As a dividend growth investor, I seek an overall satisfactory blend of yield, safety, and growth at what I believe to be a reasonable price.
Along with a high savings rate, this is a highly effective trifecta to rapidly build wealth in a relatively short span of time.
My portfolio is comprised of a mix of stocks with low yields and high growth prospects, moderate yields with moderate growth prospects, and high yields with little growth.
Today, we'll be discussing a stock that I don't yet own, but would perfectly fit into the middle category above.
T. Rowe Price Group (hereafter referred to by its ticker symbol) is a dividend stock with a yield about 50% above the S&P 500's yield of 1.90% (NASDAQ:TROW).
We'll be discussing TROW's dividend safety and growth profile, fundamentals and risks, in addition to the valuation aspect of an investment in TROW.
We'll then conclude the article with my annual total return estimate for TROW from its current valuation.
A Very Safe Dividend With Mid To High-Single Digit Dividend Growth Potential
Dividend safety is a very important consideration for an investor that will eventually be dependent upon their investment holdings for a large portion of their income.
In order to assess the safety of TROW's dividend, we'll be examining both the company's EPS payout ratios and FCF payout ratios.
In its previous fiscal year, TROW generated adjusted diluted EPS of $7.15 against dividends per share of $2.80 during that time, for an adjusted diluted EPS payout ratio of 39.2%.
In its current fiscal year, Yahoo Finance is expecting $7.80 in EPS against $3.04 in dividends per share, for an EPS payout ratio of 39.0%.
Moving to FCF, TROW generated operating cash flow of $1.6199 billion in 2018 against capital expenditures of $168.5 million, for total FCF of $1.4514 billion (page 53 of TROW's most recent 10-K). Against the $694.3 million in dividends paid during that time, this equates to an FCF payout ratio of 47.8%.
TROW's FCF payout ratio for its current fiscal year should remain roughly the same as it was last year, in the high-40% range.
When we consider that the above payout ratios strike a great balance between rewarding shareholders in the present while also leaving adequate capital to fund future growth, I believe TROW's dividend is quite safe for the foreseeable future.
Image Source: Simply Safe Dividends
Given our analysis above, it shouldn't come as a surprise that Simply Safe Dividends and I agree that TROW's dividend is very safe.
With the company's dividend safety now addressed, we'll move to our analysis of the dividend growth potential.
Image Source: Simply Safe Dividends
While TROW's 5 year and 20 year DGR growth is unlikely to repeat itself over the long-term, TROW certainly doesn't have to repeat that sort of growth to be a great investment.
When we consider that TROW's payout ratios could slightly expand in the years ahead, I believe it's reasonable to conclude that TROW's dividend growth could slightly exceed its earnings growth in the years ahead.
Yahoo Finance is expecting 6.1% annual earnings growth over the next 5 years (compared to the 13.9% annual earnings growth over the past 5 years). I believe this earnings estimate is about on par with TROW's earnings growth potential, if not a bit on the low end.
Even in a scenario where TROW is only able to deliver 6-7% earnings growth over the long-term, the company is positioned well to deliver high-single digit dividend increases in the short-term and the upper end of mid-single digit dividend growth over the long-term.
Now that we've set our expectations for TROW's dividend growth, we'll be moving to why it's likely that TROW will be able to deliver the earnings growth necessary to meet our dividend growth expectations.
A Solid Reputation, Experienced Management Team, and No Long-Term Debt
TROW is among the largest asset managers in the world. Through its 500+ investing products, TROW had $1.126 trillion in assets under management or AUM at the end of September 2019.
According to page 51 of its most recent 10-K, TROW derived 90.3% of its $5.4 billion in net revenues in 2018 from investment advisory fees, which are generally assessed as a percentage of AUM.
The remaining 9.7% of net revenues in 2018 were derived from administrative, distribution, and servicing fees.
Image Source: T. Rowe Price Group 2019 Investor Day Presentation
As illustrated above, TROW's business is primarily concentrated in the United States, with international investors representing a small slice of the company's overall asset mix.
TROW is primarily invested in U.S. equities, as well as multi-asset classes, which can include a variety of investment classes, such as U.S. equities, international equities, U.S. fixed income, and international fixed income, with the objective of a collaborative fundamentally driven investment culture to meet client investment objectives.
