How much of one’s success is ultimately dictated by luck?
Probably quite a bit.
Probably more than we’d like to admit.
But I’d posit that a lot of it – also more than some of us would like to admit – has to do with our individual attitudes and efforts.
There’s so much opportunity in the world, but many of us simply fail to reach out and grab some of it.
If one truly believes they cannot be successful, it’s true.
But if one is willing to think positively and make the most of the opportunities around them, amazing things can happen.
One of the best ways to do this is to take one’s savings (from living below one’s means) and convert that capital into shares in world-class businesses paying safe, growing dividends to shareholders.
This thought process is at the heart of dividend growth investing – a long-term investment strategy whereby one routinely buys stock in high-quality companies that reward shareholders with reliable, rising cash dividend payments – reliable, rising cash dividends which can one day open up financial freedom by offsetting all real-life bills.
You can find hundreds of stocks qualifying for this strategy over at the Dividend Champions, Contenders, and Challengers list.
This list has compiled information on US-listed stocks which have raised dividends each year for at least the last five consecutive years.
I’ve taken the thought process I just mentioned and used that to accumulate enough wealth and passive dividend income to achieve financial freedom and retire in my early 30s.
My Early Retirement Blueprint details much of that journey.
Even after growing up poor and only having access to relatively modest means throughout my life, I built the FIRE Fund.
That’s my real-money portfolio, and it generates enough five-figure passive dividend income for me to live off of.
Much of my success, despite my humble start, came down to the saving and investing I’ve quickly outlined, but there’s another key aspect that I haven’t yet mentioned: valuation.
See, price is only what you pay, but it’s value that 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.
There’s so much opportunity out there for us mere mortals to grab onto, not the least of which are the undervalued high-quality dividend growth stocks we can all buy with our savings as we strive to achieve financial freedom in life.
Now, the whole topic of valuation invites seeming complication, but it’s less complicated than you might think.
Fellow contributor Dave Van Knapp has greatly simplified the whole conversation through Lesson 11: Valuation.
Written as part of a series of “lessons” designed to teach the dividend growth investing strategy, it explains valuation using basic language and even provides a template you can easily apply on your own.
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…
Xylem Inc. (XYL)
Xylem Inc. (XYL) is a US-based global water technology company.
Founded in 2011, Xylem is now a $33 billion (by market cap) major player in water technology that employs ~23,000 people.
Xylem was technically founded in 2011 after being spun out from former parent company ITT Inc. (ITT), but its roots (under ITT) actually date back decades.
As an independent business, Xylem now focuses on providing water technology solutions for commercial and residential customers.
These solutions include the transport, treatment, testing, and more efficient usage of water.
FY 2024 revenue can be broken down across four business segments: Water Infrastructure, 30%; Water Solutions and Services, 27%; Measurement & Control Solutions, 22%; and Applied Water, 21%;
Roughly half of revenue is derived from the US.
Water Infrastructure, the largest segment by revenue, is where a range of Xylem products, such as wastewater pumps, filtration, treatment equipment, and controls are designed to help with the transportation and treatment of water.
The Water Solutions & Services segment, which was created after Xylem acquired Evoqua Water Technologies Corp., a leader in mission-critical water treatment solutions and services, in 2023 for $7.5 billion, specializes in mission-critical water treatment solutions and services.
Measurement & Control Solutions is where products, such as meters and sensors, are used to help with testing.
The Applied Water segment is where products including pumps and valves are instituted to increase water efficiency for customers.
As you can see, Xylem is perfectly positioned to capture a large portion of the secular demand coming from the world’s increasing thirst (pun intended) for clean, usable water.
Water is our most precious resource.
We quite literally cannot live without it.
It’s required for basic survival.
There is no future world in which human beings will suddenly stop needing clean water.
This base level of necessity is accentuated by growing demand.
A rising global population means more humans requiring water.
Simultaneously, manufacturing and new forms of technology (such as data centers) are heavily consuming ultra-pure forms of water.
Against this demand backdrop is an uncomfortable truth: All the water that currently exists is all that will ever exist.
Demand is rising; supply is finite.
This is why I believe water is fast becoming the world’s “liquid gold”, much in the way that oil had that designation throughout most of the 20th century.
Gaining access to clean, usable water is only becoming more challenging for people all over the world, which is exactly where Xylem comes in.
