I’m always on the hunt for high-quality dividend growth stocks trading for less than fair value.
After all, high-quality dividend growth stocks are a fantastic way to build both wealth and growing income.
The wealth component related to stocks is well-known: stocks are one of the best-performing asset classes known to man over the long run, meaning compounding can turn a small sum of money into a rather large sum of money over a fairly long period of time.
[ad#Google Adsense 336×280-IA]However, there’s also no shortage of sob stories out there where investors got hammered by stocks, seeing their money evaporate right before their very eyes.
I don’t buy the “next hot thing”. I don’t bother with unproven business models or companies that are routinely unprofitable.
Instead, I invest my own hard-earned money into some of the best businesses in the world – my personal portfolio is filled with almost 100 high-quality dividend growth stocks, spread out across every conceivable industry, with exposure to every country and territory in the world.
You can find more than 700 examples of US-listed dividend growth stocks by checking out David Fish’s Dividend Champions, Contenders, and Challengers list.
These dividend growth stocks are fantastic because they pass a “litmus test” whereby the underlying businesses are so routinely and regularly increasingly profitable that they end up with excess cash flow – and they share this growing excess cash flow with shareholders in the form of growing dividends.
Obviously, it’s easy to see how one’s wealth grows over time when you’re sticking to investing in some of the best companies around.
But then you get that growing income via the increasing dividends these stocks are paying, which ends up being icing on what’s already a pretty delicious cake.
These growing dividends – funded by the growing profits these companies generate – are a completely passive source of income.
While the intelligent thing to do is to reinvest this dividend income back into high-quality dividend growth stocks while one is still actively building their wealth/portfolio (which buys more shares which pay more growing dividends), this income can be “switched over” to paying one’s real-life bills at any point in time.
If you’re able to pay your expenses with the dividend income your portfolio generates, you’re essentially financially independent.
That means you own all of your time, and are able to spend it however you want.
It’s a position I’m almost in myself, and I’ve only been saving and investing for about six years. So when I say this strategy is wonderful, I don’t think I’m exaggerating.
With that said, one shouldn’t buy any dividend growth stock at any price at any time.
I mentioned at the outset that I’m always on the hunt for these stocks when price is below fair value.
Said another way, I specifically want to buy high-quality dividend growth stocks only when they’re undervalued.
I want to pay less than what a stock is reasonably worth.
Why?
Well, both the income and wealth components discussed earlier are positively impacted when one pays less for a stock.
The income component is positively influenced by virtue of the relationship between price and yield: price and yield are inversely correlated, meaning a lower price will equal a higher yield.
All else equal, price and yield move perfectly inverse of one another – any decline in price results in yield increasing in a perfectly corresponding manner.
So buying a stock when it’s undervalued (compared to fairly valued or overvalued) will result in a higher yield (assuming no change to the dividend), which is more income in your pocket now… and more income, in aggregate, for the life of the investment.
More money? Yes, please!
Of course, since we’re talking about dividend growth stocks, that dividend growth is also positively impacted by buying at a lower price.
A 7% dividend raise is naturally (and mathematically) more attractive on a yield of 4% versus a yield of, say, 3%.
And since a dividend raise is based on management’s view of a company’s profit and prospects for growth rather than what some individual investor paid for its shares, you want as high of a yield and/or as many shares as possible to compound those raises with.
This is all fine and great for your income both now and later, but buying a high-quality dividend growth stock when it’s undervalued will also positively affect your wealth in the form of better potential long-term total return.
Yield is one aspect of total return, and we can already see how that part is given a big boost when paying less.
But capital gain – the other aspect – is also given a big potential boost via the potential upside you invite when you buy a stock at a price well below its intrinsic value.
Paying $50 for a stock worth $75 puts the potential for $25 on your side right off the bat, in addition to that additional yield and better dividend growth. And that’s all on top of any additional upside coming down the road via additional profit a company generates, increasing its intrinsic value.
Plus, you’re simply risking less.
Either you’re risking less on a per-share basis or you’re risking less in terms of total capital outlay; either way, a margin of safety (paying a price below fair value) adds an element of security.
While this sounds wonderful, how does one go about actually determining what a stock is worth?
