What do plants and a dividend growth stock portfolio have in common?
For one, plants require a steady supply of water and light to both survive and grow. The same can also be said of a dividend growth stock portfolio, which best grows with regular infusions of capital.
The other thing that both plants and a dividend growth stock portfolio need is the time to grow. Even the mightiest of oak trees and the largest of investment portfolios once started as small seeds.
One stock within my portfolio that I'd like to build out in the years ahead is the most dominant asset manager in the world, which is BlackRock (NYSE:BLK). For the first time since my prior article on the stock in June, let's take a look at BlackRock's risks and why it is a strong buy for dividend growth investors.
Last month, BlackRock announced that it was raising its quarterly dividend by 18.2% from $4.13 to $4.88 per share. With such a strong raise, it's worth asking the following: Can BlackRock afford its dividend?
I'll look at the stock's dividend yield compared to its industry and its payout ratios to answer this question.
BlackRock's 2.60% dividend yield is moderately lower than the asset management industry average of 2.90%. This suggests that the market views the stock's dividend as relatively safe compared to its industry.
BlackRock reported $39.18 in adjusted diluted EPS in 2021 against $16.52 in dividends per share that were paid during that time. This equates to an adjusted diluted EPS payout ratio of 42.2%.
Looking at the current year, analysts are expecting that BlackRock will produce $42.34 in adjusted diluted EPS. Compared to the $19.52 in dividends per share that are slated to be paid this year, this is a payout ratio of 46.1%.
Since the asset management industry is a capital-light business, I view payout ratios around 40% as quite sustainable. That's why I believe BlackRock's dividend will grow in line with or slightly ahead of earnings over the long term.
And with analysts forecasting 12% annual earnings growth over the next five years, I'm reiterating my annual dividend growth rate of 8% for the long run.
BlackRock produced splendid results for its shareholders in 2021.
For one, the company's average assets under management or AUM grew 24.1% year-over-year to $9.36 trillion last year. And even better, BlackRock ended the year with over $10 trillion in AUM (all details sourced from page 1 of BlackRock's Q4 2021 earnings press release). This makes it the first asset manager to reach the monumental milestone.
As a result of BlackRock's significantly higher AUM base, it shouldn't come as a surprise to learn that the company's net revenue surged 19.6% higher year-over-year to $19.37 billion last year (data according to page 1 of BlackRock's Q4 2021 earnings press release).
BlackRock's adjusted diluted EPS growth lagged behind revenue at 15.8% year-over-year, posting $39.18 in adjusted diluted EPS last year. This can be explained by the fact that BlackRock rewarded all employees with 8% pay raises that went into effect last September. While this cut into BlackRock's margins, I believe it will be a wise move for the company to attract and retain the best talent.
Aside from BlackRock's healthy operating fundamentals, the company also possesses a rock-solid balance sheet (pun intended).
This claim is supported by BlackRock's interest coverage ratio, which improved from an already great 32.8 in 2020 ($6.73 billion in earnings before interest and taxes/$205 million in interest expenses from page 4 of BlackRock's Q4 2021 earnings press release) to an even better 40.9 last year ($8.38 billion in EBIT/$205 million in interest costs according to page 4 of BlackRock's Q4 2021 earnings press release).
For context, BlackRock's EBIT would need to crash almost 98% for the company to be rendered unable to cover its interest expense with earnings. The odds of this happening to a company of BlackRock's quality are essentially zero, however.
BlackRock's fundamentals show a company that is one of the best on the entire planet. That's why I believe the stock could be very lucrative to dividend growth investors if acquired at the right price.
Even with BlackRock's admirable business performance last year, prospective investors and current shareholders alike should know the risks facing the stock. That's why I'll be going over several key risks facing BlackRock from the company's recently released 10-K filing.
The first risk to BlackRock is that a decline in its AUM for whatever reason would lead to reduced revenue and earnings (page 21 of BlackRock's recent 10-K). That's because BlackRock's investment advisory fees are assessed and earned based on its AUM.
One way this risk could manifest itself would be a temporary equity market crash. But since the market always bounces back eventually, this is more of a fleeting risk in nature.
One of the more concerning ways that BlackRock could see its AUM materially decline would be if the company were unable to continue beating its benchmarks, which could lead clients to look to other asset managers. BlackRock's unparalleled reputation as an asset manager is its biggest competitive advantage.
Another risk to BlackRock that could damage its reputation and lead clients to take their capital elsewhere would be a major cyber breach of the company's information technology systems (pages 24-25 of BlackRock's recent 10-K).