Its bevy of products are designed to facilitate access to clean water – something that is almost guaranteed to have purpose and value for as long as humans are around.
That helps to explain why Xylem has been so incredibly consistent and prolific when it comes to revenue, profit, and dividend growth.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Indeed, Xylem has increased its dividend for 15 consecutive years.
That’s as long as the track record possibly could be, stretching back to when Xylem became an independent entity.
As you can see, Xylem has been a dividend payer and grower right from the start.
Its 10-year dividend growth rate of 10.9% is quite strong.
More impressively, double-digit dividend growth is something that Xylem has been extremely consistent with.
Even its most recent dividend increase, which was announced earlier this year, came in at 11.1%.
And with a payout ratio of just 41.2%, Xylem has plenty of room to continue with this behavior.
What you have to give up in order to access that double-digit dividend growth is yield.
The stock’s yield of 1.2% is the trade-off.
However, for younger dividend growth investors who understand the value of a high-quality compounder, this is an acceptable trade-off.
Actually, this trade-off isn’t quite as bad as it usually is.
The current yield is 10 basis points higher than its own five-year average.
Getting sustainable double-digit dividend growth out of a high-quality compounder directly exposed to a clear secular growth theme is the kind of stuff that younger dividend growth investors with a very long time horizon dream of.
Revenue and Earnings Growth
As dreamy as it may be, though, much of the preceding is based on information from the past.
However, investors must be attuned to what may happen in the future, 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 during the valuation process.
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 ability to roughly gauge where the business could be going from here.
Xylem increased its revenue from $3.7 billion in FY 2015 to $8.6 billion in FY 2024.
That’s a compound annual growth rate of 9.8%.
This top-line growth is surprisingly strong, but revenue in the absolute sense was given a large boost by the 2023 acquisition of Evoqua Water Technologies Corp.
That acquisition skews things.
Meanwhile, earnings per share grew from $1.87 to $3.65 over this period, which is a CAGR of 7.7%.
We see some slight drag on EPS growth, hampered by the fact that the all-stock acquisition was funded by equity in Xylem.
On one hand, we could say that this bottom-line growth rate is more reflective of Xylem’s true growth profile.
On the other hand, evidence is pointing to Evoqua improving upon Xylem’s prior growth trajectory.
I’d point to FY 2024 showing 30.8% YOY EPS growth – a substantial acceleration in growth.
Is the short-term pain of dilution worth the long-term gain of more growth?
Early indications are a resounding yes.
If we balance out a post-Evoqua Xylem with a larger float against the pre-Evoqua Xylem with less growth, I think we’ve moved from a high-single-digit growth regime to a low-double-digit one.
Looking forward, CFRA believes that Xylem’s CAGR for its EPS over the next three years will be 13%.
This corroborates with what I was just saying.
CFRA notes: “[Xylem]’s order backlogs remain near record levels (~$5B at Q3), providing strong visibility for 2025-2026 despite macroeconomic uncertainty. Growth assumptions anticipate continued backlog conversion and pricing actions. We’re encouraged by broad participation across [Xylem]’s portfolio, with Measurement & Control (22% of sales) standing out amid robust demand for smart metering and digital solutions.”
CFRA then highlights the crux of the matter: “Water scarcity creates sustained long-cycle tailwinds.”
That’s it right there.
Water scarcity is a real and growing issue across the world, and this creates extremely long-term tailwinds for the likes of Xylem.
There is effectively no risk of obsolescence here, as water will never be obsolete.
I simply find it impossible to imagine a future in which demand for what Xylem offers suddenly disappears – or even falls off.
In my view, CFRA’s forecast is very reasonable.
In fact, Xylem itself is guiding for $5.06 (at the midpoint) in adjusted EPS for FY 2025 – guidance that has been raised throughout the year after starting at $4.60 in Q4 FY 2024’s report.
This midpoint guidance would represent 18.5% YOY growth in adjusted EPS, which is quite remarkable.
Again, I think Xylem has moved from reliable high-single-digit EPS growth to reliable low-double-digit EPS growth.
It was a great business before.
It’s now an even better business.
And this higher bottom-line growth regime should be able to support similar dividend growth, meaning Xylem’s demonstrated dividend growth over the last decade (which had actually been exceeding EPS growth) can more sustainably continue.
