Many people think of investing as a risky endeavor.
I’d argue it’s the opposite.
Not investing is the riskiest thing one can do.
Think about it.
If you don’t invest, you can never secure your finances or freedom, instead relegating yourself to needing to work until the day you die.
Look, I like to work.
But needing to work, no matter what, is not a nice place to be in life.
No, you want to be in a position of working because you want to, and that’s only possible when you have the optionality that wealth and passive income confers.
And when it comes to building wealth and passive income, I know of no better strategy than dividend growth investing, which is a long-term investment strategy that entails buying and holding shares in high-quality businesses that pay safe, growing dividends to shareholders.
You can find hundreds of examples of what I’m talking about by looking over the Dividend Champions, Contenders, and Challengers list.
This list has compiled invaluable information on US-listed stocks that have raised dividends each year for at least the last five consecutive years.
These tend to be some of the best stocks you can buy, as it requires greatness of a business to be able to afford to pay out ever-larger cash dividends to shareholders.
Moreover, those safe, growing cash dividend payments can form a fantastic bedrock of passive income you need to claim that aforementioned optionality and freedom.
I’ve been employing this strategy for myself for the last 15 years, using it to guide me as I’ve gone about building the FIRE Fund.
That’s my real-money portfolio, and it pays me enough five-figure passive dividend income for me to live off of.
I’ve been fortunate enough to live off of this since I was able to retire in my early 30s.
My Early Retirement Blueprint shares how that’s possible (and more achievable than you might think).
Another way in which this strategy tends to funnel you right into some of the best stocks out there is the strategy’s focus on valuation at the time of investment.
Price represents what you pay, but value represents 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.
Routinely buying undervalued high-quality dividend growth stocks can lead to transformative optionality and freedom in one’s life over time – optionality and freedom that I think is completely necessary.
Of course, recognizing undervaluation might sound easier said than done.
Well, that’s where Lesson 11: Valuation comes in.
Written by fellow contributor Dave Van Knapp as part of an overarching series of “lessons” designed to teach the dividend growth investing strategy, it deftly explains how valuation works and how to go about easily valuing almost any dividend growth stock you’ll run across.
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…
United Parcel Service, Inc. (UPS)
United Parcel Service, Inc. (UPS) is a global parcel delivery and supply chain management company.
Founded in 1907, United Parcel Service (hereafter referred to as UPS) is now an $84 billion (by market cap) logistics leader that employs nearly 375,000 people.
The company reports results across three segments: U.S. Domestic, 66% of FY 2024 revenue; International, 20%; and Supply Chain Solutions, 14%.
This is the world’s largest package delivery company.
I’ll quickly give you an idea of the gigantic scale we’re talking about: UPS has a footprint across 120 countries, and it uses 530+ planes, 120,000+ vehicles, and ~2,000 package facilities to deliver 20+ million packages and documents to residences and businesses every single day.
Despite negative sentiment around this company, some of which is deserved for self-inflicted wounds, the business model is in the right place at the right time.
There are three secular trends coinciding and creating a confluence of long-term tailwinds for UPS.
The first trend is consumerism.
Consumption is rising globally, fueled by factors such as rising wealth, social media, and human psychology around envy.
Rising consumption means more goods needing to move from one point to another.
The second trend is population growth.
The number of humans walking around recently crossed over the 8 billion mark.
That’s even more people consuming more than ever.
The third trend is e-commerce.
E-commerce, which has experienced ascendence over the last decade or so, has led to much more demand for point-to-point shipping.
More goods are being shipped directly to consumers (rather than to centralized stores) as a result of online purchases, which creates more volume across smaller loads for one-on-one shipments.
These three trends, which are almost certainly irreversible at this point (and almost certainly to only become stronger over time), plays right into the hands of UPS and reinforces the world’s need for a company of UPS’s ability and scale.
There is no imaginable future in which the world will be consuming less and/or shipping less products globally, which means there’s almost no imaginable future in which UPS is not successful.
And that success translates into higher revenue and profit, as well as larger dividends to shareholders.
Dividend Growth, Growth Rate, Payout Ratio and Yield
To that last point, UPS has already increased its dividend for 16 consecutive years.
Much of this stretch overlaps with the big trends I just laid out, so this could be just the start for UPS.
Its 10-year dividend growth rate is 9.3%, although this was skewed higher by a ~50% dividend boost in early 2022, but more recent dividend raises have been greatly moderated into a low-single-digit range.
