Hard to make money.
Easy to spend it.
It’s a conundrum we all deal with.
But once you start to set habits that allow you to live below your means, spending becomes harder – making saving and investing easier.
And when it comes to investing, it can be incredibly simple and straightforward.
One of the most simple – but also effective – ways to invest is to utilize dividend growth investing.
This is a long-term investment strategy which entails buying and holding shares in high-quality businesses paying out safe, growing dividends to shareholders.
You can find hundreds of examples of these businesses by perusing the Dividend Champions, Contenders, and Challengers list.
This list has dedicated data on US-listed stocks that have raised dividends each year for at least the last five consecutive years.
You’ll notice one household name after another on this list.
And I’ll tell you why that is: It takes a special kind of business to be able to consistently generate the ever-higher profit necessary to fund ever-larger dividend payments.
Thus, this strategy tends to almost automatically funnel investors right into great businesses, and great businesses tend to make for great long-term investments.
I can speak from firsthand experience, as I’ve been employing the strategy for the last 15 years.
It’s helped me to build the FIRE Fund.
That’s my real-money portfolio, and it throws off enough five-figure passive dividend income for me to live off of.
I’ve actually been able to live off of this passive dividend income since I quit my job and retired in my early 30s.
For more on how financial freedom and such an early retirement is possible, be sure to read my Early Retirement Blueprint.
Now, while great businesses can be great long-term investments, valuation at the time of making any investment is also a crucial part of the equation.
The reason for that is this: Price is what you pay, but value is 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.
Properly making use of the dividend growth investing strategy by steadily buying undervalued high-quality dividend growth stocks is a simple, straightforward path to wealth, passive dividend income, and even financial freedom.
Of course, recognizing undervaluation first requires one to already understand the ins and outs of valuation.
And that’s precisely where Lesson 11: Valuation comes in.
Written by fellow contributor Dave Van Knapp, it uses simple terminology to share the ins and out of valuation, even providing a template you can easily use on your own to estimate the fair value of almost 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…
Union Pacific Corp. (UNP)
Union Pacific Corp. (UNP) is an American railroad holding company which serves as the holding company for the Union Pacific Railroad.
Founded in 1969 under the current holding company iteration, but with the railroad itself dating back to 1862, Union Pacific is now a $134 billion (by market cap) railroad behemoth that employs approximately 30,000 people.
Union Pacific is the largest public railroad in North America, operating the second-largest freight rail network in the US (with the network being concentrated within the Western 2/3 of the US).
Revenue breaks down across the following categories: Industrial Freight, 37% of FY 2024 revenue; Bulk Freight, 32%; and Premium Freight, 31%.
This railroad has already been around for more than 160 years.
The durability, resilience, and timelessness of this business model is hard to overstate.
Its immense value and importance to the US as a critical component of the economy’s backbone makes the railroad network vital.
This has been true for more than a century now, and there’s no indication it won’t be true for another century (and beyond).
To the contrary, despite its age, this company may now actually be in the best position it’s ever been in.
It operates within the favorable confines of a local duopoly… and industry oligopoly.
BNSF, part of Berkshire Hathaway Inc. (BRK.B), is the only true direct railroad competitor on the US West Coast, which is where Union Pacific’s network is located and operates.
Moreover, after years of consolidation, there are now only seven Class I railroads across North America (compared to more than 40 back in 1980).
And the possible reaches of this consolidation will soon be tested in a major way, as Union Pacific has recently announced a deal to acquire the Eastern Class I railroad Norfolk Southern Corp. (NSC) for $85 billion in an effort to create the country’s first transcontinental railroad.
This deal will make Union Pacific the first of its kind, further scaling the network and strengthening its cost advantages.
Speaking of which, railroads have huge built-in advantages over trucking.
It’s estimated that railroads have four times the fuel efficiency (which is also an environmental advantage) of trucking on a per ton-mile of freight basis, and a train can simply carry much more freight per haul than a truck, making railroads the obvious choice when no waterway connects the origin and destination of shipments.
And then there’s the onshoring of manufacturing playing out precisely as construction, in general, is picking up (emanating from data center buildouts and housing shortages), which means even more domestic economic activity and demand for the movement of freight across the US.
All of this should lead right to continued growth across Union Pacific’s revenue, profit, and dividend.
Dividend Growth, Growth Rate, Payout Ratio and Yield
To date, Union Pacific has increased its dividend for 19 consecutive years.
