My primary goal as an investor is to build a portfolio of dividend growth stocks so large that it generates enough growing dividend income for me to live off of.
At that point, I’ll consider myself financially independent.
I’m trying to hit that mark where dividend income exceeds expenses by 40 years old, which I’m on pace for.
As such, you can imagine that I’m always on the lookout for undervalued dividend growth stocks that are still high quality.
[ad#Google Adsense 336×280-IA]Why wouldn’t I be?
All else equal, a cheaper dividend growth stock will sport a higher yield.
And that’s because price and yield are inversely correlated.
Said another way, a stock paying out $2.00 per year will yield 4% at $50 per share.
But what if you could snag that same stock at $40 per share?
Your yield climbs to 5%.
That’s a 100-basis point spread!
So if we assume that stock is worth $45 per share, paying $50 is paying $5 too much. Not only did you essentially “waste” $5, but you accepted a lower yield than you otherwise could have had if the stock were priced more appropriately.
And since the stock market recognizes value over the long run – even if prices can be irrational over the short term – you’re putting capital at risk by overpaying.
Paying $40, on the other hand, for that same stock not only increases your yield dramatically, but it also allows you a margin of safety.
That margin of safety is there so that in case you’re wrong about your assumptions or the company doesn’t perform as expected, you can still eke out a solid return that is helped significantly by that higher yield.
I’d recommend checking out Dave Van Knapp’s valuation guide if you haven’t already. It pieces together a holistic system designed to value dividend growth stocks. So that could be incredibly helpful if you find it difficult to separate price from value.
These dividend growth stocks I invest in and write about all the time are stocks that have lengthy track records of not just paying dividends to shareholders, but also frequently and reliably increasing the amount of those dividends.
And you’ll find more than 700 of these dividend growth stocks (those that are US-listed) on David Fish’s Dividend Champions, Contenders, and Challengers list, which is the most robust and in-depth resource on dividend growth stocks that I’m aware of.
Taking a quick look at Mr. Fish’s list and crosschecking some of the stocks there against a few valuation metrics is always a great way to find some interesting investment opportunities by weeding out the undervalued stocks.
What we do with this weekly series is do the work for you and present the results.
Want a higher yield and a larger margin of safety? Read on.
Let’s check out a dividend growth stock on Mr. Fish’s list that is potentially undervalued right now…
Praxair, Inc. (PX) produces, distributes, and sells atmospheric and process gases, as well as surface coatings, globally. Their primary product offerings include oxygen, helium, and nitrogen.
They are the largest industrial gas supplier in both North America and South America, as well as one of the largest suppliers worldwide.
Supplying industrial gases is a very lucrative business model due to the fact that many companies require a constant and reliable supply for many different production processes.
The wide array of industries that Praxair supplies to include manufacturing, marketing, electronics, aerospace, energy, and chemicals.
Even better, Praxair generally provides its products and services after long-term contracts are signed which allows Praxair to build and supply on-site, guaranteeing revenue out for many years.
This attractive model has in part allowed the company to increase its dividend for the past 22 consecutive years.
And over the last decade alone, they’ve increased their dividend to shareholders at an annual rate of 15.8%.
Pretty impressive stuff there, especially considering you’re getting a yield of 2.76% right now.
Combining that yield with the growth rate indicates pretty good prospects for high total returns. In addition, that current yield is not only well above the broader market, but it’s also substantially higher than the 1.9% this stock usually yields.
The payout ratio sits at 55.8% right now, which is moderate. However, it’s temporarily elevated thanks to recent earnings per share results that have been negatively impacted by currency effects.
All in all, though, it’s tough to dislike these numbers.
You’re getting a pretty appealing yield in absolute terms that’s much higher than its recent historical norm.
And that dividend is likely to continue growing for the foreseeable future, perhaps at a higher level than as of late if currency effects reverse.
So we’ll now go ahead and check the underlying growth in revenue and earnings per share over the last decade. This will tell us a lot about where the business has been as well as where it might be going, which will also help immensely when it comes time to value the company’s stock.
Praxair’s revenue increased from $7.656 billion to $12.273 billion from fiscal years 2005 to 2014. That’s a compound annual growth rate of 5.38%.
Looking at profit growth on a per-share basis, EPS is up from $2.20 to $5.73 over this ten-year stretch, which is a CAGR of 11.22%.
The bottom line was helped greatly by the reduction in outstanding shares as the company regularly repurchases stock, leading to a rather solid result even in the face of challenges like the Great Recession and strong dollar.
The outstanding share count was reduced by approximately 10% over the last decade and the company continues to buy back stock – they recently authorized a new $1.5 billion repurchase program (about 1.5% of the company’s market cap).
Looking at future growth, S&P Capital IQ anticipates that Praxair will grow its EPS by a compound annual rate of 6% over the next three years.
This seems to be in line with recent guidance by Praxair, with currency currently affecting the company somewhat significantly. However, the company has noted that they’re in a position to realize highly accretive growth when markets recover.
Praxair’s balance sheet also lends credence to the quality of the firm. The long-term debt/equity ratio is 1.54 and the interest coverage ratio is over 14. So there’s leverage there, but nothing particularly concerning.
The company’s profitability, however, is outstanding. Over the last five years, Praxair averaged net margin of 14.14% and return on equity of 27.26%. These metrics are well in excess of major competitors.
Overall, I think Praxair is a fantastic firm that’s currently facing some growth issues due to currency effects. But long-term contracts that ensure great revenue visibility, excellent profitability, and a yield that’s substantially higher than its recent historical norm could all be combining to present an opportunity here.
What kind of opportunity do we have?
The stock’s current P/E ratio is 20.18. That’s not much lower than the five-year average for this stock, but the company’s EPS is temporarily lower than normal. So I view this P/E ratio as deceivingly high, although it’s still lower than what it usually would be for this stock.
Okay. So what is the stock actually worth? What should we pay?
I valued shares using a dividend discount model analysis with a 10% discount rate and a long-term dividend growth rate of 7.5%. I think there’s a sizable margin of safety present there since the long-term growth rate for both EPS and the dividend is much higher than my input there. But I am factoring in near-term challenges. The DDM analysis gives me a fair value of $122.98.
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 believe we’re quite possibly looking at a very undervalued stock right now, but let’s compare my analysis and valuation with that of what some professional analysts that track this stock have 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 PX as a 4-star stock, with a fair value estimate of $125.00.
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 PX as a 3-star “hold”, with a fair value calculation of $107.30.
So I came in pretty close to Morningstar there, but all three numbers indicate undervaluation. I like to average out the three numbers so that we can work with one, final number. That smooths out the results and gives us something to focus on. That number is $118.43. That valuation indicates the stock is potentially 12% undervalued right now.
Bottom line: Praxair, Inc. (PX) is a high-quality company providing necessary industrial gases to a variety of companies in a variety of industries, often within the construct of long-term contracts and on-site facilities. The 22 years of dividend growth looks set to continue and the yield right now is substantially higher than what this stock usually offers. In addition, there’s the potential for 12% upside. This stock could immediately improve your portfolio.
— Jason Fieber, Dividend Mantra