“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
Couldn’t agree more with Warren Buffett on that one, though it’s kind of hard to disagree with anything that the greatest investor of the 20th century has to say about investing.
But what if you could buy a wonderful company at a wonderful price?
Wouldn’t that be something?
While I’m perfectly fine with paying a fair price for an outstanding business, I’m even more interested in scoring a deal on high-quality stocks.
[ad#Google Adsense 336×280-IA]Paying less than fair value for a stock, especially one that’s high quality, accomplishes so many feats with so little work.
In fact, there’s really very little work involved when it comes to buying undervalued stocks.
You simply have to refrain from paying more than fair value.
The “workload” is similar to buying groceries or clothing on sale.
There’s no work involved there. One only needs to buy merchandise for less than it’s worth.
But that’s the crux of the matter at hand.
How does one know what a stock is worth?
Knowing what a stock is worth involves determining its intrinsic value.
Price simply tells you how many of your hard-earned dollars you have to exchange or a share.
But intrinsic value tells you what you’re actually getting for that money, what a share is actually worth.
To determine intrinsic value, one has to have some kind of system in place that’s designed to separate price from value. Dave Van Knapp, a long-time writer and investor, has shared his system with you readers as part of his dividend growth investing lessons, but you’re free to use any system that works for you.
I tend to look at historical multiples and yield against what’s currently offered, and then also use a dividend discount model analysis. But I’ll go over that a little later.
Now, I mentioned that buying a wonderful stock for a wonderful price accomplishes many feats with so little work.
Those feats are pretty amazing, especially when compared to the difficulty level of the task of paying less than fair value for great stocks.
The first feat you accomplish when you pay a wonderful price for a wonderful stock is that you reduce your risk.
If you pay $50 for a stock that’s really only worth $40, you needlessly put $10 on the line. How likely is it that that shares are later repriced closer to the actual value of $40? Impossible to really determine the actual odds, but why risk it in the first place?
If you pay $35 for that same stock, you not only avoided needlessly putting excess capital at risk, but you also allowed yourself a margin of safety. Just in case you made a mistake when you valued that stock and it’s worth less than $40, you allowed for a margin of safety that gives you wiggle room. It reduces the odds that you’ll destroy capital.
Another feat you accomplish is that you increase your yield.
All else equal (assuming no change in the dividend), a lower price means a higher yield because yield and price are inversely correlated.
So if the above stock pays a $1 annual dividend, it yields 2.5% at its “fair price” of $40.
But paying $50 means you just lowered your yield down to 2%.
Conversely, paying that $35 means you boosted your yield all the way up to 2.86%.
That’s a pretty big spread there. And that makes an immediate impact on your income.
Why would you want to accept much less income on the same amount of capital put to work?
The third feat that’s accomplished when you buy an undervalued stock is that you boost your potential total return compared to what it would have been had you paid a fair price or higher.
Not only do you buy in to odds that the undervaluation that was present when you invested disappears over time, but you also, as aforementioned, increase your yield.
The combination of a higher yield and the potential for additional long-term capital gains from the closing of the spread between price and fair value means you’re increasing your possible total return.
Not only do you get the natural total return from yield and long-term capital gains that exist as a natural function of great dividend growth stocks, but you also get that additional boost from a higher starting yield and possible repricing.
It’s because of these “easy wins” that I’ve attempted to always buy high-quality dividend growth stocks for less than they’re worth.
And that mantra has resulted in the portfolio that I currently control. It’s not the biggest portfolio out there, but it’s not bad for a 33-year-old guy that built it on the income from a regular day job.
That portfolio is chock-full of dividend growth stocks.
I buy these stocks because I’m trying to attain financial independence by 40 years old, whereby my growing dividend income covers my expenses.
After looking at all the methods and strategies out there designed to build passive income that grows faster than inflation (so as to increase one’s purchasing power over time), I decided that buying equity in wonderful businesses that reward shareholders with a chunk of growing profit as the best way to accomplish what I’m after.
And if you’re also looking for these stocks, you’ll find all you can possibly handle on David Fish’s Dividend Champions, Contenders, and Challengers list.
It’s the list of dividend growth stocks, a compilation of more than 700 US-listed stocks that have all increased their dividends for at least the last five consecutive years.
So what I attempt to do is find stocks on Mr. Fish’s list that are currently undervalued so as to accomplish all of those wonderful feats in one easy stroke.
And I think we have a great candidate…
Emerson Electric Co. (EMR) is an industrial conglomerate that designs and supplies product technology and solutions for industrial, commercial, and consumer markets.
Emerson is just one of my favorite companies to invest in, which is why I have a fairy large stake in the company.
They’re one of those companies that flies under the radar but produce products and provide services that are absolutely necessary (and practically ubiquitous) across almost every major industry and end market out there.
Their products range from air conditioning compressors to electric motors to measurement devices to entire installed process management systems. These products and systems are vital to their clients.
But as a dividend growth investor, a company’s ability to pay and increase a dividend, as well as its willingness to continue doing so, is vital to me.
And it’s here that Emerson absolutely knocks it out of the park.
