dividend writer for The Motley Fool. I'm a proud co-founder of Wide Moat Research, Dividend Kings, and the Intelligent Dividend Investor. My work can be found on Seeking Alpha, Dividend Kings, iREIT, and the Intelligent Dividend Investor. My goal is to help all people learn how to harness the awesome power of dividend growth investing to achieve their financial dreams and enrich their lives. With 24 years of investing experience, I've learned what works and more importantly, what doesn't, when it comes to building long-term wealth and income streams and achieving long-term financial goals.

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