You’re born. You go to school. You work for most of your waking hours for about 40 or so years. You retire for a few years. Then you die.
This is the overarching paradigm of life that most people believe is an unbreakable truth.
But I experienced a massive paradigm shift in my own life that I believe is possible for almost anyone else.
That paradigm shift is financial independence, which can be achieved by living below your means and investing in high-quality dividend growth stocks.
Financial independence allows one to circumvent the who’e “9-5 till 65” grind, freeing up resources that can be instead directed toward passions, relationships, experiences, and the pursuit of happiness.
But one cannot break the mold without taking action. The onus is always on the individual to blaze a new path forward in life.
However, I’ve taken it upon myself to do whatever I can to motivate and inspire you readers by providing actionable ideas.
And that’s what today’s article is all about.
I’m going to highlight a high-quality dividend growth stock that appears to be undervalued right now.
Dividend growth investing is an extremely powerful long-term investment strategy, perfectly suited to the idea of achieving financial independence at an early age.
That’s because investing in wonderful businesses that pay growing dividends allows one to build a sustainable and growing source of passive income.
It’s this passive income that allows one to jettison the typical “work until you’re old and used up” routine.
Once you have enough money to cover your expenses in life, you no longer have to work for your income. While you’ll probably continue to take on activities that provide income for as long as you’re able to, financial independence offers one the opportunity to undertake activities based on pure joy and desire (not based on remuneration).
Working because you want to – not because you have to – is part of that paradigm shift.
But one needs passive income in order for this shift to occur.
Indeed, I built a real-life six-figure dividend growth stock portfolio that generates five-figure passive dividend income on my behalf, which covers all of my basic bills (rent, food, transportation, etc.) in life. This has rendered me financially free in my 30s.
One amazing aspect of this investment strategy is that these businesses are often easy to understand – and easy to find.
David Fish’s Dividend Champions, Contenders, and Challengers list certainly helps with that latter issue, as it contains invaluable and pertinent information on more than 800 US-listed stocks that have paid increasing dividends for at least the last five consecutive years.
Perusing that list will reveal hundreds of companies that are household names, selling products and/or services that people all over the world use and enjoy.
But it’s a bit more complicated than just perusing a list.
Finding a business that’s within your circle of competence is a great start. But you also want to make sure high-quality fundamentals (business growth, responsible leverage, robust profitability, etc.) are present.
In addition, paying the right price is of utmost important.
Said another way, you don’t want to pay far too much for any stock, even a great dividend growth stock.
While price is what you’re paying for something, it’s value that tells you what it’s actually worth.
And paying more than what a stock is worth is obviously never a great idea, especially if you routinely do this over and over again over a lifetime of investing.
That’s because it can inhibit your income and potential long-term total return, all while increasing your risk.
Conversely, an undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and less risk.
This is relative to what the same stock would offer if it were fairly valued or overvalued.
Price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.
That higher yield will give your long-term total return potential a boost right off the bat, as income (dividends or distributions) is one of two components of total return.
The other component is capital gain, and that, too, is given a potential boost via the “upside” that exists between the lower price paid and the higher intrinsic value of a stock.
The favorable gap between price and value that exists when a stock is undervalued serves to provide for additional possible capital gain, which is on top of whatever organic capital gain could/would occur as a business becomes worth more (as it increases its profit over time).
And when you have more upside, you naturally have less downside.
As such, undervaluation limits one’s possible risk. And the more undervalued a stock is, the less risky it likely will be.
But the key is learning how to value a business and its stock in the first place.
Fortunately, there are many resources out there designed to help an investor value just about any dividend growth stock out there.
One such resource is fellow contributor Dave Van Knapp’s lesson on stock valuation, which is part of a larger series of lessons on the dividend growth investing strategy.
Pulling all of these ideas and resources together, I’m now going to discuss a high-quality dividend growth stock that currently appears to be undervalued…
General Mills, Inc. (GIS) manufactures and markets a number of global branded food products.
Founded in 1856, General Mills is often thought of as a cereal company. Huge brands like Cheerios, Lucky Charms, Wheaties, and Cinnamon Toast Crunch contribute to that perception.
However, the company is much, much more than cereal – General Mills sports more than 100 brands in more than 100 countries.
Beyond cereal, General Mills has dominant brands in the baking, pastries, ice cream, organic food, frozen pizza, snack foods, soups, and yogurt spaces.
Brands outside the cereal space include Betty Crocker, Pillsbury, Yoplait, Progresso, Annie’s, Fiber One, Nature Valley, Totino’s, and Häagen-Dazs.
When thinking about businesses that are easy to understand, it’s tough to think of a better example than a company that produces food products like cereal, yogurt, and ice cream.
People all over the world buy and enjoy these products, which helps General Mills make a lot of money. And that in turns allows the company to share a large chunk of that profit directly with their shareholders, via a growing dividend.
General Mills has paid out an increasing dividend for 14 consecutive years.
Over the last decade, the dividend has grown at an annual rate of 10.4%.
That dividend growth rate is very impressive in and of itself, but it’s even more impressive when you consider the stock yields 3.80% right now.
Landing a yield near 4% along with double-digit dividend growth, on a packaged food company’s stock, is the kind of stuff that dividend growth investors dream of.
Moreover, that yield is 80 basis points higher than the stock’s five-year average yield.
So when I discussed how undervaluation can lead to a higher yield, more income, and greater long-term total return potential, you see that dynamic playing out here.
However, General Mills has faced challenges regarding its underlying growth as of late, with many younger consumers preferring fresher foods. This has caused recent dividend growth to slow way down – the most recent dividend increase was less than 2%.
