This Dividend Growth Stock is Potentially 32% Undervalued Right Now

The US stock market is an amazing platform for building wealth over long periods of time.

It’s by far the largest and most robust market in the world, which means US citizens are some of the most naturally fortunate people around.

You have extremely easy access to some of the best businesses in the entire world – one can simply open up a brokerage account and buy shares in any publicly traded company for a few dollars per transaction.

[ad#Google Adsense 336×280-IA]With the US market compounding at nearly a double digit annual rate over its history, one’s likely to do well by buying wonderful businesses and holding them for the long haul.

The wonderful businesses that I propose one should concentrate on are dividend growth stocks like those you’ll find on David Fish’s Dividend Champions, Contenders, and Challengers list – a document that Mr. Fish tirelessly updates regularly, featuring every single US-listed stock that has increased its respective dividend for at least the last five consecutive years.

By the way, I certainly take my own advice, as you can see by checking out my real-money portfolio, which certainly spits out real growing dividends.

Looking at Mr. Fish’s list, you’ll find some of the most respected, trusted, and well-known companies on the planet.

A business model generally has to be fairly wonderful by design in order to generate the regularly increasing profit necessary to sustain higher and higher dividends for years (or even decades) on end.

So that’s somewhat of a litmus test for quality.

But what’s truly great about these stocks is the growing dividends themselves.

The dividends are a fantastic source of passive income. No need to sell shares (reducing your wealth in the process) or worry about stock prices.

Better yet, this passive income grows organically, due to the very dividend raises these stocks are so famous for in the first place. And it’s not just income growth we’re talking about but growth that tends to outpace inflation over the long run, leading to increased real income and purchasing power.

So US investors have easy access to the greatest stock market known to man, and then there are hundreds of stocks within the market that reward shareholders with growing dividends every year.

If that wasn’t good enough, even more opportunities exist!

One of the greatest opportunities for investors exist in the form of seeking out undervalued dividend growth stocks that are high quality.

Just like one can find things that are “cheap” and things that are “expensive” anywhere in the world, stocks work much the same way.

A $200 cruise that’s worth at least twice that and was $1,000 six months ago? You probably have a deal on your hands.

A top sirloin steak that’s $50 down at the local steak joint? Likely overpriced by a great degree.

So on and so forth.

But what’s great about stocks is that one can sort of drill down into a fairly reasonable estimate of intrinsic value, which is something that fellow contributor Dave Van Knapp attempted to show via his lesson on stock valuation.

Stocks are assets, and the wonderful dividend growth stocks I write about and personally invest in generate real and measurable cash flow (and share that cash flow with stockholders via those dividends), and this cash flow can be extrapolated out, which allows an investor to postulate a stock’s intrinsic value (after discounting all of that cash flow back to the current day).

One would want to pick out those high-quality dividend growth stocks that are priced less than they’re actually worth for three massive reasons:

The first thing one must consider is that we are, after all, talking about dividend growth stocks.

And all else equal (assuming no change to the dividend policy), a lower price equates a higher yield.

When a stock drops in price, the yield rises by a corresponding amount. So a stock that yields 4% at $50 will yield 5% at $40. So on and so forth.

Additionally, the very organic dividend growth that comes about when companies increase their dividends is naturally made to be even more powerful when one buys an undervalued dividend growth stock.

That’s because a dividend raise’s percentage is based off of the difference between the old dividend and the new dividend. So a company that increases its dividend from $1 annually to $1.10 annually is handing out a 10% raise to shareholders. That 10% has nothing to do with price or yield.

But that 10% raise is more powerful in compounding terms if you’re able to receive it off of a lower price and correspondingly lower yield. A 10% raise on a 5% yield is naturally much more money in your pocket than a 10% raise off of a 4% yield.

That higher yield (and more powerful dividend growth) also lends itself to potentially higher total return over the long haul.

Yield is, of course, one major aspect to one’s total return, and empirical evidence shows that dividends account for a significant portion of stock investors’ total return over the history of the stock market.

So the higher the yield, the better your potential total return over the long haul, all else equal.

Furthermore, any repricing that may occur at some point later if/when the market sees the difference between a stock’s price and value will also provide for additional capital gain.

Finally, paying less money reduces your overall risk.

Naturally, paying $40 for all future cash flow a firm can/will generate is better than paying $50 for the same stream of future money.

You’re risking less money by spending less. And you limit your downside by spending less, increasing the odds of a margin of safety just in case something goes wrong or your estimates are off.

Now, this is assuming that the company hasn’t materially and permanently deteriorated, as some price drops are warranted.

But that’s why we do our due diligence.

Well, that’s exactly what I’m about to do for you readers – you’ll see a little due diligence on a high-quality dividend growth 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 monster in the biotechnology space, with blockbuster drugs that include Enbrel, Epogen, and Aranesp.

