This Dividend Growth Stock is Potentially 20% Undervalued

Why work for your whole life if you don’t have to?

That’s a question that assumes there’s another possibility other than actually working at a day job to sustain yourself until you collect some type of retirement income (be it Social Security, pension income, or income from retirement plans you have).

But there is another way.

The method I follow is to live below my means and aggressively invest my excess cash flow into high-quality dividend growth stocks.

Taking a look at my real-life, real-money portfolio will show you what I’m talking about.

[ad#Google Adsense 336×280-IA]Dividend growth stocks are wonderful in that they actually pay you to own them.

Just like if you were to own a business outright, you want to collect your rightful piece of the profit a business you own a small part of generates.

Who wants to own a business (be it the entire thing or just a piece of it) and not collect a share of the profit?

Well, dividend growth stocks represent equity ownership in the types of businesses that agree with that premise.

These businesses generally increase their profits over longer periods of time because they tend to sell products and/or services that people and/or other businesses all over the world demand. Better yet, they share a piece of those growing profits with shareholders in the form of growing dividends. It’s a wonderful arrangement.

You can find more than 700 specimens via David Fish’s Dividend Champions, Contenders, and Challengers list, which is an incredible resource that tracks every single US-listed stock with at least five years of demonstrated dividend growth.

An eventual outcome of saving your money and regularly investing it into high-quality dividend growth stocks is that you end up generating enough passive and growing dividend income to live off of, basically rendering you financially independent.

My personal portfolio (which I linked to above) should spit out more than $10,000 in dividend income this year. Not enough to live off – yet. But I’m only 33. I’m still saving and investing.

However, there’s a little bit more to it than that.

First, you want to focus on quality.

There’s a reason why I have inserted that word multiple times in this article.

While you can maybe make money by investing in low-quality businesses if you time things right, I don’t believe that’s a great way to approach long-term investing with the explicit goal of generating enough growing dividend income to one day live off of.

Why invest in a business that isn’t profitable and doesn’t have any clear competitive advantages when you have great businesses out there that have become so proficient at being increasingly profitable and competitive that they basically regurgitate cash flow?

But perhaps just as important, you also want to focus on value.

Stocks are really no different than other merchandise in that you don’t want to knowingly and unnecessarily pay more than you should.

In fact, you should be actively looking to pay less.

How does one go about that?

The first thing is to understand that price and value are very much not the same thing.

Price is simply what you pay for something. It’s how much money you have to exchange for something.

Value, however, is what something is actually worth. Value tells you what you’re getting for your money, for better or worse.

Fortunately, you’re not alone in trying to determine the difference between price and value for dividend growth stocks.

A valuation system shared by fellow contributor Dave Van Knapp, published here on the site, is extremely easy to to use.

Even better news is that we can use this basic understanding to our advantage.

We specifically want to look for undervalued dividend growth stocks that are high quality.

That’s because undervalued dividend growth stocks will generally come attached with a higher yield, greater potential long-term total return prospects, more possible income growth, and less risk.

All else equal, a lower price will equate to a higher yield.

And what does a higher yield mean? More money in your pocket on the same investment size!

Since we know that yield is a major aspect of one’s total return, you’re automatically increasing your potential long-term total return prospects when seeking a higher return than you otherwise would have had.

That’s not to mention the additional upside possibility that exists if you buy a stock less than it’s worth.

You could be locking in more capital gains above and beyond what already might exist from the natural appreciation of shares as the underlying business improves and becomes worth more over time.

If you buy a stock at $50 when it’s worth $75, you put chances of that $25 gain on your side if the market realizes the mispricing that’s taken place and closes the gap. That’s in addition to the likelihood that the stock becomes worth more than $75 over time as the business becomes bigger and better.

Of course, a $75 stock could become worth $50 or less over time, too.

Now, I think the odds of this happening when one focuses on high-quality stocks is somewhat slim. Always possible but unlikely.

But that’s also why we want to buy when a stock is undervalued. If a stock that was worth $75 becomes worth $50 over time due to deterioration in business fundamentals, you’re still in pretty good shape when you pay $50.

Buying when a stock is vastly undervalued puts a margin of safety in your favor, thereby reducing your risk.

You see the benefits of focusing on high-quality dividend growth stocks that are undervalued.

How do we put this into practice, though?

I’ll show you how that works by naming and dissecting such a stock below!