First, consider they’ve increased their dividend to shareholders for the past 58 consecutive years.
That’s almost six decades, folks. Just take a second to consider what kind of business model you have to have in order to send not just checks to shareholders, but checks that are larger every year for more than five decades straight.
And these checks aren’t just growing in size. They’re growing by a rather significant degree.
Over the last decade, the company has grown its dividend by an annual rate of 8.1%.
Not too shabby for a company whose operations are naturally cyclical, especially considering that this time frame includes the financial crisis and ensuing Great Recession. Nonetheless, Emerson kept on growing their dividend right through all of that.
And what’s really fantastic right now is that Emerson’s stock yields 4.38%.
That’s not only near an all-time high (eclipsed only by the depths of the financial crisis), but it’s also substantially higher than the usual yield this stock offers.
The five-year average yield for EMR is only 2.7%. So an investor buying in today is able to immediately boost their income (and potential long-term total return).
And with a payout ratio of just 52.1%, there’s still plenty of room for Emerson to continue its amazing streak of dividend growth.
The company is basically sending only a little over half of its profit in the form of a dividend, which is really just about a perfect mix of retaining profit to continue growing the company and sharing the wealth with shareholders.
Now, a dividend growth track record of almost 60 years basically speaks for itself, but let’s take a closer look at underlying operational growth across the top and bottom lines to see what we’re working with here. This will help us value the business a little later.
Revenue for Emerson has increased from $17.305 billion to $24.537 billion from fiscal years 2005 to 2014. That’s a compound annual growth rate of 3.96%.
Not outstanding growth, but one has to keep in mind the challenging economic climate for growth over this period. One attractive aspect is that Emerson’s revenue base isn’t so large to where future growth should be seriously stunted.
Meanwhile, earnings per share is up from $1.70 to $3.03 over the last decade, which is a CAGR of 6.63%.
Emerson’s commitment to buying back shares has helped generate that excess bottom-line growth: The company’s outstanding share count is down by approximately 15% over this time frame, which is rather notable.
S&P Capital IQ believes the company will compound its EPS by an annual rate of 8% over the next three years, which isn’t out of line with Emerson’s long-term proven trajectory. I think this is a pretty solid number to work with; however, the strong dollar will continue to weigh on Emerson since 54% of last fiscal year’s sales were generated outside of the United States & Canada geographical region.
A wonderful price on a fair company isn’t what we’re after, as Buffett has so eloquently pointed out. But Emerson’s balance sheet adds to the high-quality picture we’re painting here.
A long-term debt/equity ratio of 0.35 and an interest coverage ratio over 16 are both very solid numbers. Overall, Emerson uses leverage extremely responsibly, with earnings before interest and taxes able to cover interest expenses more than 16 times over.
The company’s profitability just adds to the quality proposition. Over the last five years, Emerson averaged net margin of 8.93% and return on equity of 20.99%. These are robust numbers in absolute terms (especially when factoring in the fairly low debt load) and very competitive in relative terms.
I think the case is made for Emerson being a wonderful company.
Almost six straight decades of dividend raises is the kind of track record that doesn’t just materialize out of thin air. A business has to do a lot of things right over numerous economic cycles to make that happen.
Leverage is very reasonable, profitability is strong, and the long-term growth is there.
In addition, Emerson has already announced that it’ll be spinning off its Network Power business (likely to close in the fall of 2016), which could unlock even more value for long-term shareholders.
We want a wonderful company at a wonderful price. If Emerson’s a wonderful company, is the price also wonderful?
The stock’s P/E ratio is only 11.88 right now. That’s severely below the five-year average P/E ratio of 20.2. Moreover, the price-to-book ratio is also well below its long-term average. And as mentioned above, the current yield is dramatically higher than the five-year average.
Looks to be a steal here, but what’s the stock actually worth? What’s a reasonable estimate of intrinsic value?
I valued shares using a dividend discount model analysis with a 10% discount rate and a 7% long-term dividend growth rate. That growth rate appears reasonable considering the moderate payout ratio, long-term dividend and EPS growth, and projection for profit growth moving forward. The DDM analysis gives me a fair value of $67.05.
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.
My perspective is such that this a wonderful company available for a wonderful price. But do some professional analysts agree?
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 EMR as a 4-star stock, with a fair value estimate of $62.00.
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 EMR as a 3-star “hold” with a fair value calculation of $45.50.
Fairly disparate conclusions there, which is why I like to average things out. Taking the three opinions and condensing them down into one average, we get $58.18. I think that’s a very reasonable conclusion here. And that would imply that this stock is potentially 36% undervalued right now. A wonderful company at a wonderful price, indeed.
Bottom line: Emerson Electric Co. (EMR) is a high-quality company that’s been around for 125 years, increasing its dividend for almost half that time. Its products and services stretch the gamut of global industry and geography, with its core offerings being necessary and ubiquitous. The stock appears historically cheap right now with a yield near its all-time high and the possibility of 36% upside. This strikes me as an incredible opportunity, which is why I recently added to my position. You may want to consider the same.
— Jason Fieber, Dividend Mantra