Undervalued Dividend Growth Stock of the Week: Emerson Electric (EMR)

February 2, 2015
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We all want cheap, high-quality stocks.

They’re sometimes difficult to find, but awfully rewarding when you come upon one with capital in hand.

Even better if you score a deal on a stock that pays a dividend. That means you are basically “paid to wait”.

The stock may turnaround quickly, or it may not. But a dividend ensures you’re collecting some cash while Mr. Market makes up his mind.

I focus on these stocks.

Cheap, high-quality stocks that pay dividends.

More specifically, I want stocks that grow their dividends as well.

These dividend growth stocks can be found on David Fish’s Dividend Champions, Contenders, and Challengers list.

There are over 600 US-listed stocks that can be found there that not only pay dividends, but have increased their respective payouts for at least the last five consecutive years.

But 600 is a lot of stocks too choose from, right?

And not every single one is a great buy right now.

That’s why I focus on those that are priced below what they’re worth.

Just like anything in life, I’m trying to buy $1 for $0.50.

Valuing stocks is part art and part science, and it takes some time to become comfortable with it. If you haven’t yet, I’d recommend checking out Dave Van Knapp’s guide to valuation, which offers a lot of valuable insight here.

It’s incredibly important to learn how to do this if you’re interested in buying individual stocks, as you could not only potentially save yourself a lot of money by avoiding unnecessary losses, but also boost your potential gains over a long period of time.

For instance, I bought a 2006 Toyota Corolla with approximately 20,000 miles for $5,400 at the end of 2013. The car was really worth more than $10,000. That means that I could probably drive the car around for a few years “for free” and later sell it for the same price I paid.

It’s along the same lines with stocks. Buy a stock for less than it’s worth and you could potentially collect “free” upside.

I’m always interested in adding such undervalued dividend growth stocks to my own personal portfolio, and it appears I may just have found one.

I’m going to share that potential opportunity with you today.

Emerson Electric Co. (EMR) is an industrial conglomerate that designs and supplies product technology and solutions for industrial, commercial, and consumer markets.

This is one of those companies that flies under the radar a bit, but is an absolute powerhouse of a business.

Founded in the late 1800s, the company now employs more than 115,000 people across 220 manufacturing locations worldwide.

A sampling of their products includes motors, switches, air conditioning compressors, drives, valves, and electric tools. What’s great is that the company provides a lot of automation solutions and installed components, which means that there is a great opportunity for recurring revenue due to switching costs. Focusing on quality and customer relationships creates a great business relationship, and it seems that Emerson excels here.

This lengthy operational history and excellent market position has led to one of the best dividend growth records out there.

The company has increased its dividend for the past 58 consecutive years, which is absolutely incredible.

emrThe dividend growth itself is also very solid, as the dividend has increased at an annual rate of 8.1% over the last decade.

An incredible track record and growth in the upper single digits is about as good as it gets, folks.

Yielding 3.31% right now, that’s not only well above the broader market, but also higher than what a lot of the competition currently offers. I view this yield as pretty attractive.

And a payout ratio of 61.6%, while slightly high, leaves room for future dividend raises, more or less in line with profit growth.

This is just one of those slow and steady stocks. Consistent dividend raises year in and year out. Attractive yield, growth well above the rate of inflation, and you can count on it. There’s nothing to really dislike here.

Now, I’ve said it once and I’ll say it again: You simply cannot pay increasing dividends for 58 years straight without doing something right on the business side. A poor business can’t possibly sustain that type of activity. What you’ll see below is Emerson bearing that truth out.

The company’s revenue has increased from $17.305 billion in fiscal year 2005 to $24.537 billion in FY 2014. Over that ten-year period, that’s a compound annual growth rate of 3.96%. Not outstanding, but a little revenue growth goes a long way if a company is using it properly.

Earnings per share, which is a better barometer for a company’s growth since it measures profit, has grown from $1.70 to $3.03 during this time frame, which is a CAGR of 6.63%. That’s a bit more like it. Their healthy buyback program – Emerson bought back more than 100 million shares over this period, reducing the share count by over 15% – certainly helped boost their EPS growth. That’s an example of responsible use of cash.

S&P Capital IQ is calling for 8% compound annual growth in EPS over the next three years. They believe margins will expand and the buybacks will help fuel growth. This isn’t out of line with what the company has historically registered, so it seems very plausible to me.

Another responsible use of cash can be seen in how well a company manages its balance sheet. And Emerson manages its leverage extremely well. A long-term debt/equity ratio of 0.35 and an interest coverage ratio of 16.36 indicates a comfortable debt position.

Their profitability is solid and places them in a competitive position. They’ve posted net margin that’s averaged 8.93% over the last five years, with return on equity that’s averaged 20.99%. The margins and returns that EMR is generating is above most of the competition out there, which speaks to their quality as a firm.

I honestly don’t know what more an investor could want here, which is why I’m a shareholder in this fine company. You’ve got an excellent dividend track record with a yield that’s attractive right now, and the fundamentals across the board are near the top of the heap or at the top. The growth has been somewhat lackluster over the last decade, but that’s true of many industrial firms. But the fact that they grow in the upper single digits over the last decade which included the Great Recession is a pretty solid result, in my view.

Generally, a high-quality stock like this is priced at a premium. But that doesn’t necessarily appear to be the case right now. The stock is trading hands for a P/E ratio of 18.64 right now, more or less in line with the broader market. But that’s a slight discount to its five-year average P/E ratio of just over 20.

So that clues us in a bit, right? We have a stock that’s generally priced at a premium to the market, but that premium has disappeared.

But we need to know what we should actually pay for this stock, so let’s see if we can come up with a fair value.

I valued shares using a dividend discount model analysis with a 10% discount rate and a 7% long-term growth rate. That rate was used as it is relatively in line with EMR’s 10-year EPS growth rate, while it’s also below the forecast over the foreseeable future. The payout ratio is moderately high right now, so future dividend growth will largely track EPS growth. The DDM analysis gives me a fair value of $67.05.

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 it looks like, based on my analysis, this stock is priced below its intrinsic value. But if you don’t want to take just my word for it, let’s see what some of the analysts that follow this stock think about 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 EMR as a 4-star stock, with a fair value estimate of $69.00.

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 EMR as a 3-star “hold”, with a fair value calculation of $61.50.

Looks like I’m in the middle there, but I wasn’t too far off. If we average these three numbers so that we can work with just one final number, we get $65.85. That would indicate that this stock is potentially 15% undervalued right now, which is perhaps an opportunity to buy into a world-class business for less than it’s really worth. I’m already a shareholder, but I’m considering buying more here.

sc emrBottom line: Emerson Electric Co. (EMR) is a high-quality business with one of the longest dividend growth streaks in existence. They are incredibly shareholder friendly with big buybacks, an attractive yield, and a conservative balance sheet. Meanwhile, their competitive advantages are almost built in to the business model, as long-term contracts serve to produce switching costs. Usually, this stock is priced at a premium, but it’s not today. This could be just the opportunity you’ve been waiting for to buy into a great stock at a substantial discount.

– Jason Fieber, Dividend Mantra

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