Emerson Electric Co. (EMR) is an industrial conglomerate that designs and supplies product technology and solutions for industrial, commercial, and consumer markets.

So we just discussed the premise of investing in a company that is able to routinely increase its profit over the course of many years, and then you have to have that penchant for sharing that with shareholders in the form of growing dividends.

Well, this is about as good as it gets, folks.

Emerson Electric has increased its dividend for 59 consecutive years.

One of only a very small handful of companies in the entire world that can lay claim to a track record like that, which is true because of how difficult it is.

First off, being in operation for almost 60 years is tough. Many businesses can’t even do that.

But to then pay and increase dividends for that kind of stretch is truly amazing.

That requires properly managing through changes in the industry, economic downturns, stock market crashes, technological advances, inflation, war, and competition. Not an easy feat, making Emerson that much more special and rare.

One thing that helps this business in that regard is their diversification.

They’re an old-fashioned “industrial” firm at first glance, but the business goes much further than that.

Emerson operates through five business segments: Process Management, Industrial Automation, Network Power, Climate Technologies, and Commercial & Residential Solutions.

Through these segments, they manufacture and provide products ranging from wind turbine controls to electric motors to compressors to power tools.

In addition, they offer services ranging from process automation to thermal management.

They’re exposed to almost every industry out there, so labeling them as an “industrial” firm is somewhat simplistic.

And the company believes its installed base of systems represents over $250 billion of infrastructure architecture, which means Emerson has been firmly committed to by its clients. This should keep the company for years to come.

Getting back to that dividend, though, we already see how impressive that lengthy track record is.

CaptureBut it’s not just the length of time we’re talking about here.

Over the last decade, the company has increased its dividend at an annual rate of 8.4%.

Not the biggest growth rate out there, but it’s still far higher than what inflation has averaged over that period. Moreover, you have to keep in mind that even almost 60 years in, Emerson is still growing that dividend at a rather high rate.

However, their dividend growth can be lumpy from one year to the next, reflecting any changes in their underlying business operations, which in turn reflects any changes in the broader economy due to their vast exposure to multiple industries.

For instance, the most recent increase was just a little over 1%, which is obviously disappointing. But I think it’s important to not be myopic about this stock.

What’s also important to keep in mind is that the stock yields 4.10% right now.

So dividend growth might be a little lacking right now since Emerson has seen some slowdowns in many areas of its business, notably due to the volatility in the energy patch right now (approximately 1/3 of Emerson’s sales last fiscal year came from this sector), but you’re getting a very, very appealing yield to make up for some of that.

That yield is roughly double that of the broader market. It’s also almost 100 basis points higher than the five-year average yield of 3.1% for this stock.

So those benefits I laid out earlier when it comes to buying undervalued stocks is clearly laid out here with that big yield.

What’s great is that you know that Emerson knows what it’s doing. It doesn’t build up this kind of track record by mismanaging the dividend.

The payout ratio is 50.7% right now, which is actually quite conservative.

Management is clearly being conservative right now. Rather than hand out big raises that could be unsustainable if the business has further issues, resulting in a dividend cut, they’re being prudent. I think that’s a good thing.

All in all, the dividend metrics here are almost as good as it gets. You’ve got a huge yield, moderate payout ratio, and a dividend growth track record that is almost second to none.

However, we really want to look at underlying top-line and bottom-line growth to see exactly what kind of progress the business is making. If a company can’t grow, the dividend will eventually stop growing, too.

Looking at growth will also tell us a lot about what the business is worth. Obviously, a faster-growing business is more attractive than a business that is growing more slowly, and will deserve a higher multiple of its profit.

But we always want to make sure we’re paying the appropriate price, regardless of growth.

I like to always look at the prior decade for any company. 10 years is a good time frame to get a feel for what a company is capable of, and that kind of time frame tends to smooth out short-term cycles or other temporary headwinds.

Revenue for Emerson grew from $20.133 billion in fiscal year 2006 to $22.304 billion in FY 2015. That’s a compound annual growth rate of 1.14%.

Not really what we want to see here, but the last decade has been challenging for a number of firms. There was the financial crisis and the ensuing Great Recession. Growth since then has also been challenging across the world.

However, the company increased its earnings per share from $2.24 to $3.99 over this period, which is a CAGR of 6.62%.

Respectable bottom-line growth for a firm like this. Steady share repurchases greatly helped this, with the company reducing its outstanding share count by approximately 18% over the last decade.

