When I first set out to create a passive income stream back in early 2010, I figured I’d have a hard time with it.
I mean, if creating passive income were so easy, everyone would be doing it.
Well, some people lack the motivation, interest, or knowledge necessary to do so.
But that isn’t to say it’s a particularly difficult endeavor.
There are actually a number of strategies out there one can use to create passive income for themselves, potentially allowing one to retire early and go about life without concerns about income.
Dividend growth investing is my favorite strategy of all.
When I came across the concept of dividend growth investing, I was hooked.
Dividend growth investing is basically buying and holding high-quality stocks that pay growing dividends.
You mean to tell me a company will pay me a growing dividend payment simply for buying and holding its stock?
That’s pretty much the gist of it.
There are more than 800 US-listed stocks that have paid increasing dividends to their shareholders for at least the last five consecutive years, and you can check them all out by taking a peek at David Fish’s Dividend Champions, Contenders, and Challengers list.
Indeed, many stocks on Mr. Fish’s list have paid out increasing dividends for decades.
Just imagine that.
You buy a stock. You hold it. Two pretty simple actions.
In return, you could collect a growing passive income stream for decades.
After discovering and falling in love with the idea of buying and holding high-quality stocks that pay growing dividends, I’ve spent seven years of my life building a six-figure portfolio that now generates five-figure growing dividend income on my behalf.
What do I have to do to receive this passive income?
Nothing. That’s why it’s passive.
Better yet, this passive income covers a major chunk of my personal core expenses.
As such, I’m pretty free to go about my life without having to work a job I don’t really want.
But there are no secrets here between us; you can freely access my “blueprint” for early retirement, which is pretty robust and accessible for most people.
And creating more passive income in order to potentially retire even earlier is what today’s article is about.
I’m going to discuss a high-quality dividend growth stock sourced from Mr. Fish’s list that appears to be undervalued right now.
It’s that “undervaluation” that’s key.
An undervalued dividend growth stock should offer a higher yield, greater long-term total return prospects, and less risk.
That’s relative to what the same stock would offer at a higher price that reflected fair value or overvaluation.
Undervaluation simply means the price being paid for a stock is below its intrinsic value.
Said another way, an undervalued stock is likely worth more than its price.
This disconnect between price and value leads to the aforementioned benefits, and I’ll show you how that works.
First, price and yield are inversely correlated.
All else equal, a lower price leads to a higher yield.
That higher yield means more current and ongoing income in your pocket, which is exactly what those looking to retire earlier should be looking for.
This increased income also positively impacts total return, as total return is simply the sum of capital gain and dividends/distributions. The more of both you can get, the higher your total return will be.
In addition, capital gain is also given a boost via the potential “upside” that exists between the lower price paid and the higher intrinsic value.
While the stock market may not be terribly accurate for valuation over the short term, price and value tend to converge over the long haul.
That convergence can lead to capital gain, thus boosting total return.
All of this combines to reduce one’s risk, too.
If you’re looking at risk in terms of upside versus downside, paying less, all else equal, boosts the former while simultaneously reducing the latter.
Paying less also introduces a margin of safety, which is a “buffer” that exists just in case the value of the business drops due to unfortunate and unforeseen issues.
The less you pay, the bigger this margin of safety will be. And it also offers that downside protection.
While it might seem that all of these benefits are reserved for some secret society or something, the truth is that there are a number of systems and processes that exist solely to help an investor estimate a stock’s fair value, which allows an investor to pick stocks that appear to be priced below their intrinsic worth, thus offering these benefits.
One such system is a valuation guide introduced by fellow contributor Dave Van Knapp, which is part of an overarching series of lessons on dividend growth investing.
Once you have an undervalued high-quality dividend growth stock in sight, it’s simply a matter of deciding whether or not to invest.
But to make things even easier for you readers, I’m going to share a stock that appears to be undervalued right now.
Amgen, Inc. (AMGN) is a global biotechnology company that develops and manufactures a range of human therapeutics.
Amgen is a giant among biotechnology firms, sporting some of the world’s most successful drugs and a market cap near $120 billion.
It’s their size and scale that offers some semblance of safety in a field that can be fraught with risk due to spending on R&D that may not pan out as expected.
However, Amgen already has a stable of high-profile and very profitable drugs that include the likes of Enbrel, Sensipar, Epogen, and Aranesp.
In addition to several existing and maturing big-money treatments in oncology and immunology, they have a strong pipeline of drugs that continue to roll out.
