This 6.6% Yielding Dividend Growth Stock Could Generate 20+% Annual Returns Over The Coming Decade

Posted On August 16, 2018 9:28 am

Valuation: Attractive Price Means High Margin Of Safety And Even Better Future Returns

There are theoretically dozens of ways to value a company but for stable business model dividend growth stocks two in particular have proven the most useful over time. The first is to look at the price to cash flow or P/CAFD. This is the yieldCo equivalent of a PE ratio and can be used in concert with a formula devised by Benjamin Graham, Buffett’s mentor and the father of modern value investing.

That formula states that a fair multiple (in this case P/CAFD) is: (8.5 + 2X (long-term CAFD/Share growth))/discount rate (decimal form). The discount rate is your targeted return.

  • Price/CAFD: 8.8
  • Implied 10 Year CAFD/Share Growth Rate: 0.2%
  • Analyst 10 Year CAFD/Share Forecast: 25%
  • Conservative Graham Fair Value Multiple: 25.2
  • Conservative Graham Fair Value Estimate: $55.44
  • Discount To Fair Value: 65%

Currently NYLD’s price to cash flow (based on 2018 guidance) is 8.8. In general anytime you can buy a quality income producing asset with growing cash flow for a single digit cash multiple you’re likely to make money. In this case using the Graham fair value formula we can do two things. The first is estimate what long-term CAFD/share growth rate is baked into the stock. That implied growth rate is currently just 0.2%.

For context analysts expect NYLD, under GIP’s sponsorship, to grow its cash flow by 25% per year over the next decade. Even if analysts are being wildly optimistic the point is this stock is pricing in no growth at all, which is an absurdly pessimistic view. As a result the price/CAFD ratio is likely to expand greatly in the future as NYLD delivers far greater growth than the price currently implies. But how much multiple expansion are we likely to see?

That’s where the second use of the Graham Fair formula comes in. Using very conservative growth assumptions (10% cash flow growth vs 25% analyst expectations) and a 10% discount rate (market’s historical return is 9.2%) we get a fair value cash flow multiple of 25.2. Or to put another way according to Benjamin Graham’s valuation formula a yieldCo that can realistically grow its cash flow at 10% per year is worth paying 25.2 times cash flow. That would mean a share price of $55.44 and implies that NYLD is about 65% undervalued.

Of course no valuation model is 100% foolproof so we need to also use other approaches. For stable dividend stocks another time tested method is comparing the yield to its historical yields. That’s because over time a dividend stock’s yield tends to mean revert or fluctuate around a relatively fixed point that approximates fair value.

  • 5 Year Average Yield: 6.1%
  • 5 Year Median Yield: 5.8%
  • Current Yield: 6.6%
  • Estimated Discount To Fair Value: 11%

Now in the case of young dividend stocks (NYLD launched in 2013) we have to remember that we’re working with a limited data set. Normally I like to compare against a 5 year average yield and a 13 year median, to make sure that this model is accurately modeling valuations over time.

Since NRG Yield has spent much of its life in a bear market (thanks to the late 2015 sell off over worries about renewable power tax credits, then the early 2016 correction, and then NRG announcing it was ending its sponsorship) the historical yields are skewed to the upside. However, even with this stock having been beaten down for most of its life its current yield still implies it’s at least 11% undervalued.

Factoring in both approaches (as well as the Gordon Dividend Growth Model from the dividend profile) I estimate the stock is conservatively worth $27.40 per share or about 29% undervalued.

  • Estimated Fair Value: $27.40
  • Estimated Discount To Fair Value: 29%
  • Multiple Expansion Annualized Return Boost: 3.5%

This means that not just is NYLD a great buy today, but that over the next decade as its valuation likely rises to fair value that will boost total returns by 3.5% annually (on a CAGR basis). This means that using conservative growth estimates NYLD may be capable of 20% annualized total returns through 2028. And if analysts are right about the yieldCo’s growth accelerating? Well then annualized total returns could clock in as high as 30%. Either way NYLD is poised to potentially become not just one of the best performing dividend stocks of the next decade, but one of the best performing stocks period.

This is why I so strongly recommend NYLD today, to any investor comfortable with its risk profile.

About author

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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