S&P Capital IQ foresees this type of growth rate continuing, calling for 8% compound annual growth for Emerson’s EPS over the next three years.

With the challenges that Emerson has been seeing across most of its business lines, this could prove to be optimistic. But Emerson has “been there, done that”, operating and prospering through many difficult periods. I don’t see anything that would indicate this time is different.

Further evidence of the company’s quality and flexibility is the balance sheet.

For a company that is sensitive to broader economic moves in either direction, it’s important to be flexible in regards to debt. Being strategic with your debt during times of distress can be a great advantage, while being weighed down with debt can be a great hindrance in terms of growth and how much cash flow is available for shareholders.

The company’s long-term debt/equity ratio is 0.53.

And an interest coverage ratio of over 21 indicates a very healthy amount of leverage when weighed against earnings.

Moreover, Standard & Poors has given them a credit rating of A.

Profitability is another strong suit for Emerson, with numbers that are not only fantastic in absolute terms but also very, very competitive for the industry.

Over the last five years, the firm has averaged net margin of 9.48% and return on equity of 22.67%.

Better yet, there’s been a steady and noticeable uptrend with the profitability since fiscal year 2012.

So, overall, I think it’s fair to say that Emerson checks off the boxes for quality.

You’re getting a great balance sheet, solid profitability, fairly decent underlying growth considering the environment, a broadly diversified business that serves almost every sector of the economy, heavy infrastructure build-out, and a track record for dividend growth that is nearly unmatched.

That extremely lengthy dividend growth track record should offer plenty of consolation to investors worried about today’s volatility, extending into dividend cuts across many companies in the oil & gas space. Emerson’s stock serves as a bedrock, a strong foundation when many other stocks are faltering a bit right now.

Moreover, a near-term catalyst for even more income and also potentially more upside is the previously announced spin-off of the company’s Network Power business. Emerson has stated its intention to keep the dividend unchanged after the separation of this segment, with the separated business potentially even paying a dividend of its own.

Sales were admittedly down about 9% in FY 2015 compared to the prior year. And the company’s large energy exposure, while not uncommon among businesses that have any type of manufacturing operations, is a potential short-term liability. In addition, one has to consider that FY 2015’s results included a one-time divestiture gain of $0.90 for EPS.

But the stock is down more than 25% since the beginning of 2015. That means Emerson has lost more than ¼ of its market cap in just over a year.

This could be a great opportunity to get a high-quality dividend growth stock at an appealing valuation.

The stock trades for a P/E ratio of 12.35 right now. That’s substantially lower than both the broader market and the stock’s own five-year average P/E ratio of 19.1. Even factoring out the aforementioned divestiture gain, the stock is still notably cheap on a price-to-earnings ratio basis. Moreover, the stock’s current yield is very high both in absolute and relative terms, currently sitting more than 100 basis points higher than it’s averaged over the last five years.

Seems incredibly cheap for the quality of the business and the legacy of dividend growth. But what would be a fair price to pay? What’s a reasonable estimate of the stock’s intrinsic value?

I valued shares using a dividend discount model analysis with a 10% discount rate and a 6.5% long-term dividend growth rate. That growth rate is lower than both the five-year and ten-year dividend growth rates the stock has made good on. Factoring in the moderate payout ratio, continued buybacks, and forecast for underlying growth moving forward, I think there’s a solid margin of safety in that assumption. The DDM analysis gives me a fair value of $57.91.

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.

Even with a conservative model, there’s still a significant margin of safety based on the valuation I’m looking at. However, it’s a big world out there with a lot of eyeballs on Emerson’s stock. Let’s take a look at some professional analysts’ opinions on the stock’s valuation.

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 $47.30.

So we’ve got three different numbers there. That’s why I like to blend them together, averaging out the three valuations so as to come up with something fairly conclusive. Blending three totally different opinions with different methodologies gives us a final valuation of $55.74, indicating the stock is potentially 20% undervalued right now.

eBottom line: Emerson Electric Co. (EMR) has a nearly unmatched track record for dividend growth, built on the foundation of a truly wonderful business. The company has operated through some challenges lately, but the stock’s steep decline over the last year has provided the opportunity to buy into a great business at a very attractive valuation, with the potential for 20% upside on top of a 4%+ yield. This could be one of the best long-term opportunities available right now.

— Jason Fieber