TROW has proven itself to be adept at meeting the needs of clients with varying investment objectives, whether its individual investors or institutional investors.
Image Source: T. Rowe Price Group 2019 Investor Day Presentation
TROW is among the best performing asset managers in the entire industry, with 60% of its funds performing in Morningstar's top quartile over the past 3 years, 76% performing in the top quartile over the past 5 years, and 78% of its funds performing in the top quartile over the past 10 years.
For a significant majority of TROW's funds to be performing in the top quartile of the funds that Morningstar tracks only further supports the notion that TROW is an established player in the asset management industry, with a strong reputation geared toward performance.
Image Source: T. Rowe Price Group 2019 Investor Day Presentation
In an environment that is continually transitioning to a more passive investment approach, TROW continues to show that its actively managed funds have proven to be great investments over a variety of time periods, net of higher fees compared to passively managed funds.
For instance, 89% of TROW's funds had beaten TROW's benchmarks over the past 3 years, 5 years, and 10 years, which included the S&P 500, Russell 1000 growth, Russell 1000 value, and numerous other indices.
Image Source: T. Rowe Price Group 2019 Investor Day Presentation
As part of its commitment to meet the needs of both its individual investor and institutional clients, TROW has recently added numerous investment funds to its 500+ existing funds.
Image Source: T. Rowe Price Group 2019 Investor Day Presentation
While the asset management industry is continually shifting in the preferences of both individual investors and institutional investors, McKinsey and Company is expecting massive flows over the next 5 years into actively managed assets, with $32 trillion expected to flow into actively managed funds in the Americas alone.
When we consider TROW's strong reputation of delivering favorable outcomes for its clients to help achieve their investment objectives, it's not unreasonable for us to conclude that TROW will be able to seize its share of these inflows in the years ahead, which will increase its AUM, and with it, its net revenues that will translate into bottom line growth.
Image Source: T. Rowe Price Group 2019 Investor Day Presentation
Not only is TROW doing a great job at delivering results for its clients, but the company has also used a significant portion of its excess cash flows to buy back its shares over the past 5 years. The company managed to retire an impressive 9% of its shares over the past 5 years, at favorable valuations to shareholders.
While there are certainly many companies that are arguably squandering resources engaging in share buybacks at nosebleed levels, TROW is repurchasing shares at what I believe to be reasonable valuations, which suggests the company is an efficient steward of its shareholders' capital.
Besides TROW's decent operating fundamentals in the midst of a dynamic industry, TROW also boasts a balance sheet that is free of long-term debt.
It goes without saying, that TROW's fiscal conservatism allows it a level of flexibility with dividend increases and share buybacks on the level of very few other companies. This will undoubtedly prove to be beneficial to long-term shareholders of TROW.
Finally, TROW's highly experienced management team is the feather in the cap of the company that will help it build upon its already strong reputation in the industry.
President and CEO William Stromberg has worked for TROW for the past 32 years. Mr. Stromberg has served in a variety of positions during his career with the company, including as the head of Equity from 2009 to 2015, head of U.S. Equity from 2006 to 2009, Director of Equity Research from 1996 to 2006, Portfolio Manager of the Capital Opportunity Fund from 2000 to 2007 and of the Dividend Growth Fund from 1992 to 2000, and as an equity investment analyst from 1987 to 1992.
Simply put, Mr. Stromberg has proven himself to be well versed in the industry, working his way up from an analyst to the President and CEO of the company over the past 3 decades.
While CFO Céline Dufétel joined the company in 2017, she was managing director and global head of marketing, product management, and client service at Neuberger Berman, and prior to that, Ms. Dufétel was a partner and head of the North American Asset Management practice with McKinsey & Company.
Despite her lack of experience with TROW, Ms. Dufétel certainly possesses the experience necessary to be a key contributor to TROW's success in the years ahead due to her prior industry experience.
When we take into consideration TROW's decent operating fundamentals, immaculate balance sheet, and management team that is experienced in the most key positions, it becomes clear that TROW could be a great investment at the right price.
Risks To Consider:
While TROW is a wonderful company and it's among the leaders of the asset management industry, that doesn't mean that an investment in the company comes without its own sets of risks.