One has to keep this inconsistency in mind and average thing out.
Still, even just low-single-digit dividend growth might be enough in this case.
I say that because this stock features an eye-popping yield of 6.6%.
This yield is in REIT and MLP territory.
It is highly, highly unusual to see this stock with a 6%+ yield, and this is a result of the stock’s price and valuation being pushed down in response to UPS’s myriad of issues (such as higher labor costs and a reduction in volume with key customer Amazon as Amazon builds out its own delivery network and becomes a competitor).
To put that unusualness in perspective, this yield is 350 basis points higher than its own five-year average.
This yield is more than twice as high as it usually is.
It’s quite remarkable.
One cautionary point is the payout ratio, though, with it sitting at 97.2%.
This is dangerously high.
While I don’t necessarily expect UPS to cut its dividend, this does help to explain why the most recent dividend raise was a pittance (less than 1%).
I would expect more of the same when it comes to near-term dividend growth.
Quite simply, UPS got ahead of itself with that massive dividend raise in 2022, pulling forward numerous years of dividend growth all in one shot.
It’s now paying the price for that reckless dividend raise and being limited on the dividend growth, but the starting yield is also much higher than normal.
I suppose one’s view on this depends on their overall thirst for yield/income.
If one would rather have that yield/income today, UPS pulling all of that growth forward is great.
If one would rather let all of that healthily play out over time, this overstep on dividend growth will be seen as a mistake.
Either way, it’s an outsized dividend with a nice history of growth behind it, and I think it would be especially suitable for, and attractive to, income-oriented investors.
Revenue and Earnings Growth
As attractive as it may be, though, much of that is based on backward-looking dividend metrics.
However, investors must always have a forward-looking mindset, as the capital of today is risked for the rewards of tomorrow.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will be of use when later estimating intrinsic 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.
Blending the proven past with a future forecast in this manner should give us the direction we need to build a case for where the business could be going from here.
UPS moved its revenue from $58.4 billion in FY 2015 to $91.1 billion in FY 2024.
That’s a compound annual growth rate of 5.1%.
Very respectable top-line growth out of UPS, especially considering how large and mature it already was a decade ago.
Growing a sales base of nearly $60 billion isn’t easy, and I think it just goes to show the inevitability of more goods moving across the world.
Meantime, earnings per share grew from $5.35 to $7.72 (adjusted) over this period, which is a CAGR of 4.2%.
If there’s one word I think of when looking at UPS over the last decade, it’s “lumpy”.
Before the pandemic, UPS was plodding along nice and steady.
It then experienced a surge in demand and an explosion in revenue and profit during the pandemic.
From there, high on success, unionized employees in the company’s workforce negotiated much higher wages, and this is all while key customers (such as Amazon) were quickly becoming formidable competitors and lessening their reliance on UPS (while also slowly eating UPS’s lunch).
In response to the latter, UPS started to cut business ties with Amazon, which is one of the largest retailers in the world.
A drop in volumes and margins ensued, which caused a severe drop in EPS over the last two years.
Had the pandemic never occurred, I believe we’d be looking at a different picture – one with slightly higher and more steady top-line and bottom-line growth.
But this is the world we live in.
Nonetheless, with a lot of recent challenges already played out and in the open, which have pressured both the business and the stock, the future may be better than the past.
Looking forward, CFRA is forecasting an 8% CAGR for UPS’s EPS over the next three years.
That would, indeed, be a better future than the past, and I think it’s more indicative of what UPS is truly capable of in a “normal” environment with fewer shocks and disturbances.
What I think is key to UPS’s near-term growth is the firm’s focus on optimization.
CFRA highlights this: “UPS’s transformation strategy targets $3.5B in cost savings during 2025, with $80M realized in Q1. The company plans to reduce operational workforce by ~20,000 positions and close 73 facilities by June 2025. Network automation has increased U.S. volume through automated facilities to 63%.”
Did you catch that?
There’s a significant decrease in the workforce coming; workers had negotiated higher wages – perhaps too high – from a prior position of strength, which is now coming back to bite them.
Simultaneously, automation is coming.
These two actions will likely materially move the needle on costs and margins for UPS.
CFRA also notes: “While package demand remains challenged, UPS demonstrates strong cost management and operational efficiency improvements. Though headwinds persist, including projected declines in durable goods consumption, we believe current valuation and dividend yield provide an attractive entry point. The company’s proactive approach to network optimization positions it well for when market conditions stabilize.”