While I wouldn’t expect General Mills to continue with that level of disappointing dividend growth moving forward, it would also seem to be unreasonable to expect ~10% dividend growth moving forward. The real answer – the base expectation for long-term dividend growth – likely lies somewhere in the middle.
The payout ratio has climbed somewhat significantly over the last decade. It’s now sitting at 70.3%.
What’s happened here is, the company has been increasing its dividend faster than the rate at which the business has grown. That’s why I believe a resetting of expectations regarding dividend growth is prudent.
That said, the long-term business growth looks a lot better than 2%.
Let’s now move on to that business growth.
In order to value the business and its stock, we must first gauge business growth. It’s nigh impossible to value a business without knowing growth.
So we’ll look at what General Mills has done over the last decade (a pretty good proxy for the long haul), keeping in mind that the last decade was particularly challenging for the company (factoring in the financial crisis, Great Recession, and changing consumers’ tastes).
We’ll then compare that historical top-line and bottom-line growth to an estimate of near-term future profit growth.
Combining the past and the anticipated future in this manner should give us a pretty good look at the company’s business growth, with that business growth ultimately fueling dividend growth.
General Mills has increased its revenue from $13.652 billion to $15.620 billion between fiscal years 2008 and 2017. That’s a compound annual growth rate of 1.51%.
The company was actually on a great revenue growth trajectory up until about FY 2014, at which point sales growth stalled and even turned negative. The result here is clearly disappointing, and the company has its work cut out for it, but it’s not like it’s a broken story. We’re talking basic food products here.
Bottom-line growth fared a bit better due to share buybacks, with earnings per share advancing from $1.86 to $2.77 over this same 10-year stretch. That’s a CAGR of 4.52%.
A similar story plays out with the company’s EPS – everything looked pretty good up until FY 2014. The greater portion of the last decade showed the company’s prowess and potential, but the last few years have really taken some shine off of this name.
However, some shine has come off of the stock’s valuation, too, which is why this stock is being featured for today’s article. The stock is down almost 30% since July 2016. While a resetting of the valuation in line with reduced expectations is appropriate, there’s nothing that indicates this company is somehow permanently broken.
Looking out over the near term, CFRA is predicting that General Mills will compound its EPS at an annual rate of 7% over the next three years.
That would be an acceleration from what we see manifested over the last decade. Part of that expectation is based off of organizational streamlining, which should reduce costs and improve margins.
One other area of real potential for General Mills is international sales. The vast majority (over 75%) of the company’s sales come from North American retail and foodservice products. This leaves a lot of room for international expansion.
Overall, I don’t see why the company can’t normalize growth and put itself in a position to come near CFRA’s expectation both over the near term and long term.
One area of potential improvement is the balance sheet. While General Mills is not overly leveraged (especially in comparison to some of its peers), the balance sheet is not particularly impressive.
The long-term debt/equity ratio is 1.77, while the interest coverage ratio is a bit under 9.
While the balance sheet is good but not great, profitability is a strong suit for the company.
If they are able to improve margins – the possibility is noted above – that would be coming off of a rather robust base.
Over the last five years, the company has averaged net margin of 9.68% and return on equity of 29.43%.
Net margin came in at 10.61% for FY 2017. These are very strong numbers for this space.
There’s a lot to like about this dividend growth stock.
It’s an easy-to-understand business model. While growth has been a bit disappointing over the last decade, the strong margin, international growth potential, and fantastic lineup of brands bode well for the company.
Trix are for kids. But dividends are for adults.
And I believe General Mills will continue delivering on the latter precisely because of wonderful and well-known brands like the former.
With the drop in price and valuation over the last 15 months, the stock now looks fairly appealing…
The P/E ratio is sitting at 18.45. That’s lower than the broader market and the industry average – by a good measure. It’s also lower than the stock’s five-year average P/E ratio of 20.6. And as noted earlier, the current yield is significantly higher than the recent historical average (although that’s partly due to the expanded payout ratio).
So the stock is cheaper than it usually has been over the last five years, but how undervalued might it be? 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 a long-term dividend growth rate of 6.5%.
That DGR basically splits the difference between the 10-year demonstrated DGR and the most recent increase. It’s a resetting of expectations, although it’s also below CFRA’s near-term forecast for EPS growth.
There’s some cautiousness here on my part due to recent disappointing growth. But keep in mind this is a long-term valuation model.
The DDM analysis gives me a fair value of $59.64.
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.
I don’t find the stock to be wildly undervalued. It’s not massively cheap here. But it’s a solid food company. The yield is near 4%. And the potential for growth acceleration is there. However, my opinion isn’t the only one around. I like to compare my viewpoint to that of what professional analysts come up with, which adds perspective and depth.
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 GIS as a 4-star stock, with a fair value estimate of $58.00.
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 GIS as a 4-star “BUY”, with a fair value calculation of $49.48.
It’s interesting the latter firm would recommend a stock they believe is overvalued. But their 12-month target price is very close to what I came up with for intrinsic value. Nonetheless, averaging the three numbers out gives us a final valuation of $55.71, which would indicate the stock is potentially 8% undervalued here.
Bottom line: General Mills, Inc. (GIS) is a high-quality food products company with a corporate history dating back more than 160 years. Over 100 brands in over 100 countries gives the company massive international growth potential. While investors wait for improvements to take hold, you can count on a yield near 4%, along with the potential for 8% upside. This is a pretty unique combination of yield, quality, and value in this space. Dividend growth investors should take a close look at this one.
— Jason Fieber
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