The first risk facing TROW is that the company's revenues are based on the market value and composition of the assets under its management, which are subject to fluctuation caused by factors that are outside of the company's control (page 11 of TROW's most recent 10-K).
While TROW has benefited greatly from the decade long bull market, that will inevitably come to an end at some point, and we will once again enter into a bear market (though it's worth noting the next bear market likely won't be nearly as bad as the Great Recession).
Not only does a bear market cause a decline in TROW's AUM and the revenues that it generates, but investors also can withdraw their funds at any time without advance notice and with little penalty.
Typically, when markets begin to plummet as they did during the Great Recession, investors withdraw their funds because of an irrational sense of panic at the precise time they should be adding to their portfolio.
These two events materializing are a double whammy to both TROW's AUM and the revenues that it generates, which weighs on the company's financial results until the market eventually recovers and its AUM increase while capital flows back into the company's products.
Furthermore, TROW is a stock that's a bit more volatile than the broader markets, with a beta of 1.24.
This was no more evident than during the Great Recession, when the share price plummeted over 60% from $60 a share in August 2008 to less than $23 a share in February 2009.
It's for that reason that investors with limited tolerance for high beta, volatile stocks should generally avoid investments such as TROW.
The combination of temporarily impaired earnings power and extremely negative investor sentiment absolutely batters stocks such as TROW when recessionary bear markets set in.
Another risk to TROW is the fact that the asset management industry has become highly competitive in terms of investment fees (page 12 of TROW's most recent 10-K). The shift from an investor preference of higher fee, actively managed investment products to lower fee, passively managed investment products has produced a downward pressure in asset-weighted average expense ratios.
In fact, according to Morningstar's most recent U.S. Fund Fee Study, investors paid less than ever before to own funds in 2018. Compared to 2017 alone, fees fell 6%. What's more, investors are paying roughly half as much to own funds than they were in 2000.
The three major factors (i.e. greater investor awareness of the importance of minimizing fees, increased industry competition, and the move to fee-based financial advice) that have driven asset-weighted average fees lower over the past couple decades show no signs of diminishing in the years ahead.
If TROW isn't able to continue to offer investment products that deliver returns that are competitive with that of its peers while offering competitive management fees, the company risks losing market share to its competitors. This could have an adverse impact on the company's financial results over the long-term.
Another risk facing TROW is that the company is exposed to a variety of risks arising from its international operations (pages 15-16 of TROW's most recent 10-K).
While fluctuations in currency rates tend to even out over time, there are other key risks to consider as a result of TROW's international operations, which include the potential for adverse changes in international legal and regulatory environments, political instability, and economic uncertainty.
Should any industry regulations be modified or any new regulations be introduced in TROW's international markets, this could have a detrimental impact on TROW in the sense that changes in regulations or the addition of regulations would require TROW to spend more on compliance with such regulations. This has the possibility of negatively impacting TROW's earnings capacity at any given time.
As indicated on page 18 of TROW's most recent 10-K, the company maintains a significant presence in the United Kingdom to support its global investment management business. Because there is the possibility that the UK and the EU are unable to reach terms for a separation agreement, there is increased economic uncertainty surrounding the UK. This is the type of risk that TROW faces as a result of its international presence.
The final notable risk to TROW is that the company could be subject to losses if it fails to properly safeguard sensitive and confidential information (page 19 of TROW's most recent 10-K).
Any breach of TROW's system could result in serious damage to the company's reputation, open the possibility of significant capital and operating expenditures to investigate and remedy such breach, subject TROW to regulatory action and liability for a failure to protect client data, and allow the company's competitors access to its proprietary business information. Any of these outcomes would have a materially adverse effect on TROW's financial results.
Although we have discussed what I believe to be a few of the key risks associated with an investment in TROW, we certainly haven't discussed all the risks facing TROW. For a more comprehensive discussion of the risks associated with an investment in TROW, I would refer interested readers to pages 11-19 of TROW's most recent 10-K.
A High-Quality Company Trading At A Discount To Fair Value
Now that we've established TROW is a high-quality company, we'll be determining the fair value of the company's shares.
In order to do so, we'll examine a few of TROW's historical valuation metrics and use the dividend discount model or DDM to arrive at our fair values.
The first valuation metric we'll be using to arrive at a fair value for shares of TROW is the 13 year median TTM dividend yield.