Their extremely profitable and much-needed portfolio of drugs have inundated the company with growing profit, which they’ve decided to share with their owners (the stockholders).

The company now has a streak of six consecutive years of dividend raises under its belt.

Sure, not the lengthiest track record around, but every multi-decade stretch has to start somewhere.

And this biotech firm is proving its desire to grow its dividend aggressively; the company has increased its dividend at an annual rate of 29.9% over the last three years, with its most recent dividend increase being right in that neighborhood.

With a moderate payout ratio of just 47.8%, even with all that massive recent dividend growth, there’s still plenty of room for Amgen to continue handing out very healthy dividend boosts.

Generally speaking, a stock with such massive dividend growth will come attached with the trade-off of offering a rather low yield.

But that’s not really the case here: Amgen’s stock yields 2.63%, which is not only much higher than the broader market but also more than 100 basis points higher than the stock’s average yield over the last five years.

CaptureSo you remember those points earlier, right?

You’re getting a much higher yield to compound that huge dividend growth off of.

The dividend metrics are obviously pretty fantastic, overall.

But if Amgen isn’t doing the right things in terms of running the business and growing, it’s all for nothing.

However, that’s far from the case here.

We’ll look at the last decade for top-line and bottom-line growth, along with a forecast for near-term growth moving forward, which will combine to tell us where the company’s been, where it might be going, and what it’s likely worth right now.

Revenue growth is fairly solid, with the company increasing it from $12.430 billion in fiscal year 2005 to $20.063 billion in FY 2014. That’s good for a compound annual rate of 5.46%.

Meanwhile, earnings per share is up from $2.93 to $6.70 over the last ten fiscal years, which is a CAGR of 9.63%.

Amgen is buying back boat loads of its own stock, which has certainly helped the profit growth numbers. And I think this will be accretive due to the valuation, as I’ll go over later.

What’s notable about this growth is that it’s largely been secular. A few bumps here and there, but growth has largely been a fairly straight line up.

Extrapolating out current sales trends and guidance by the company, S&P Capital IQ believes that Amgen will compound its EPS at a 10% annual rate over the next three years. Seeing as how this is in line with what see above, there’s not much of a stretch here.

Fundamentally, the rest of the company is sound.

The balance sheet is the one area where I think some improvement could be made, however.

Their long-term debt/equity ratio sits at 1.17, with an interest coverage ratio of 6.3.

A large amount of debt isn’t uncommon among pharmaceutical and biotechnology firms, but these numbers do have room for some improvement. That said, the company is comfortably covering its interest expenses.

Profitability is outstanding, characteristic for this industry.

Over the last five years, the company has averaged net margin of 26.49% and return on equity of 20.34%.

There’s a lot to like here. The growth has been really solid over the last decade, especially in terms of dividend growth. Although, it’s likely that the dividend growth will slow seeing as how underlying profit growth has only supported some of those dividend increases – an expanding payout ratio coming off of no dividend at all seven years ago has fueled much of this.

But the company’s core products are extremely profitable, as demonstrated above. And their pipeline is robust, with 16 compounds in Phase III trials.

We have a world-class biotechnology firm here, but is the price matching the quality and growth prospects?

The P/E ratio is sitting at 18 right now. That’s not only notably below the broader market but also lower than some larger, more mature firms that aren’t growing (or expected to grow) as fast. In addition, the current yield is about as high as this stock has ever offered. All in all, paying 18 times earnings for a company expected to continue growing into the double digits seems like a pretty compelling opportunity, especially in this market.

What’s a good estimate of the stock’s intrinsic value then?

I valued shares using a dividend discount model analysis with a 10% discount rate and an 8% long-term dividend growth rate. That growth rate is on the higher end of what I usually allow for, but I think Amgen’s quality, position, growth prospects, pipeline, payout ratio, and penchant for handing out big dividend raises puts a lot of confidence in that model. The DDM analysis gives me a fair value of $216.00.

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.

We’re looking at a stock where there’s a big potential disconnect between the price it’s selling for and its intrinsic fair value. And my view on this isn’t alone.

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 AMGN as a 5-star stock, with a fair value estimate of $194.00.

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 AMGN as a 4-star “buy”, with a fair value calculation of $184.60.

So there’s some harmony here, with a general agreement that the stock is worth more than it’s selling for. I prefer to average out these numbers so as to blend the perspectives together and come up with a final valuation. Well, that final number is $198.20. That would indicate this stock is potentially 32% undervalued right now.

scBottom line: Amgen, Inc. (AMGN) has been rewarding its shareholders with monster dividend increases for six straight years, and underlying results warrant a high degree of confidence in this continuing. High-quality fundamentals and a big pipeline means Amgen is well positioned, which makes the historically-high yield and possible 32% upside all the more attractive. I’d strongly consider this undervalued dividend growth stock as a long-term investment.

— Jason Fieber, Dividend Mantra