The technology sector has enjoyed such a breathtaking rally in recent years that most of its stocks are trading at nosebleed valuation levels right now. Broadcom (AVGO) is a bright exception. The stock has more than tripled over the last five years but it is still trading at a reasonable valuation, at a forward price-to-earnings ratio of 17.3.
It is also one of the most significant holdings of Lyrical Asset Management, which is well-known for its expertise in identifying undervalued stocks with promising growth prospects. Investors should not expect the extremely high growth rate from Broadcom that is commonly found in many other tech stocks.
But on the other hand, investors should view Broadcom favorably as it is one of the few stocks in the tech sector with a 3%+ dividend yield and high growth potential.
Broadcom designs, develops and sells semiconductors under the following business units: wired infrastructure, wireless communication, enterprise storage and industrial. Its offerings include data center chips, factory automation, energy systems and power generation, broadband access and home connectivity.
The technology sector is one of the most resilient sectors to the coronavirus crisis. In fact, many tech stocks have benefited from the pandemic, which has accelerated many favorable long-term trends, such as the shift of companies to the digital era. Broadcom did not enjoy accelerated growth last year and thus it did not benefit from the pandemic as much as many tech companies. On the other hand, it posted record earnings which proved its resilience to the pandemic.
In the latest quarter, Broadcom grew its revenue 12% over the prior year’s quarter thanks to sustained demand for networking from cloud and for broadband from service providers as well as a significant ramp in wireless. As a result, the company grew its earnings per share 18% and posted record free cash flows of $3.25 billion.
Even better, Broadcom expects the strong business momentum to remain in place for the foreseeable future. It thus expects to grow its revenue 13% in the first quarter of the year. Thanks to its bright business outlook, Broadcom raised its dividend 11% in the latest quarter.
Broadcom benefits from a strong secular trend, namely the increasing demand for semiconductors, partly thanks to the booming sales of smart phones. It is remarkable that Apple (AAPL), the most important customer of Broadcom, accounted for more than 20% of the total revenue of Broadcom in 2020.
Broadcom has also grown its earnings per share via a long series of acquisitions. Its management is well known for its competency in identifying attractive takeover targets and integrating them in the business of Broadcom. The most important acquisition was the one of Avago Technologies in early 2016.
Thanks to these growth drivers, Broadcom has grown its earnings every single year in the last decade. During this period, the company has grown its earnings per share at an impressive 28.7% average annual rate. On the one hand, the strong demand for the products of Broadcom will remain in place for the foreseeable future. On the other hand, investors should not expect the company to continue growing at its historical rate, partly due to its growing size. Overall, we expect Broadcom to grow its earnings per share at a 7.5% average annual rate over the next five years.
Dividend & Valuation Analysis
Broadcom has raised its dividend for nine consecutive years and, hence it is about to become a Dividend Achiever. Thanks to its healthy payout ratio, which currently stands at 55%, and the reliable growth trajectory of the company, it is safe to expect many more dividend raises in the upcoming years. Moreover, the stock is offering a 3.2% dividend yield, which is a high yield within the tech sector.
Broadcom is currently trading at a forward price-to-earnings ratio of 17.3, which is higher than our assumed fair price-to-earnings ratio of 14.0 of the stock. If the stock trades at our assumed fair valuation level in five years, it will incur a 4.2% annualized drag in its returns due to the contraction of its valuation level.
Given also the aforementioned 7.5% expected earnings-per-share growth and its 3.2% dividend yield, Broadcom is likely to offer a 6.4% average annual total return over the next five years. This expected return confirms that the stock is not trading at a bubble valuation. On the other hand, investors should probably wait for a more opportune entry point.
After the breathtaking rally of the tech sector in recent years, Broadcom is one of the few tech stocks that remains reasonably valued. It is also one of the extremely few tech stocks that offer a dividend yield of 3.2% with a safe and growing dividend. While we see the stock as slightly overvalued, the stock should continue to generate positive returns. Investors should be particularly interested in buying Broadcom on any meaningful pullback in the share price.
Bob Ciura has worked at Sure Dividend since October 2016. He oversees all content for Sure Dividend and its partner sites. Bob received a Bachelor’s degree in Finance from DePaul University, and an MBA with a concentration in Investments from the University of Notre Dame.
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