It seems like nothing sticks to this market.
No matter what you throw at the market, it just keeps marching higher.
The specter of higher interest rates.
The presidential race.
Brexit.
All potential major concerns, yet the S&P 500 just recently broke through a new all-time high.
[ad#Google Adsense 336×280-IA]Fortunately, I’m not buying the entire market (if I were, I’d be a bit concerned right now).
And I’m guessing you’re not buying it either, or you wouldn’t be reading this article.
I instead focus on individual stocks and their respective valuations.
After all, the stock market is nothing more than a market of stocks.
So while a rising tide usually lifts all boats, some boats aren’t floating as high as others.
Speaking of boats, I don’t even concern myself with all of them; if the entire US stock market comprising thousands of stocks is an ocean, I prefer to focus on a port.
That port, for me, is filled with high-quality dividend growth stocks.
Stocks like those you’ll find on David Fish’s Dividend Champions, Contenders, and Challengers list, which is the most robust compilation of US-listed stocks with at least five consecutive years of dividend raises I know of.
I focus on high-quality dividend growth stocks because they pay me to own them. The dividends I collect are like nice “pay checks” I don’t have to work for.
Not only that but they usually pay me more and more every year. So it’s like receiving raises all the time, except I don’t have to do anything to earn those raises (other than stay invested).
Said another way, I’m only riding boats that pay me to step aboard.
You can see what I mean by checking out my personal portfolio; it’s filled with high-quality dividend growth stocks across the board, and I’m on pace to collect almost $11,000 in dividend income over the next 12 months.
So you can see that I’m a huge fan of dividend growth stocks.
However, it’s imperative that one doesn’t just buy random dividend growth stocks at random prices.
One should first make sure that a stock passes muster – the fundamentals and competitive advantages should both be strong.
Paying a good price at the time of investment, though, is perhaps even more paramount to an investor’s long-term success.
That’s because valuation has a direct and lasting impact on yield, total return, and risk.
As such, it’s vital that an investor not only look for high-quality dividend growth stocks but look for high-quality dividend growth stocks that are undervalued.
An undervalued dividend growth stock will almost always come attached with a higher yield right off the bat.
All else equal, a stock’s yield is higher when its price is lower; price and yield are inversely correlated.
This higher yield positively affects total return, leading to the potential for stronger long-term total return on the investment.
In addition to the higher yield positively affecting total return, the upside that exists between the (lower) price you pay and the (higher) value of the stock is additional potential capital gain over the long run.
So an undervalued dividend growth stock puts an investor in an advantageous position regarding both components of total return: yield and capital gain.
And this all has an effect of reducing one’s risk.
You’re not only spending less money per share when you’re snagging a stock that’s undervalued but also introducing a margin of safety.
That margin of safety means the company could misstep here and there, reducing the value of the stock a bit, and you’d still likely come out ahead.
Conversely, paying more than fair value means one or two missteps can put you badly upside down on your investment.
What’s great about all of this is that one doesn’t need to perform voodoo magic in order to have a good idea of what a stock is worth.
In fact, a system that’s specifically designed to help estimate intrinsic value can make the process straightforward and intuitive.
One such system is freely accessible right here on the site.
Put together by fellow contributor Dave Van Knapp, it takes a lot of the guesswork out of the equation, putting an investor in control as it relates to estimating fair value.
And once you have a good idea of what a stock is worth, it’s just a matter of seeking out a price as far below that level as possible.
But I’m going to do you readers one better by revealing and discussing a high-quality dividend growth stock that right now appears to be significantly undervalued.
Are you ready?
Then read on…
Amgen, Inc. (AMGN) is a global biotechnology company that develops and manufactures a range of human therapeutics.
Amgen is a $122 billion company (by market cap), focusing on six different therapeutic areas: oncology/hematology, cardiovascular, inflammation, bone health, neuroscience, and nephrology.
Key drugs include Enbrel, XGEVA, Kyprolis, Epogen, Sensipar, Aranesp, and Prolia.
Cancer, kidney disease, and rheumatoid arthritis are just a few major health problems that Amgen addresses via its therapeutics.
As humans live longer, and as the world becomes richer, demand for access to high-quality medicine should only increase over time.
And the truth is that, unfortunately, the world still has a lot of large-scale health problems that require ongoing research and medication to help solve.
This basic thesis continues to show up in Amgen’s financial results. Better yet, the company continues to share the wealth with its shareholders.
They’ve increased their dividend for six consecutive years now.
