Occam’s razor is a problem-solving principle that states that among competing hypotheses, the one with the fewest assumptions should be chosen.
The principle is usually boiled down into the following: the simplest answer is often the right answer.
It might be part of the human condition to constantly seek out a complicated solution to an easy problem.
I see this with investing all the time.
By living below my means and investing my excess capital into high-quality dividend growth stocks like those you’ll find on David Fish’s Dividend Champions, Contenders, and Challengers list, I’ve achieved financial independence in my early 30s.
My investing style is very simple.
It involves buying up shares in some of the world’s most well-known and successful businesses, allowing these companies to go out and make money for me and give me a chunk of their growing profit via growing dividends.
I just sit back and collect growing passive dividend income my real-life six-figure dividend growth stock portfolio generates for me, which is now in the five figures.
When people I meet for the first time hear about my investment strategy, they’re often puzzled.
They almost immediately counter with any number of “better” investment ideas: cryptocurrency, tech startups, angel investing, penny stocks, or a “friend’s” really good business that just needs a little capital.
Are these investment ideas necessarily better?
No.
But they’re definitely a lot more complicated, and they’re also generally a lot riskier.
Because of their complexity, people assume they must be better.
However, when I press on to find out just how successful in investing these people have been, I almost never get a very good answer.
Investing in some of the world’s most known and successful businesses is so easy and obvious, people assume it must be a poor investment strategy.
But it’s anything but, as my personal experience has shown.
If you don’t believe me, just take a look at how Warren Buffett – the world’s most successful investor of all time – invests: Buffett invests in many of these same companies!
However, as simple as this answer might be, it’s not something that can be done blindly.
One still needs to make sure they’re picking the right business at the right valuation.
The former part of that statement can be boiled down into making sure a company is within one’s circle of competence, sports high-quality fundamentals, and has durable competitive advantages.
The latter part of that statement is a bit more intricate, but valuing a dividend growth stock isn’t that difficult.
Yet making sure you’re getting the right valuation can have major implications.
Price is what something costs, but value is what something is worth.
And when dealing with stocks, the two numbers rarely, if ever, match up very well.
But an intelligent investor will use this to their advantage, buying up a high-quality dividend growth stock when it’s undervalued (i.e., when a stock’s price is well below its intrinsic value).
That’s because undervaluation confers significant long-term benefits to the investor.
An undervalued dividend growth stock should present a higher yield, greater long-term total return potential, and less risk.
This is all relative to what the same stock might otherwise offer if it were fairly valued or overvalued.
All else equal, a lower price will result in a higher yield. Price and yield are inversely correlated. So when paying a lower price for a stock, an investor should be able to “lock in” a higher yield.
This higher yield can lead to more current and ongoing passive investment income.
In addition, it can lead to greater long-term total return potential, as total return is comprised of income (dividends/distributions) and capital gain.
We can see how the income portion is positively affected by a higher yield.
But the capital gain portion is also given a potential boost via the “upside” that exists when the price paid for a stock is well below the fair value of a stock.
While price and value can be wildly mismatched over the short term at any given time, the two tend to more closely align over longer periods of time.
And if one is able to pay a price that’s much lower than value, that creates something like a “coiled spring” that serves to accelerate capital gain on top of whatever natural, organic capital gain would occur as a high-quality business increases its profit and naturally becomes more valuable as a result.
If this weren’t fantastic enough, undervaluation can also reduce risk.
Paying a price well below value builds in a “margin of safety”, which acts as a buffer to protect the investor against unforeseen events that could destroy value.
If you estimate a stock’s value at $50 and pay $50, you have no margin of safety. If something unbeknownst occurs to reduce the value of the business, you could quickly be upside down on your investment (owning a stock that’s worth less than you paid).
This adds unnecessary risk.
It’s just one more reason why it’s so important to first estimate fair value, then pay as far below that estimation of intrinsic value as possible.
The good news about this is that there are a number of resources out there designed to help any investor with the task of valuation.
One such resource is available right here at the site.
As part of a lengthy series of articles that are designed to educate prospective investors on the dividend growth investment strategy, fellow contributor Dave Van Knapp wrote a “lesson” that specifically highlights how to go about valuing dividend growth stocks.