According to Gurufocus, TROW's TTM yield of 2.69% is well above its 13 year median yield of 2.19%.
While I don't view a reversion to a yield of 2.19% as likely due to the increased competition within TROW's industry as we discussed in the above section, I do believe a reversion to a fair value yield of 2.5% and fair value of $119.20 a share is realistic.
This would imply that shares of TROW are trading at a 6.9% discount to fair value and offers 7.4% upside from the current price of $110.94 a share (as of October 12, 2019).
The next valuation metric we'll utilize to determine the fair value of shares of TROW is the 13 year median TTM price to FCF.
According to Gurufocus, TROW's TTM price to FCF of 18.48 is also below its 13 year median TTM price to FCF of 20.64.
Assuming a reversion to a TTM price to FCF of 20.00 and a fair value of $120.06 a share, shares of TROW are trading at a 7.6% discount to fair value and offer 8.2% upside from the current price.
The third valuation metric we'll use to estimate the fair value of shares of TROW is the 13 year median TTM price to sales ratio.
According to Gurufocus, TROW's TTM price to sales ratio of 4.96 is well below its 13 year median TTM price to sales ratio of 5.52.
Assuming a reversion to a fair value price to sales ratio of 5.50 and a fair value of $123.02 a share, TROW is trading at a 9.8% discount to fair value while offering 10.9% upside from the current price.
The final valuation method that we'll use to place a fair value upon shares of TROW is the dividend discount model or DDM.
Image Source: Investopedia
The first input into the DDM is the expected dividend per share, which is the annualized dividend per share. In the case of TROW, that amount is currently $3.04.
The next input into the DDM is the cost of capital equity, which is another term for the rate of return that an investor requires on their investment. In my case, I believe a 10% rate of return is adequate for the amount of time and effort I dedicate to researching investments and monitoring my investments on occasion.
The third and final input into the DDM is the long-term dividend growth rate or DGR.
As we've indicated numerous times in the past, this is the most difficult input of the DDM.
While the first two inputs are a matter of a quick search for the company's annualized dividend per share and of personal preference to set a rate of return, the long-term DGR is difficult to accurately predict for a number of reasons, including the fact that an investor must take into consideration a company's payout ratios, long-term earnings growth rate, industry fundamentals, and company fundamentals.
When we take into consideration that TROW's dividend payout ratios are slightly under what is considered to be ideal and that TROW is likely to achieve a long-term earnings growth rate of 6-7%, I believe it's realistic to expect a 7.5% long-term DGR.
Upon plugging these inputs into the DDM, we arrive at a fair value of $121.60 a share.
This means that shares of TROW are trading at a 9.0% discount to fair value and offers 9.6% upside from the current price.
When we average the 4 fair values above, the fair value of shares of TROW is $120.97.
This implies that shares of TROW are trading at a 8.3% discount to fair value while offering 9.0% upside from the current price.
Summary: T. Rowe Price Group Is A Dividend Champion With 10%+ Annual Total Return Potential
As a result of TROW's solid reputation as an asset manager, the company has been able to reward shareholders with over 3 decades of consecutive dividend increases.
While the increased competition within the industry will undoubtedly create a challenge for TROW with its margins and with respect to maintaining its status among top asset managers in the industry, the company possesses a strong balance sheet and reputation, in addition to a very capable management team to navigate these risks.
Adding to the case for an investment in TROW is the fact that shares of the company are trading at an 8% discount to fair value.
Between the 2.7% yield, 6-7% earnings growth, and 0.9% annual valuation multiple expansion, T. Rowe Price Group is likely to deliver 9.6-10.6% annual total returns over the next decade.
For a company of TROW's quality, coming close to nearly doubling the projected annual total returns of the broader market over the next decade from its current price seems to be a reasonable buying opportunity in my opinion.
This article was written by
Kody's Dividends
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Hi, my name is Kody.I run Kody's Dividends. As you might guess, this is a blog primarily documenting my journey towards financial independence using dividend growth investing as the means to transform the dream of financial independence into a reality.I am forever indebted to this community because it helped me transition from simply being an investor to being a full-time analyst beginning in June 2021. Aside from my five to six articles a week here on Seeking Alpha, I am also a contributor to Dividend Kings and iREIT on Alpha.
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