I think that sums it all up.
The last two years have undoubtedly been tough for UPS, but the company is positioning itself well for a better future.
If we take CFRA’s 8% number as our base case, I think will allow the payout ratio to slowly decrease (with dividend growth trailing the rate of EPS growth).
That means shareholders should expect modest dividend growth over the next several years, as UPS is still digesting that ill-advised ~50% dividend boost from 2022.
However, once the business and payout ratio normalize, that would set the dividend up for a growth rate that is more in line with UPS’s historical average.
That implies mid-single-digit (or better) dividend growth moving out into a longer-term time horizon.
This kind of dividend growth coming on top of a near-7% yield is extremely unusual.
Yields of well over 6% are almost always accompanied by low-single-digit dividend growth, at best – and sometimes no growth at all.
For those with the patience to see the investment through the near-term challenges, there is a lot yield and growth to be had over time.
Financial Position
Moving over to the balance sheet, UPS has a good financial position.
The long-term debt/equity ratio is 1.2, while the interest coverage ratio is over 9.
The latter is artificially and temporarily low, negatively impacted by EBIT pressure.
Putting things in perspective, UPS is carrying approximately $20 billion in long-term debt, which is not overly burdensome for an $84 billion company.
Profitability is strong.
Return on equity has averaged 75.9% over the last five years, while net margin averaged 8%.
ROE is being accentuated by the balance sheet, but even ROIC is often over 20%.
UPS is definitely generating high returns on capital, which is great to see.
With a tough two-year stretch apparently behind the company, there’s much to look forward to over the next the coming years.
And with economies of scale, a massive global network, and barriers to entry, the company does benefit from durable competitive advantages.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
A key risk here relates to the very business model, as some of UPS’s major customers (such as Amazon) are becoming formidable competitors by building out their own delivery networks, becoming independent, and even taking business away from UPS.
This a capital-intensive business directly exposed to economic cycles and macroeconomics.
Big changes in the global supply chain have been playing out for years, only to pick up steam by tariff uncertainty, which crates some uncertainty for UPS.
UPS’s workforce is heavily unionized, and this has led to cost pressures after large pay raises were negotiated by workers.
With a global footprint, the company is exposed to geopolitics and currency exchange rates.
There are many risks to weigh, particularly the customer-to-competitor transition.
But the valuation, which has been pushed down to multiyear lows after a 50%+ drop in the stock’s price from recent highs, seems to price in plenty of risk already…
Valuation
The P/E ratio is sitting at 14.5.
That’s a below-market multiple that is also well off of the stock’s own five-year average P/E ratio of 19.1.
The P/CF ratio of 8.7, which is incredibly low, is also far lower than its own five-year average of 11.8.
And the yield, as noted earlier, is significantly 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 5%.
The next few years will likely see muted dividend growth (probably below 5%), which will let the payout ratio cool down a bit and become healthier.
However, after that occurs, UPS would be freed up to grow the dividend at a rate more befitting the company’s growth profile.
My model builds in dividend growth which is more akin to what UPS was doing before the pandemic.
Back then, dividend raises were pretty reliably between 5% and 7%.
I am on the lower end of that range, though, as there’s that near-term slowdown to account for.
The DDM analysis gives me a fair value of $137.76.
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.
My view is that this stock has been punished too much after its 50%+ slide, and the valuation now looks compelling after it got too expensive in 2022.
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 UPS as a 4-star stock, with a fair value estimate of $124.00.
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 UPS as a 4-star “BUY”, with a 12-month target price of $124.00.
I came out a bit high, but we all agree that some serious undervaluation appears to be present. Averaging he three numbers out gives us a final valuation of $128.59, which would indicate the stock is possibly 23% undervalued.
Bottom line: United Parcel Service, Inc. (UPS) is the largest parcel delivery company in a world in which demand for parcel deliveries are steadily rising on the back of population growth, climbing wealth, and escalating consumption. The company almost can’t do well over time. With a market-smashing yield, a payout ratio set to moderate, mid-single-digit dividend growth, more than 15 consecutive years of dividend increases, and the potential that shares are 23% undervalued, long-term dividend growth investors looking for a high-yield bargain in an expensive market should have a close eye on this name right now.
-Jason Fieber
Note from D&I: How safe is UPS’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 99. 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, UPS’s dividend appears Borderline Safe with a moderate 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.
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Disclosure: I’m long UPS.