Although not a particularly lengthy track record, be mindful that the company just started paying a dividend in 2011. So they’ve essentially increased their dividend every year possible, since initiating a dividend.
Making up for lost time, the three-year dividend growth rate stands at 29.9%.
While I don’t think that’s a reasonable expectation for future dividend growth looking out over the long term, there hasn’t been a noticeable slow down; the most recent dividend increase was was over 26%.
But the payout ratio has climbed steadily and aggressively since the dividend was first initiated.
It’s currently 42.3%.
There’s certainly some room for further expansion there, but I’d expect dividend growth to moderate moving forward.
In addition to this monster dividend growth, though, the stock offers a current yield of 2.45%.
Not only is that yield appealing in a world where interest rates worldwide are frequently in negative territory but it’s also well above the stock’s own five-year average yield of 1.5%.
In fact, there’s a spread of almost 100 basis points!
So, sure, the dividend growth might not be completely monstrous moving forward. However, the starting yield is now far higher than what it’s averaged for investors over the last five years. Moreover, the company has the capacity to still deliver very strong dividend growth moving forward, as I’ll soon explain.
In order to form a baseline expectation for future dividend growth, we must first look at what kind of underlying growth the company has generated over the last decade. We’ll then compare that to a near-term forecast.
This will help us estimate future growth, as well as what the company might just be worth.
From fiscal years 2006 to 2015, Amgen increased its revenue from $14.268 billion to $21.662 billion. That’s a compound annual growth rate of 5.01%.
Looking at the bottom line over this 10-year stretch, Amgen grew its earnings per share from $2.48 to $9.06, which is a CAGR of 15.48%.
The rather large gap between the two numbers can largely be explained by Amgen’s extensive share buyback activity, which has seen the company reduce its outstanding share count by approximately 36% over this period.
This is really strong growth for a fairly large biotechnology firm, especially in terms of the bottom line.
Moving forward, S&P Capital IQ expects Amgen to generate 8% compound annual growth in its EPS over the next three years, citing growth in certain key drugs ( Prolia, XGEVA, Enbrel and Kyprolis) offset somewhat by additional competition from biosimilars.
This would be a steep drop from what Amgen has done over the last decade, although I think there’s a margin of safety in that prediction. Amgen’s healthy pipeline (16 compounds in Phase III trials) is a tremendous backstop.
Meanwhile, the rest of the company’s fundamentals are rather strong.
The balance sheet is leveraged, though not uncommonly so.
Amgen has a long-term debt/equity ratio of 1.04 and an interest coverage ratio over 8.
Biotechnology companies like Amgen generally feature debt levels in line with what we see above.
But while leverage is perhaps a weak spot for this industry, profitability is most certainly not.
Over the last five years, Amgen has averaged net margin of 26.75% and return on equity of 21.82%.
Really incredible numbers there – and there’s been a slight improvement in both metrics over the last five years compared to the prior five.
Looking at all of this, one might expect the stock to be rather expensive.
But it seems that’s not the case at all.
The stock actually looks cheap right now.
The P/E ratio is 17.29 right now, which is a discount to both the broader market and the stock’s own five-year average P/E ratio. Furthermore, the yield, as noted earlier, is substantially higher than its recent historical average.
So the stock appears to be on sale. What, then, is a fair price to pay? What’s a reasonable estimate of the stock’s intrinsic value?
I valued shares using a dividend discount model analysis. I assumed a 10% discount rate and a long-term dividend growth rate of 8%. This growth rate is well below the company’s demonstrated EPS and dividend growth but factors in a higher payout ratio and lower forecast for EPS growth moving forward. The DDM analysis gives me a fair value of $216.00.
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 viewpoint is such that this stock is trading for a price that’s meaningfully below its fair value. But is that viewpoint completely out of line? Let’s check.
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 AMGN as a 4-star stock, with a fair value estimate of $194.00.
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 AMGN as a 4-star “buy”, with a fair value calculation of $190.10.
I usually come in pretty conservative in these comparisons, but this time I came in high. Nonetheless, averaging out these three numbers gives us a final valuation of $200.03. So we have a stock that’s potentially 23% undervalued right now.
Bottom line: Amgen, Inc. (AMGN) is a high-quality firm with an incredible stable of blockbuster drugs, along with a strong pipeline. Their demonstrated growth over the last decade is impressive, and the company continues to share the good fortune with shareholders in the form of a growing dividend. I expect that to continue. With a yield well above its recent historical average and the potential for 23% upside, this is an opportunity that long-term dividend growth investors should take seriously.
— Jason Fieber
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