The stock market continues to defy gravity.
I mean, we’re sitting here with a Dow Jones Industrial Average that’s creeping up on 20,000 points.
Yet I’ve been almost incessantly hearing about how a market crash is imminent – for about four years now.
If you were one to believe in that and keep cash on the sidelines all this time, you would have missed out on a lot of long-term opportunities.
Even recently, we’ve seen how nobody can really predict the market.
Almost everyone believed that the market was going to drop substantially after Donald Trump became the President-elect.
Yet the S&P 500 is up 5% over just the last month!
While great for one’s net worth (assuming they’re invested in stocks), this has the effect of reducing the number of attractively valued stocks available.
But there are still some opportunities out there…
I’ve spent almost seven years of my life building the six-figure Full-Time Fund that generates enough passive dividend income to cover the bulk of my core personal expenses.
This real-life, real-money portfolio is chock-full of high-quality dividend growth stocks.
These are stocks that reward their shareholders with growing dividend payments.
Dividends are a share of the profit a company generates. Well, if profit is growing, so should the dividend. And if profit isn’t growing, I’m probably not interested in investing anyway.
If a company is able to routinely increase its profit and dividends for years on end, it stands to reason it’s a very high-quality company.
That’s in part why I focus on these stocks, hundreds of which can be found on David Fish’s Dividend Champions, Contenders, and Challengers list.
Mr. Fish has compiled information on the more than 700 US-listed stocks with at least five consecutive years of dividend increases.
While growing dividends are a great initial litmus test for quality, the growing dividends are also a great source of completely passive income.
I’d know: I’m on pace to collect about $1,000 per month in dividend income over the next 12 months from the stocks in my personal portfolio.
And this income is likely only going to grow for the rest of my life.
But as appealing as all of this is, I don’t go and just buy random dividend growth stocks at random prices.
First, one should make sure any company they’re going to invest in passes their quantitative and qualitative analysis.
One should be looking at the financial statements first to see what the growth, debt, and profitability looks like.
And then one should also be considering whether or not a company has any competitive advantages in place to protect the business model from competition over the long term.
But even if all of that looks great, one also has to consider the price they’re paying for the stock.
After all, price is simply what you pay; value is what you’re getting in return.
A stock could be priced at $50 per share. Or $20 per share. Or $100 per share.
But none of these numbers mean a thing without knowing how much the stock in question is worth.
While the intrinsic value of any dividend growth stock isn’t a concrete number that you can pull up like its price, worth is also not some abstract concept.
The value of any dividend growth stock can be estimated with a reasonable level of accuracy and confidence.
And a tool designed to do just that is actually available right here on the site.
Dave Van Knapp, a fellow contributor and dividend growth investor, put together a valuable series of lessons on dividend growth investing.
Valuing dividend growth stocks is one of those lessons, and it’s truly a great (and free!) resource.
Once you’re able to estimate the fair value of a dividend growth stock, you’ll have the context necessary to decide whether or not the price being asked is sensible.
However, we actually want more than sensible.
We want to buy a high-quality dividend growth stock when it’s undervalued.
The rationale is pretty straightforward.
An undervalued dividend growth stock will offer a higher yield, greater long-term total return prospects, and less risk.
This is compared to what would be offered if the same stock were fairly valued or overvalued.
See, price and yield are inversely correlated. All else equal, a lower price will increase the yield.
That higher yield means – you guessed it – more income.
And not just more income now but potentially more income for the life of the investment. That higher starting yield could very well impact current income, dividend growth, and aggregate dividend income.
Moreover, that positively impacts one’s total return over the long run, since yield is a major component of total return.
On top of that, capital gain, the other component of total return, is also positively impacted due to the possible upside that exists between the lower price paid and the higher intrinsic value.
If you deem a stock to be worth $50 but pay $40, you’re putting the odds on your side that the market recognizes that mispricing over the long run.
If it does, that’s $10 of upside per share. That’s in addition to the natural upside that’s present as a natural course of the business making more money and becoming worth more over time.
Of course, paying less also reduces one’s risk.
Paying $40 rather than $50 is risking $10 less per share of your hard-earned cash.
Buying a high-quality dividend growth stock when it appears to be undervalued institutes a margin of safety.
That means if your estimate of fair value is off, or if the company doesn’t perform as you expect, you can still come out okay.
The last thing you want to do is pay estimated fair value or more only to watch the company start to stumble.
Buying an overvalued asset is almost always a bad idea, as a lot of people saw right before the housing crash.
But the good news is that even in this market there are select high-quality dividend growth stocks that appear to be undervalued.
Read on to see a great example…
Amgen, Inc. (AMGN) is a global biotechnology company that develops and manufactures a range of human therapeutics.
Amgen is one of the world’s largest and most successful biotechnology firms.
With a market cap of over $110 billion, there are few companies that offer the kind of scale, breadth, and R&D capability.
And with blockbuster drugs like Enbrel, Neulasta, Epogen, Sensipar, Aranesp, and XGEVA bringing in a lot of profit now, and 16 compounds in Stage III trials, Amgen is likely to continue raking in the cash over the foreseeable future.
