Undervalued Dividend Growth Stock of the Week: Cardinal Health Inc. (CAH)

There was a viral story circulating the Internet this past week.

Apparently, there’s a gentleman who took a $2.5 million inheritance and wasted 90% of it by day trading.

So he bet his last $250,000 that Apple Inc. (AAPL) would have a terrible quarter.

If he was right, he’d gain millions.

If he was wrong, he’d lose it all.

Well, Apple reported a fantastic quarter.

The stock is up substantially as I write this article. And this gentleman, if he’s being genuine, is now broke.

It’s a cautionary tale with many different lessons.

But I think what someone should really take away from this story is that you shouldn’t treat the stock market like a casino.

If you approach it like a casino, you’ll get casino results. And we know that the house usually wins.

On the other hand, when you approach the stock market as simply a market full of stocks – a place to buy equity in wonderful businesses that will reward you as a shareholder with increasing payments for simply holding stock – you should do well over the long run.

I mean, it’s just not that difficult to invest intelligently and grow your wealth and income.

My experience is the perfect example.

I was almost 28 years old when I started my journey to financial independence. I had a negative net worth. And I was working in the auto industry.

Basically, most people would say I didn’t have a shot.

Yet I was able to retire at 33 years old.

And I control a real-life six-figure portfolio chock-full of the high-quality stocks I just mentioned, and this portfolio generates five-figure dividend income that covers a substantial portion of my monthly core personal expenses.

I didn’t do anything terribly difficult. My path can be replicated by almost anyone.

However, I can tell you what I didn’t do: I didn’t bet against great companies.

I instead invest in great businesses for the long run.

After all, great businesses became great by doing a lot of things right.

They sell products and/or services that people and/or other businesses demand.

Because of that, they’re able to regularly register higher profit.

And best of all, many wonderful businesses share that rising profit with their shareholders via growing dividends.

You can see what I mean by checking out David Fish’s Dividend Champions, Contenders, and Challengers list, which is a compilation of more than 700 US-listed stocks with at least five consecutive years of dividend increases.

While investing in fantastic businesses and holding on to that equity for the long haul is the only sensible way to invest, in my opinion, getting paid your fair share of profit makes even more sense.

Shareholders are the collective owners of any publicly traded company. And so if a company is regularly making more money, so should the shareholders.

And that’s why I buy high-quality dividend growth stocks and hold on to them for the long term.

I’m able to sit back, let these companies do all the hard work, and collect a bunch of growing “paychecks”.

Being a dividend growth investor is literally the easiest “job” I’ve ever had!

As you can see, I always shake my head when I hear about people trading stocks like baseball cards. It’s so hard to go that route and risk all your money. Why not make it easy?

That said, there’s a little more to it than this.

One must make sure they’re buying into a high-quality businesses that makes sense from a quantitative and qualitative point of view.

Perhaps just as importantly, though, you want to buy these high-quality dividend growth stocks when the price is appealing.

And the price is appealing when it’s below intrinsic value.

Price is only what you’re paying for something. Value, however, is what that something is worth.

As such, you want to buy high-quality dividend growth stocks when they’re undervalued.

An undervalued dividend growth stock will almost always offer numerous advantages to the investor.

Think a higher yield, better long-term total return prospects, and less risk.

That’s all relative to what would otherwise be present if the same stock were fairly valued or overvalued.

All else equal, a lower price will mean a higher yield. That’s because price and yield are inversely correlated.

That higher yield means more income in your pocket both in current terms and, potentially, on an ongoing basis.

And the higher yield also positively impacts total return, as yield is one of two components of total return.

The other component is capital gain, and capital gain is also positively impacted via the upside that exists between the lower price paid and the higher intrinsic value of the stock. If that gap closes, that’s capital gain.

Of course, this all works in your favor from a risk standpoint, too.

You’re probably going to be risking less absolute capital when you pay less per share.

Or you’re buying more shares with the same amount of money.

Either way, you’re introducing a margin of safety, whereby the company could misfire, or your projections could be off, but the investment could still be worth more than you paid.

So you can see that valuation is extremely important.

That’s why checking out fellow contributor Dave Van Knapp’s valuation guide for dividend growth stocks is incredibly worthwhile.

This guide, which is part of an overarching series of lessons on dividend growth investing, makes the concept of valuation a very easy pill to swallow.

However, I’m not going to just leave you with that…

I’m going to pull the curtain back on a high-quality dividend growth stock that appears to be undervalued at its current price.

Cardinal Health Inc. (CAH) is a major distributor of pharmaceuticals and medical supplies to a variety of healthcare clients.

What we know is that the world is growing older, richer, and larger.

As these demographic trends continue, demand for high-quality medical care will only increase over time.

And that’s why I love investing in a company like Cardinal Health.

All of those pharmaceuticals and medical supplies that you see at your local pharmacy don’t just arrive magically. No, companies like Cardinal Health distribute these products to customers all over the country.

In fact, they serve more than 20,000 pharmacies. In addition, they provide resources to more than 75% of the hospitals across the country, and they provide 1.8 million patients at home with a variety of products in home healthcare.

And seeing as how being a middleman can be a brutal business in terms of margins, scale definitely matters.

Well, Cardinal Health is generating well over $100 billion in revenue per year.

Scale, indeed.