That’s low-double-digit dividend growth on top of the starting yield, combining for a low-teens to mid-teens type of annual total return profile (comparing to the stock’s 15.5% 10-year total return CAGR).
Again for those who appreciate high-quality compounders, Xylem is a terrific candidate.
Financial Position
Moving over to the balance sheet, Xylem has a very strong financial position.
The long-term debt/equity ratio is 0.2, while the interest coverage ratio is over 25.
Notably, unlike a lot of other companies that have seen their balance sheets deteriorate, Xylem’s long-term debt load has actually been reduced in recent years.
The balance sheet was also protected by the decision to use equity, rather than debt, to fund the Evoqua acquisition.
When you combine the resiliency of the core business model with the resiliency of this balance sheet, Xylem is nearly unassailable.
Profitability is good, and upgrades are likely with Evoqua already integrated.
Return on equity has averaged 10.1% over the last five years, while net margin has averaged 7.7%.
I’d like to see higher returns on capital, and I believe Xylem will deliver on this over the coming years (stemming from more scale, greater productivity, enhanced pricing power, and higher volumes).
As a leading company providing products designed for improved usage of our most precious resource, Xylem is in a powerful position as it pertains to the world’s increasing thirst (pun intended) for access to clean water.
And with economies of scale, industry know-how, switching costs, IP, R&D, brand power, and an installed base that’s entrenched, 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.
Litigation and regulation both seem to be somewhat limited for Xylem relative to many other business models, but competition in this space is fierce.
The company has exposure to geopolitics, currency exchange rates, and sovereign debt loads, as large infrastructure projects (water or otherwise) often stem from government entities and public spending.
Input costs can be volatile, and recent inflationary and tariff pressures could be near-term headwinds.
Xylem has become quite large, which may start to introduce the law of large numbers.
These risks strike me as very acceptable, especially relative to the quality, resiliency, and visibility of the business.
Yet, the valuation doesn’t seem to fully express Xylem’s high standard…
Valuation
The stock is trading hands for a forward P/E ratio of 27.1, based on midpoint adjusted EPS guidance for this year.
For a company staring down reliable double-digit EPS and dividend growth as it draws on secular growth within its core competency, that’s not an egregious earnings multiple at all.
Keep in mind, this stock’s five-year average P/E ratio is 45.1, so to say that this stock tends to get (and deserve, in my view) a large premium is understating things.
Against that average, the stock’s current level is not out of line; to the contrary, just about every multiple I look at is below its respective recent historical average.
The cash flow multiple, at 22.4, which is quite a bit below its own five-year average of 25.8 is another example of this.
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, a 15-year dividend growth rate of 12%, and a long-term dividend growth rate of 8%.
This is the same model I used the last time I analyzed and valued Xylem, and I remain confident in it.
I’m basically assuming medium-term dividend growth to be roughly in line with the expectation for EPS growth, which doesn’t seem unreasonable.
When we look at what Xylem has been doing with both its EPS and dividend growth of late, continuing on with a 12% dividend growth rate (which is very close to its demonstrated dividend growth over the last decade) is not a high hurdle to clear.
That said, we can’t bank on low-double-digit growth indefinitely, and I’m modeling in a realistic slowdown into a high-single-digit rate of growth.
The DDM analysis gives me a fair value of $141.02.
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.
I see some modest undervaluation on Xylem shares.
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 XYL as a 3-star stock, with a fair value estimate of $129.00.
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 XYL as a 5-star “STRONG BUY”, with a 12-month target price of $165.00.
I landed right about in the middle this time around. Averaging the three numbers out gives us a final valuation of $145.00, which would indicate the stock is possibly 6% undervalued.
Bottom line: Xylem Inc. (XYL) is a wonderful business providing the world with products designed to facilitate better access to the world’s most precious resource. There is no possible future in which humans will suddenly stop needing water, which gives this company lots of long-term visibility and resiliency. With a market-like yield, double-digit dividend growth, a low payout ratio, 15 consecutive years of dividend increases, and the potential that shares are 6% undervalued, dividend growth investors looking for a high-quality compounder exposed to the secular growth within water have a great investment candidate on their hands with this one.
-Jason Fieber
Note from D&I: How safe is XYL‘s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 66. 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, XYL‘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 XYL.