Perhaps best of all, the company is very generous in regard to sharing a good chunk of their profit with their shareholders.
The company has increased its dividend for six consecutive years, for starters.
While not the longest streak around, every streak has to start somewhere.
Moreover, they’re making up for much of that potential shortcoming via dividend growth: the three-year dividend growth rate stands at a monstrous 29.9%.
Indeed, the most recent dividend increase was over 25%.
And with a payout ratio of just 40%, there’s still plenty of room for more where that came from.
On top of that huge dividend growth, the stock actually offers a very appealing yield of 2.68%.
For perspective, that’s quite a bit higher than the broader market.
Furthermore, it’s more than 100 basis points higher than the stock’s own five-year average yield.
That means investors today are locking in a yield that’s almost twice as high as what investors have typically, on average, received over the last five years.
Talk about a great example of how undervaluation impacts yield.
But in order to determine what kind of dividend growth to expect moving forward, we want to know what kind of underlying growth Amgen will be able to deliver.
Well, a great place to start is by looking at what the company has done over the last decade. If a company has a long-term track record for a certain amount of growth, the odds are pretty good that it’ll continue.
We’ll then compare that to a near-term forecast for future growth which, when kind of blended together, should give us an idea as to what to expect from the company over the foreseeable future.
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%.
Meanwhile, the company grew its earnings per share from $2.48 to $9.06 over this same 10-year period, which is a CAGR of 15.48%.
Solid revenue growth but fantastic EPS growth.
The excess bottom-line growth can be largely explained by the company’s share buyback activities: Amgen reduced its outstanding share count by approximately 36% over the last decade.
Looking out over the next three years, S&P Capital IQ believes Amgen will compound its EPS at an annual rate of 8%, citing increased growth in key drugs like Prolia, Enbrel, and Kyprolis being somewhat offset by increased biosimilar competition.
That could prove to be quite conservative, as Amgen has generated year-over-year EPS growth of almost 14% for the first nine months of FY 2016.
Nonetheless, Amgen could continue easily handing out double-digit dividend raises for many years to come, even if they’re only growing at 8%. That’s because the payout ratio is still so low. However, biotechnology isn’t quite as reliable as, say, toilet paper or razors from the standpoint of revenue and profit, so I’d prefer they err on the side of caution.
But I find it likely there’s still plenty of dividend growth yet to come from this company.
In addition to the solid growth, Amgen also has great fundamentals across the rest of the business.
The balance sheet, for instance, is in great shape.
Common for a biotechnology firm, they have debt. But it’s not unusual or particularly concerning.
The long-term debt/equity ratio is 1.04. And the interest coverage ratio is over 8.
Usually, these numbers might be slightly mediocre. However, Amgen’s total cash matches its long-term debt, offsetting each other. As such, I’m just not concerned at all.
Profitability is also outstanding, as is the case with many great biotechnology companies.
In fact, Amgen has some of the best profitability metrics in the industry.
Over the last five years, they’ve averaged net margin of 26.75% and return on equity of 21.82%.
As a dividend growth investor, there’s a lot to like here about Amgen.
You’ve got one of the biggest, most diversified, and profitable healthcare companies in the world.
And as the world’s demand for access to high-quality healthcare increases as our planet’s wealth, age, and population all grow, companies like Amgen are positioned extremely well.
However, there are risks. Biosimilars are a competitive risk. R&D must constantly yield promising new drugs. And there are regulatory hurdles to constantly overcome.
But the long-term rewards seem to far outweigh the risks, from my point of view.
With that said, one would think the stock would be priced a premium.
Well, I’d argue the stock actually looks quite cheap…
The stock is trading hands for a P/E ratio of 14.88. That compares quite favorably to the stock’s own five-year average P/E ratio of 17.7. The company’s cash flow is also cheaper than its been, on average, over the last five years. And as noted earlier, the stock’s current yield is almost twice as high as its recent historical average.
Am I painting a picture here? The picture appears to look a lot like undervaluation. But how cheap might the stock be?
I valued shares using a dividend discount model analysis. I factored in a 10% discount rate. And I assumed a long-term dividend growth rate of 8%. That growth rate is on par with the near-term forecast for EPS growth, which itself looks conservative. However, with a low payout ratio and the matching of a conservative underlying growth forecast, I think this is a conservative look at their dividend growth potential. 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.
So my perspective shows a stock that is significantly undervalued. But maybe I’m way off. Let’s see what some professionals value this stock at.
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 5-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 $185.20.
Looks like I’m not too far off after all. If we average these three valuations out, so as to blend together these different viewpoints, we get a final valuation figure of $198.40. That would indicate we have a stock on our hands that is potentially 32% undervalued.
Bottom line: Amgen, Inc. (AMGN) is a high-quality global biotechnology company that has positioned itself to take advantage of long-term trends in healthcare. With a yield almost twice as high as the five-year average, investors are locking in a yield much more attractive than what’s usually available. Moreover, with the possibility of 32% upside on top of that, this could be one of the best current opportunities for long-term dividend growth investors.
— Jason Fieber
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