With all of this in mind, being able to buy a high-quality dividend growth stock when it’s undervalued can be a compelling and powerful long-term investment opportunity.
It may be simple.
But the simplest answer is often the right answer.
Let’s now explore a high-quality dividend growth stock that appears to be undervalued at this time…
Amgen, Inc. (AMGN) is a global biotechnology company that develops and manufactures a range of human therapeutics.
With a market cap over $120 billion, Amgen is one of the world’s largest and most successful healthcare firms in general, but they’re an absolute giant when it comes to biotechnology firms specifically.
If the simplest answer is often the right answer, it makes sense to focus on investment themes that are simple and highly likely to transpire.
Well, there are few themes that are simpler and more likely to transpire than the world growing older, richer, and bigger.
After all, this is a trend that’s been playing out for a long time.
And as this continues to unfold, the demand for access to high-quality medications (in order to save, prolong, or better one’s life) is only going to grow.
That bodes well for a firm like Amgen, which has profitable and sought-after branded drugs like Enbrel, Sensipar, Epogen, and Aranesp.
While they continue to bring in the profit from their exposure to treatments in oncology and immunology, they also commit themselves to maintaining a strong pipeline of drugs (16 compounds in Phase III trials) that will allow the company to increase its profit (and thus its dividend) for many years to come.
While the company is relatively new to the dividend growth arena, they have an outstanding track record of delivering secular-like growth in their profit for many years.
But the dividend growth track record is thus far nothing less than mighty impressive.
The company has paid out an increasing dividend for seven consecutive years.
And I believe they’re positioned very well to eventually build that track record into many decades.
That’s partly evidenced by the fairly modest payout ratio of just 41.6%.
What’s really great about this payout ratio is that it’s still so low even after Amgen has been delivering monster dividend growth since they started paying an increasing dividend back in 2011.
The five-year dividend growth rate stands at 48.2%, which is one of the highest five-year growth rates I’ve ever run across.
Now, one can’t expect that kind of dividend growth to continue indefinitely, which is why you’d expect to see growth deceleration.
However, even the most recent dividend increase was still a sizable 15%.
And when looking out over the foreseeable future, the company seems poised to continue delivering double-digit dividend growth.
While you wait for those big dividend raises to come in, the stock offers a very appealing yield of 2.70% right now.
That’s well in excess of the both the broader market and the industry average.
It’s also a good 80 basis points higher than the stock’s own five-year average, although we have to consider that the stock’s dividend was $0 as recently as early 2011.
Still, you’re looking at a yield coming up on 3% along with the potential for double-digit dividend growth for at least the next few years.
Plus, we have to consider the company is nearing an announcement for a dividend increase which would boost this yield even higher, assuming the stock price doesn’t materially change.
That kind of combination of income and growth doesn’t just pop up every single day.
But in order to build that expectation for dividend growth moving forward, we first must be able to build an expectation for profit growth moving forward.
And the best place to start looking at the company’s long-term earnings growth is what they’ve done over the last 10 years.
So we’ll see what Amgen has done in terms of top-line and bottom-line growth over the last decade first.
And then we’ll compare that to a near-term forecast for profit growth moving forward.
Combining and blending the past and the predicted future in this manner should give us a pretty good idea as to what we can expect from Amgen (in terms of profit and dividend growth) when looking out over the future.
The company grew its revenue from $14.771 billion to $22.991 billion from fiscal years 2007 to 2016. That’s a compound annual growth rate of 5.04%.
This kind of revenue growth is, frankly, right in line with what I’d expect for a relatively mature company like Amgen.
Meanwhile, earnings per share expanded from $2.82 to $10.24 over the same 10-year period, which is a CAGR of 15.41%.
Quite a discrepancy between top-line and bottom-line growth, but it can be largely explained by the company’s share buyback activity over the last decade. This activity saw Amgen reduce the outstanding share count by approximately 33%, which is substantial.
Moving forward, CFRA estimates that Amgen will compound its EPS at an annual rate of 7% over the next three years.
This would be a notable drop from what Amgen has produced over the last decade.