But before we delve into that any more, let’s first consider the dividend growth pedigree here.

I must say that this is a stock that definitely gets the growth aspect of dividend growth correct.

Cardinal Health has paid its shareholders increasing dividends for 20 consecutive years.

So we’re talking increasing payouts straight through the dot-com bubble, 9/11, the financial crisis, numerous industry changes, and political upheaval every 4-8 years.

If that’s not impressive enough, the company’s 10-year dividend growth rate is a monstrous 22.7%.

Even after a couple decades of dividend increases, Cardinal Health continues to pump out major raises for its shareholders. A great example is the most recent dividend increase, announced last May, which was 16%.

On top of that growth, you’re getting a very appealing yield of 2.43%.

It’s not often you see a dividend growth rate well into the double digits along with a yield that’s so significantly higher than the broader market. I mean, you’re getting market-beating yield and growth here.

Keep in mind, too, that the five-year average yield for the stock is only 2.0%.

That means the current yield is more than 40 basis points higher than its five-year average.

This goes back to what I was mentioning earlier about undervaluation providing for a higher yield.

And with a payout ratio of just 43.6%, Cardinal Health has plenty of room to continue that dividend growth streak for many years to come.

In fact, I suspect that the next dividend increase might also be double digits.

There’s just a lot to like here in regard to the dividend.

Decades of dividend growth, appealing yield, huge dividend growth, and moderate payout ratio.

It checks pretty much every box across the board.

But in order to develop a reasonable expectation as to what to expect in terms of dividend growth moving forward, we must first see what kind of underlying growth Cardinal Health is generating.

So we’ll look at the last 10 years’ worth of revenue and earnings per share growth, and then we’ll compare those numbers to a near-term forecast for EPS growth moving forward.

Taken together, these figures should give us a pretty good idea of what kind of growth Cardinal Health is really generating.

Revenue for Cardinal Health is up from $86.852 billion in fiscal year 2007 to $121.546 billion in FY 2016. That’s a compound annual growth rate of 3.80%.

Not spectacular top-line growth here, but that’s to be expected when you’re working with such huge numbers. You have the scale to overcome thin margins, but the drawback to that is that growth is a bit hard to come by when absolute numbers are so huge.

Nonetheless, the bottom-line growth fared a lot better thanks to a significant reduction of the outstanding share count – the share count is down by about 18% over this time frame.

The company increased its EPS from $2.07 to $4.32 over this 10-year period, which is a CAGR of 8.52%.

Looking out over the next three years, S&P Capital IQ believes Cardinal Health will be able to compound its EPS by an annual rate of 13%.

That would be a nice acceleration from what’s been generated over the last decade. S&P Capital IQ believes some recent acquisitions (including Harvard Drug Group and Cordis) will be accretive. They also believe substantial share repurchasing will continue to provide a nice boost to EPS growth.

The rest of Cardinal Health’s fundamentals across the board are pretty strong.

The balance sheet is extremely strong, with a long-term debt/equity ratio of 0.75 and an interest coverage ratio that’s sitting over 13.

As mentioned earlier, the margins are thin in this business.

Over the last five years, the company has averaged net margin of 0.99% and return on equity of 16.06%.

The profitability is right in line with what you want to see in this business.

All in all, this is a really solid business.

The dividend yield, growth, and sustainability are all there.

And you’ve got great underlying growth, a rock-solid balance sheet, and good profitability.

You really can’t effectively or efficiently operate in this industry without massive scale. And seeing as how there are three major players – an oligopoly – that are thoroughly entrenched, Cardinal Health should continue to make plenty of money for their shareholders for many years to come.

And that also means bigger dividends.

With all that said, you might not expect the stock to be cheap in a broader market that is sitting near its all-time high.

But I’d argue the stock actually looks quite undervalued right now…

The stock’s P/E ratio is 17.96.

That’s well below the broader market.

More importantly, it’s substantially lower than the stock’s own five-year average P/E ratio of 27.3.

Investors are also paying much less for the company’s cash flow than they typically have, on average, over the last five years.

And as noted earlier, the stock’s yield is more than 40 basis points above its recent historical average.

So the stock does look cheap. But how cheap is it? What’s a good estimate of its intrinsic value?

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 pretty reasonable, in my view, when you look at the demonstrated dividend growth over the last 20 years, along with the modest payout ratio. Plus, underlying EPS growth moving forward looks strong. The DDM analysis gives me a fair value of $96.96.

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.

Wow. So my viewpoint indicates a stock that is very undervalued right now.

Of course, my viewpoint is just one of many. That’s why I like to compare my valuation with what professional stock analysts come up with.

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 CAH as a 3-star stock, with a fair value estimate of $79.00.

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 CAH as a 3-star “HOLD”, with a fair value calculation of $83.90.

It looks like I’m not the only one who feels this stock is undervalued at this price. Averaging out the three numbers gives us a final valuation of $86.62, which would mean the stock is potentially 17% undervalued here.

CAH_chartBottom line: Cardinal Health Inc. (CAH) is a major and entrenched player in an industry with huge long-term tailwinds. They’ve paid shareholders increasing dividends for two straight decades, and I don’t see that changing any time soon. With the possibility of 17% upside on top of huge dividend growth and a yield that’s well above its recent historical average, this stock looks like a great idea for long-term dividend growth investors.

— Jason Fieber

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