There are a lot of ways to accomplish that – more than one road leads to Rome – but one method is available right here on the site, put together by fellow contributor Dave Van Knapp. A lesson on valuation, it’s a great resource.
But fear not. It doesn’t end there.
I’m going to put all of this together for you by highlighting one high-quality dividend growth stock that right now appears to be significantly undervalued…
Pfizer Inc. (PFE) is a global pharmaceutical company that discovers, develops, and manufactures a range of healthcare products.
With blockbuster drugs that includes the likes of Viagra, Lipitor, Lyrica, and Prevnar 13, Pfizer is one of the world’s largest pharmaceutical firms, with prescription drugs and vaccines making up the vast majority of their business.
In addition, they also have a number of key consumer healthcare branded products: Advil, Centrum, Robitussin, and ChapStick are a few high-profile brands.
But what will surely be a tranformative move, Pfizer recently announced that it was going to merge with Allergan PLC (AGN), which will form the world’s largest pharmaceutical firm. Tax savings and other synergies are the primary reasons cited for the move, and the combined company will be based out of Ireland.
Allergan itself is one of the world’s largest pharmaceutical companies, well known for its key product in Botox.
As a dividend growth stock, Pfizer qualifies for Mr. Fish’s CCC list per its six consecutive years of dividend raises.
Not the longest track record around, I’ll give you that.
The company, like many others, cut its dividend during the depths of the financial crisis.
However, they’ve been regularly increasing their dividend ever since. And the merger with Allergan could put them on more solid ground than ever, which should bode well for the sustainability of the dividend and the growth of it.
The five-year dividend growth rate stands at 9.2% – they’ve clearly been making up for having to cut the dividend a number of years back.
While that’s a pretty impressive dividend growth rate by itself, it’s made even more impressive when considering the fact that the stock yields 4.0% right now.
That yield, by the way, is 60 basis points higher than the stock’s five-year average of 3.4%.
So you’re getting more yield now and, potentially, more aggregate income for the life of the investment. Moreover, future dividend raises (based on purchasing the stock now) will be based off of a 4% yield rather than a 3.4% yield.
A yield that high isn’t particularly easy to come across in this low-rate environment. But that yield is even more appealing when you know the underlying dividend is growing.
The only concern here might be the payout ratio: at 108%, the company looks primed for another dividend cut.
However, GAAP earnings mask the true earnings power of the firm. Using adjusted EPS (to account for acquisition costs, F/X, etc.) means the payout ratio is a far more reasonable 54.5%.
Indeed, Pfizer just increased its dividend in mid-December, an action unlikely to occur if the payout ratio were actually that high.
Now, as a dividend growth investor, future dividend growth is even more important to me than what a company has already made good on. After all, we invest in where a company is going, not where it’s been.
To determine what to expect in that regard moving forward, we need to look at the underlying financial results of the company. A company that isn’t profiting will be unable to sustain a growing dividend over the long haul. Likewise, dividend growth tends to mirror earnings growth over the very long term.
So we’ll take a look at what Pfizer has done over the last decade in terms of top-line and bottom-line growth before looking at a forecast for growth over the foreseeable future.
Revenue for the company is roughly flat from fiscal years 2006 to 2015, moving from $48.371 billion to $48.851 billion.
However, there are a couple things to keep in mind here.
First, it’s tough to move the top-line needle when you’re doing $50 billion in business in this space.
Second, Pfizer sold its consumer healthcare unit in 2006 to Johnson & Johnson (JNJ) for over $16 billion, which shrunk the firm somewhat.
This issue shows up in earnings per share growth, too.
Just looking at GAAP EPS, we see a major downtrend from $2.66 to $1.11 over this period.
As always, however, the devil is in the details.
2006 saw a massive $7.9 billion (net of taxes) one-time gain for Pfizer, primarily from the aforementioned sale of their consumer healthcare unit.
Moreover, adjusted EPS for FY 2015 came in at $2.20.
So the actual earnings growth of the company is somewhere in the mid-single digits.
Moving the comparison forward one fiscal year and using adjusted EPS for ending result, the compound annual growth rate for that nine-year stretch comes in at 8.33%.