CFRA believes that slowing growth from mature drugs will offset much of the growth potential from newer drugs coming to market.
This seems awfully conservative from what I can see, but a more accurate and reasonable estimation of growth potential moving forward may be somewhere between what the company has already clearly demonstrated (15%+) and where this forecast (7%) is at. That would peg Amgen at around 10%, which would provide for dividend growth potential at least in that same range.
That said, Amgen could come in closer to that 7% market over the next few years, or even beyond that period, and still provide for dividend growth somewhere near double digits for years to come simply by virtue of where the payout ratio is at (meaning the payout ratio would expand a bit).
Moving on to other fundamentals, the business is clearly run very well. But I think the balance sheet could be improved a tad.
The long-term debt/equity ratio stands at 1.01, while the interest coverage ratio is just over 8.
These are solid numbers, but I wouldn’t call them excellent.
Profitability, though, is a particularly robust part of the business, with the company sporting eye-popping numbers.
Over the last five years, Amgen has averaged net margin of 28.74% and return on equity of 24.30%.
The latter is juiced a little by the debt, but the margin is really extraordinary.
Overall, Amgen is, in my view, one of the highest-quality firms in any industry, but they’re certainly nothing less than a juggernaut within the biotech space.
The dividend is better positioned for growth and clearly healthier than some of the most well-known companies in the world, especially in the consumer goods space.
That provides a sizable margin of safety in terms of the company maintaining its dividend, as the industry Amgen is in is rife with risks that include regulatory issues, lengthy R&D trials that can be expensive with little or no results, patent expiration, litigation possibilities, and competition.
But with some of the better fundamentals you’ll run across – in terms of the business as a whole – Amgen is a high-quality business that can make for excellent exposure to long-term and simple-to-understand trends in healthcare.
However, even with all of that quality and potential, the stock still looks downright cheap here…
The stock’s P/E ratio is sitting at 15.36, which matches the company’s growth rate over the last decade (i.e., a PEG ratio of 1).
For perspective, that’s significantly lower than both the broader market and the industry average.
Investors are also paying much less for the company’s cash flow than what they’ve been willing to pay, on average, over the last three years.
And the yield, as discussed earlier, is substantially higher than its own recent historical average.
The stock does look cheap when we consider its quality and growth potential, but what might a reasonable estimate of its intrinsic value be?
I factored in a 10% discount rate and a long-term dividend growth rate of 7.5%.
I think that DGR is quite conservative, as it’s half of what the company has done in terms of earnings growth over the last decade.
It’s also half of what the most recent dividend increase was.
And even if the company comes in near CFRA’s estimate for EPS growth over the next three years, the company has the wherewithal to greatly exceed a DGR of 7.5% for the foreseeable future.
That said, this is a valuation model that’s looking out over the very long term, and I think this is a reasonable expectation.
The DDM analysis gives me a fair value of $197.80.
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.
My valuation model shows a high-quality dividend growth stock that appears to be considerably undervalued, but my perspective is limited to my own views. As such, I think comparing my valuation to what professional analysts come up with adds value and depth for you readers.
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 3-star stock, with a fair value estimate of $193.00.
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 AMGN as a 4-star “BUY”, with a fair value calculation of $183.98.
Interestingly enough, the latter firm has a 12-month target price of $220.00 on the stock. Nonetheless, you see some consensus that the stock could be worth closer to $200. Averaging out the three valuations gives us a fair value of $191.59, which would mean the stock appears to be 13% undervalued right now.
Bottom line: Amgen, Inc. (AMGN) is a high-quality firm that’s extremely well positioned to capture plenty of growth from simple and long-term global trends. An incredible track record for growing its profit and dividend looks set to continue for many years to come. Meanwhile, the stock appears 13% undervalued, offers a yield near 3% on a well-funded dividend, and has demonstrated double-digit dividend growth. Dividend growth investors would do well to strongly consider this stock for long-term investment.
— Jason Fieber
Note from DTA: How safe is AMGN’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 93. 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, AMGN’s dividend appears very safe and extremely unlikely to be cut. Learn more about Dividend Safety Scores here.
[ad#wyatt-income]