While BlackRock regularly upgrades its cyber security infrastructure, there are no guarantees that the company will always be able to stave off a breach. If large enough in scale, a breach could result in massive lawsuits against the company and damage its reputation among its clients. This could be enough to potentially shatter the investment thesis.
The final risk to BlackRock is that as a company with extensive operations around the world, it is subject to a variety of regulations (pages 28-29 of BlackRock's recent 10-K).
As regulations in its various markets evolve, BlackRock could be required to allocate significant resources to interpreting and complying with those regulations. This could result in elevated expenses for the company.
And if BlackRock is found to be noncompliant with any regulations, this could come with significant fines and harm to its reputation.
While I went over a few major risks associated with an investment in BlackRock, this wasn't intended to be a comprehensive discussion of the stock's risks. I would encourage readers to visit pages 21-33 of BlackRock's recent 10-K and my previous articles on the stock for a more complete discussion of its risk profile.
Based on its fundamentals, BlackRock is undoubtedly a high-quality stock. But even for the best stocks, investors have to pay a reasonable price to achieve satisfactory results.
That's why I will be using two valuation models to approximate the fair value of BlackRock's shares.
The first valuation model that I'll utilize to value shares of BlackRock is the dividend discount model or DDM, which includes three inputs.
The first input for the DDM is the expected dividend per share, which is simply the annualized dividend per share. Following its recent dividend hike, BlackRock's current annualized dividend per share is $19.52.
The next input into the DDM is the cost of capital equity, which refers to the annual total return rate that an investor requires on their investments. My personal preference is for 10% annual total returns because I believe that's fair compensation for my efforts as an investor.
The final input for the DDM is the annual dividend growth rate or DGR over the long haul.
Unlike the first two inputs into the DDM that require data retrieval to find the annualized dividend per share and subjectivity to arrive at an annual total return rate, correctly predicting a stock's DGR requires an investor to contemplate several variables: These include a stock's payout ratios (and whether those payout ratios are positioned to remain unchanged, expand, or contract over the long-term), future annual earnings growth, industry fundamentals, and the state of a stock's balance sheet.
When I consider BlackRock's payout ratios and robust annual earnings growth over the long term, I would argue that my 8% annual dividend growth rate remains justified.
Factoring these inputs into the DDM, I am left with a fair value of $976.00 a share. This implies that BlackRock's shares are trading at a 23.1% discount to fair value and can provide a 30% upside from the current price of $750.87 a share (as of February 25, 2022).
The other valuation model that I will employ to gauge the value of shares of BlackRock is the discounted cash flows or DCF model, which also has three inputs.
The first input into the DCF model is adjusted diluted EPS. BlackRock's adjusted diluted EPS in 2021 were $39.18, so I'll use that for my input.
The second input for the DCF model is growth assumptions. In my assumptions, I will attempt to err on the side of caution to build in a margin of safety.
I'll assume that BlackRock's earnings grow at a rate of 6.25% annually over the next five years, which is barely half of the analyst estimate. Thereafter, I will forecast a drop to 5.25% annual earnings growth.
The third input into the DCF model is the discount rate, which is another term for the required annual total return rate. I'll again use 10% for this input.
Plugging these inputs into the DCF model, I get a fair value of $906.67 a share. This means that BlackRock's shares are priced at a 17.2% discount to fair value and offer 20.7% capital appreciation from the current share price.
When averaging these two fair values together, I compute a fair value of $941.34 a share. This signals that shares of BlackRock are trading at a 20.2% discount to fair value and can provide a 25.4% upside from the current share price.
BlackRock's most recent dividend increase marks the 13th consecutive year that the stock has raised its payout to shareholders. Despite BlackRock's reputation as a Dividend Contender, the stock's dividend growth is far from over.
That's because, for one, the stock's payout ratios are manageable. Secondly, BlackRock easily generated double-digit net revenue and earnings growth last year. Third and finally, the stock's financial conditioning is nearly perfect with an interest coverage ratio of more than 40 last year.
BlackRock would be a convincing buy even if it were fairly valued. But based on its current share price, the stock trades at a 20%+ discount to my estimated fair value. BlackRock's unmatched fundamentals in the asset management industry and cheap valuation make the stock a strong buy for dividend growth investors at this time.
This article was written by
Disclosure: I/we have a beneficial long position in the shares of BLK either through stock ownership, options, or other derivatives. 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.