Recent results have been heavily impacted by currency concerns, the complete collapse in Venezuela’s economy, and a fairly large acquisition of Hospira. Pfizer, like most multinational companies, has been hit hard by the strong dollar and Venezuela’s financial woes.
Looking forward, S&P Capital IQ believes Pfizer will compound its EPS at a 5% annual rate over the next three years, factoring in the merger with Allergan. Condensing the numbers down and really filtering out the noise, I believe this is more or less a fairly true picture of Pfizer’s near-term and long-term growth potential.
A key aspect of a company’s quality, the balance sheet is always critical to investigate.
At first blush, the company’s ~$29 billion in long-term debt seems like a significant disadvantage.
But one has to consider this is a company with a market cap nearing $200 billion.
The long-term debt/equity ratio is actually a very reasonable 0.45, with the interest coverage ratio coming in at over 8.
All in all, Pfizer’s balance sheet is very competitive, comparing well to any other major pharmaceutical firm out there. This is especially appealing considering some of the fairly large acquisitions that Pfizer has taken on recently.
Profitability is also very solid, well in line with any major competitor out there.
Over the last five years, the company has averaged net margin of 16.70% and return on equity of 11.75%.
That margin is impressive, standing up to just about any other major company in this space. And the ROE is also really good when considering the slightly lower leverage.
The company is pretty attractive in its own right.
Investing here means you’re gaining exposure to some of the most popular prescription drugs in the world. As the world grows older, richer, and larger, the demand for these drugs should stay strong, likely only to increase over time.
However, one has to contend with patent cliffs when investing in pharmaceutical firms. For instance, Viagra will face generic competition starting in 2017.
But Pfizer has a fairly strong pipeline, with a number of biosimilars in phase 3 development.
All in all, the long-term rewards seem to heavily outweigh the risks.
You’re getting a very strong yield in a low-rate environment, made even more attractive when considering the dividend is only likely to continue growing, supported by profit growing in the mid-single digits.
And the merger with Allergan is likely going to be a game changer, permanently reducing Pfizer’s taxes and overall costs while simultaneously bringing about the largest competitor in its space.
But is the stock undervalued right now?
The P/E ratio (using adjusted EPS) is 13.41. The five-year average is 20.2. Of course, I’m using adjusted EPS against a recent historical average that’s looking at GAAP EPS. So the comparison is skewed somewhat. Nonetheless, recent currency concerns means the comparison would be unfair otherwise. I’ll also note that the yield is significantly higher right now when compared to its own recent historical average, so the valuation looks appealing on multiple fronts.
It does look compelling here. But what would be the stock’s estimated intrinsic value? What’s it likely worth?
I valued shares using a dividend discount model analysis with a 10% discount rate and a 6% long-term dividend growth rate. Factoring in the moderate payout ratio, forecast for near-term EPS growth, and the company’s recent dividend raises, I think this is a pretty accurate model. The DDM analysis gives me a fair value of $31.80.
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.
So I believe we’re looking at a stock that’s a bit undervalued right now. But factor in a market-crushing yield and the potential regarding the merger, I’m pretty excited here. And I’m not the only one excited. Pfizer recently announced it was initiating an accelerated $5 billion buyback, meaning Pfizer believes its own shares are undervalued right now. Furthermore, professional analysts have weighed in on the stock, with some believing it’s far cheaper than my take on it…
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 PFE as a 5-star stock, with a fair value estimate of $38.00.
S&P Capital IQ 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.
S&P Capital IQ rates PFE as a 4-star “buy”, with a fair value calculation of $33.10.
It’s not often you see this kind of consensus on undervaluation and a 4% yield. I came in on the conservative side, but I like to average out the three opinions so as to blend those different perspectives together into one number. That adds weight to the conclusion. The final valuation on this stock is $34.30, which means this stock is potentially 11% undervalued.
Bottom line: Pfizer Inc. (PFE) is one of the world’s largest pharmaceutical firms, set to become the largest after a massive merger. The stock yields a very attractive 4% right now, which is well above its recent historical average. Blockbuster drugs on the market, a solid pipeline, potential tax savings and synergies, and a solid underlying business that should do well with long-term tailwinds on its side means this is a great opportunity to buy shares with the possibility of 11% upside right now.
— Jason Fieber
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