Its 10-year dividend growth rate is 11.3%, which is very strong (especially considering it’s coming out of a company that’s already more than 160 years old), although more near-term dividend growth has been in a high-single-digit range.
Still, high-single-digit dividend growth is enough to make sense of the stock, as the starting yield is currently sitting at 2.4%.
Assuming a static valuation, 7%+ growth and that kind of yield can get you to a ~10% annualized total return.
For a stable, mature, defensive company, that’s not bad at all.
By the way, the stock’s market-beating 2.4% yield is 30 basis points higher than its own five-year average, so there’s a bit more juice out of the squeeze than usual right now.
Plus, the payout ratio is just 48%.
That’s almost a “perfect” payout ratio, harmoniously balancing retaining capital for growth on one hand, along with returning capital to shareholders on the other.
With the payout ratio being so balanced, the dividend set to keep “chugging along” (pun intended).
This dividend profile offers something to like for just about everyone, with solid yield, growth, and safety being offered up.
Revenue and Earnings Growth
As much as there is to like, though, much of this profile is based on past information.
However, investors must always be considering possible future outcomes, as the capital of today ends up being risked for the rewards of tomorrow.
As such, I’ll now build out a forward-looking growth trajectory for the business, which will come in handy when the time comes later 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.
And I’ll then reveal a professional prognostication for near-term profit growth.
Lining up the proven past with a future forecast in this manner should give us enough of a baseline to reasonably judge where the business might be going from here.
Union Pacific moved its revenue from $21.8 billion in FY 2015 to $24.3 billion in FY 2024.
That’s a compound annual growth rate of 1.2%.
Uninspiring top-line growth, even for a staid business model, but a railroad like Union Pacific has multiple levers to pull in order to drive excess bottom-line growth, such as buybacks and efficiency.
Indeed, the company did pull some levers and grew its earnings per share from $5.49 to $11.09 over this 10-year period, which is a CAGR of 8.1%.
That’s a bit more like it.
Quite brisk bottom-line growth out of a large railroad, and this lines up decently close with the dividend growth over the last decade (keeping in mind, as I noted earlier, recent dividend growth has been in a high-single-digit range).
Meaningful buybacks helped in a big way, with the outstanding share count down by 30% over the last decade.
Looking forward, CFRA is calling for Union Pacific to compound its EPS at an annual rate of 9% over the next three years.
CFRA states its enthusiasm for this business “…reflects [Union Pacific]’s positioning to benefit from increased U.S. manufacturing (as tariffs incentivize reshoring); new business wins across segments; solid construction demand, particularly from data centers (+33.7%/ +19.5%); and intermodal resilience.”
All of this circles back around to what I mentioned earlier.
CFRA also reinforces another argument I made earlier: “Potential [Norfolk Southern] merger could create largest transcontinental railroad and new Intermodal service from LA to Chicago should strengthen [Union Pacific]’s competitive position by directly challenging the trucking industry’s dominance on one of America’s most critical freight corridors.”
Boom.
It’s the strong getting stronger, which makes a forecast of a modest acceleration in EPS growth over the near term (relative to the prior decade) a reasonable one.
And even without the merger going through (which seems more likely to go through than not to me), Union Pacific’s baseline of 8%+ growth should move higher based on the onshoring trend alone.
On top of all of this, Union Pacific’s CEO, Jim Vena, who took over the top job in 2023, is widely recognized as one of the best railroad managers ever.
Vena has 40+ years of industry experience, with a proven track record of delivering best-in-class efficiency, service, and operational results.
Vena is a champion of PSR (precision scheduled railroading), an operational model prioritizing trains moving on fixed schedules, which helps to explain Union Pacific’s consistent sub-60% operating ratio (the lower, the better) – about as good as it gets among Class I railroads.
It’s hard to imagine a future in which Union Pacific isn’t doing better than it’s been doing, and it’s been doing great for a long time already.
In my view, shareholders should expect more high-single-digit dividend growth over the years ahead, which gets layered on top of that ~2.5% yield.
It’s an easy recipe for a low-double-digit annualized total return out of a low-risk railroad.
Right up my alley.
Financial Position
Moving over to the balance sheet, Union Pacific has an okay financial position.
The long-term debt/equity ratio is 1.8, while the interest coverage ratio is 8.
Debt has been steadily creeping higher over the last decade, which is probably the one chink in the armor for me.