This all leads to a lot of profit that continues to grow, which helps fund a growing dividend.
Indeed, Amgen has paid out an increasing dividend for seven consecutive years.
While not the lengthiest streak around, Amgen makes up for the relatively short track record with extremely impressive dividend growth.
The three-year dividend growth rate stands at 28.6%.
While that kind of dividend growth obviously cannot and will not persist forever, a payout ratio of just 43.6% and underlying earnings growth that’s very strong (which we’ll go over soon) indicates that double-digit dividend growth can and will persist for the foreseeable future.
For perspective, the most recent dividend increase was 15%.
On top of that huge dividend growth, the stock offers a yield of 2.82%.
Both the yield and dividend growth are well above the average of the broader market.
Moreover, the stock’s current yield is almost 100 basis points higher than its five-year average.
So you can see how undervaluation can lead to a higher yield and more income right here.
But as a dividend growth investor, one wants to make sure the dividend can continue to grow for years to come.
In order to formulate a baseline expectation for that, as well as to help determine an estimate of a stock’s fair value, we need to look at how much growth a business is generating.
I consider 10 years a pretty fair proxy for the long term, as it tends to smooth out short-term fluctuations and give a “big-picture” look at a company’s revenue and profit growth.
From fiscal years 2007 to 2016, Amgen increased its revenue from $14.771 billion to $22.991 billion. That’s a compound annual growth rate of 5.04%.
Meanwhile, earnings per share expanded from $2.82 to $10.24 over the last 10 fiscal years, which is a CAGR of 15.41%.
The large spread between top-line and bottom-line growth can largely be explained by the company’s share repurchasing activity over the last decade – Amgen reduced its outstanding share count by approximately 33% over this period.
Looking out over the next three fiscal years, S&P Capital IQ anticipates that Amgen will compound its EPS at an annual rate of 7%, which would be a substantial drop from what we see above.
S&P Capital IQ cites legacy product sales slowdowns not being completely offset by new product sales growth.
Pharmaceutical companies can see volatile and uneven profit growth as drugs go through life cycles, although even 7% compounded EPS growth would still be a fairly strong result, supporting plenty of dividend growth.
Overall, the growth is impressive.
The company’s balance sheet is in line for the industry, with a long-term debt/equity ratio of 1.01 and an interest coverage ratio of just over 8.
Profitability is extremely robust.
Over the last five years, Amgen has averaged net margin of 28.74% and return on equity of 24.20%.
Those are huge numbers, although one should keep the debt load in mind when looking at the ROE.
Fundamentally, Amgen is a high-quality company.
You have strong revenue, profit, and dividend growth, with the dividend supported by a moderate payout ratio.
The balance sheet isn’t overly leveraged. Profitability is impressive.
With all of this in front of us, we might expect the stock to be priced at a premium, to go along with its premium quality.
But the stock actually looks cheap here…
The stock’s P/E ratio is 15.49 right now. The five-year average P/E ratio for the stock is 18.6. So the stock’s valuation is disconnected from both its own five-year average and the broader market (which has a P/E ratio above 20). And the yield, as noted earlier, is quite a bit higher than its own recent historical average, further reflecting disconnect between price and value.
So it does seem to be undervalued, but by how much? What would a good estimate of its intrinsic value be?
I valued shares using a dividend discount model analysis.
I factored in a 10% discount rate and a long-term dividend growth rate of 7.5%.
That growth rate is on the higher end of what I allow for in my models, but I think Amgen warrants it when considering the growth profile, drug diversification, payout ratio, and overall quality.
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.
The stock looks deeply undervalued to me, but I also readily admit that my opinion is but one of many. In that regard, I’m going to compare my valuation to that of what some selected professional analysis firms have come up with to in order to add perspective.
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 ranks AMGN as a 4-star stock, with a fair value estimate of $191.00.
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 ranks AMGN as a 4-star “BUY”, with a fair value calculation of $189.50.
That’s a pretty tight consensus, indicating that the stock is likely worth close to $190. In fact, averaging these three numbers out gives us a final valuation of $192.77. With the stock trading hands for closer to $164, the stock appears to be 17% undervalued.
Bottom line: Amgen, Inc. (AMGN) is a high-quality global biopharmaceutical firm that has outstanding fundamentals across the board. The stock is growing much faster than the broader market, offers a yield almost 100 basis points higher than its recent historical average, and looks primed for 17% upside. This is one of the more compelling long-term dividend growth investment ideas I have.
— Jason Fieber
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