While I’d certainly like to see the balance sheet improve, Union Pacific doesn’t necessarily have a major issue here.
Furthermore, the tie-up with Norfolk Southern would create such a monster – a monster which would be even more critically important to the US economy, no less – that a pretty decent amount of debt would be even less of a concern.
Profitability is excellent.
Return on equity has averaged 43.1% over the last five years, while net margin has averaged 27.9%.
Although ROE is juiced by the balance sheet structure, even ROIC is routinely north of 15%.
Warren Buffett famously likes high returns on capital, and he famously likes railroads.
A match made in heaven.
Union Pacific has been a great investment for longer than I’ve been alive for, and it seems very likely to me it’ll be an even better investment over the rest of my lifetime.
And with economies of scale, extremely high barriers to entry, structural cost advantages, and an inherent ability to move a larger amount of goods in a faster and more reliable way than alternative options (such as trucking) across land, 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.
Competition is a unique risk for a railroad, as competing Class I railroads are often actually cooperative (when needing to move goods across network lines), and competitors are also constrained to their own networks, which means each railroad operates within its own duopoly.
Speaking more on competition, the existing competition is likely all that’s ever going to exist, as building a new railroad network today is nearly impossible (due to existing right-of-ways through densely populated/industrial areas); and the little competition that still exists is being consolidated (e.g., the aforementioned pending Norfolk Southern acquisition).
A railroad is an asset-heavy, capital-intensive business model, and it’s highly exposed to economic cycles that can be devastating on the downside.
If trucks become fully autonomous and more efficient (such as through electrification of the drivetrains), this could create a serious competitive threat to railroads in the future.
The pending acquisition of Norfolk Southern is a near-term distraction which adds regulatory attention/oversight, although I see the acquisition as being likely to go through and beneficial to the combined enterprise.
A stretched balance sheet limits financial flexibility, particularly around buybacks (which have been a big driver of excess EPS growth).
Although the company operates solely in North America, there is indirect geopolitical risk present vis-à-vis tariffs and the resulting onshoring of industry (which could change in the future).
Crashes/spills (which are not uncommon) can add to the litigation and regulation risks, not to mention reputational loss and additional costs through cleanups.
The overall risk profile here is not overly high, particularly in light of how enduring the business model is.
Yet, the stock sports a below-average valuation, despite a looming transformational acquisition…
Valuation
The stock is trading hands for a P/E ratio of 19.8.
This below-market earnings multiple is below its own five-year average of 21.9, making it slightly cheap relative to both the market and itself.
The cash flow multiple of 14.9, which is not high at all in absolute terms, is similarly below its own five-year average of 15.8.
And the yield, as noted earlier, is 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 8%.
I’m using a growth rate on the high end of what I normally allow for, but I think Union Pacific deserves it.
The demonstrated dividend growth over the last decade exceeds this mark, and bottom-line growth looks set to accelerate on a go-forward basis.
Meanwhile, despite strong dividend growth for nearly two decades, the payout ratio remains almost perfectly balanced, meaning dividend growth could actually slightly outpace EPS growth (which is anticipated to be at 9%) over the next several years without any issues.
I think there’s room for upside surprise here; on the other hand, I’d be shocked if Union Pacific grows its dividend significantly slower than I’m modeling in.
It’s been doing good work for more than a century, and I see nothing stopping this train (pun intended).
The DDM analysis gives me a fair value of $298.08.
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.
This stock looks unfairly cheap to my eyes.
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 UNP as a 3-star stock, with a fair value estimate of $213.00.
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 UNP as a 5-star “STRONG BUY”, with a 12-month target price of $284.00.
I’m not far off from where CFRA is at on this one. Averaging the three numbers out gives us a final valuation of $265.03, which would indicate the stock is possibly 14% undervalued.
Bottom line: Union Pacific Corp. (UNP) is a high-quality, blue-chip company with more than 160 years of success behind it. Despite its lengthy history, its status as a critical component of the US economy is set to grow even stronger with an upcoming acquisition which could create the country’s first transcontinental railroad. With a market-beating yield, double-digit dividend growth, a balanced payout ratio, nearly 20 consecutive years of dividend increases, and the potential that shares are 14% undervalued, this might just be the most obvious infrastructure play for long-term dividend growth investors right now.
-Jason Fieber
Note from D&I: How safe is UNP‘s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 80. 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, UNP‘s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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.
Disclosure: I’m long UNP.
