One thing I love in life is seeing a high-quality dividend growth stock available for a good price.
See, dividend growth stocks are the lifeblood of my personal portfolio.
In fact, the growing dividend income this collection of almost 100 stocks generates is just about enough to fund my core personal expenses, rendering me essentially financially independent in my early 30s.
So you’re unlikely to find a bigger fan of dividend growth stocks than me.[ad#Google Adsense 336×280-IA]Dividend growth stocks are stocks that not only pay shareholders dividends but also regularly and routinely increase those cash payouts – and it’s that organic income growth that’s so powerful over the long term.
Just imagine getting a 7% or 8% raise from your boss.
Now imagine getting that raise for 20 or 30 years in a row. Just imagine what kind of income you’d be sitting on.
Well, that’s what we’re talking about here with many of these high-quality dividend growth stocks: decades of raises in that range.
You can see what I’m talking about by checking out David Fish’s Dividend Champions, Contenders, and Challengers list.
It’s a compilation of more than 700 US-listed stocks with at least five consecutive years of dividend increases. Many stocks, however, sport decades of dividend growth.
But while these stocks are the lifeblood of my personal wealth and passive income, I don’t just go out and buy any old stock at any old price.
First, one wants to accept the truth that price and value are not one and the same.
Price is simply what you pay for something.
Value is what something is worth.
In this life, people will charge what they think they can get for something, regardless of the actual value of that something.
So it’s imperative as an investor to separate price and value and then buy those high-quality dividend growth stocks that are priced less than they’re worth.
When a stock is priced below its intrinsic value, it’s undervalued.
And when a stock is undervalued, a lot of things are working for you right away.
You first have a margin of safety.
If something is wrong with your estimate of a company’s fair value, or if the company makes a mistake or does something wrong, you have a margin of safety built in when you’re buying well below fair value.
If a stock is deemed to be worth $50 and you pay $50, you have no margin of safety there.
The company might announce a problem, or something unforeseen might happen.
This means the fair value of the company might actually drop, taking part of your investment with it.
If you instead pay $40 for that same stock, you have some breathing room.
You also lock in a higher yield, all else equal.
Price and yield are inversely correlated. A lower price, all else equal, means the yield is higher. So paying less means more income in your pocket now and, potentially, for the life of the investment.
This higher yield positively impacts your potential long-term total return and dividend growth prospects.
Locking in a higher yield has positive implications for your long-term total return since yield is one (of two) components of total return.
Of course, the other component, capital gain, is also positively impacted when you pay less by virtue of the upside created by the gap between the price you paid and the actual value of the stock. That’s in addition to any upside that was already there by virtue of underlying operations.
And dividend growth is also positively impacted since you’re basing all future dividend raises off of a higher base (yield).
And this all comes at less risk.
Which is riskier? Paying $50 for something worth $50 or paying $40 for something worth $50?
You’re naturally limiting your downside when you simultaneously maximize your possible upside. The better the deal, the lower the risk (all else equal).
Once one has mentally separated price from value, one still has to be able to actually estimate the fair value of a stock.
The good news is that this isn’t a particularly difficult task.
Numerous resources are available to help an investor accomplish this, but one great resource is available right here on the site.
Put together by fellow contributor Dave Van Knapp, the dividend growth investing lesson on valuation is definitely a worthwhile addition to any investor’s arsenal.
Better yet, I’m going to actually show you how this all works in real-time by going over a high-quality dividend growth stock that right now appears to be undervalued.
Archer Daniels Midland Company (ADM) is one of the world’s largest agricultural firms. They process a variety of food commodities including oilseeds, corn, wheat, and cocoa via an integrated business model spread out across six continents. Through their processing, they manufacture products including oils, sweeteners, feed, flour, and ethanol.
What we have here is a business model that’s really quite easy to understand.
And you have products that are basically essential to our everyday life as we know it.
Like dividends are the lifeblood of my financial independence, the food commodities that Archer Daniels Midland provides are the lifeblood of our civilization, more or less.
That’s a good reason why this stock has long been one of the best dividend growth stocks you could possibly get your hands on.
For instance, they’ve increased their dividend for the past 41 consecutive years.
Very few companies have amassed a track record quite like that.
Because it’s incredibly difficult to register the increasing profit necessary to pay out increasing dividends for decades on end.
But Archer Daniels Midland isn’t just handing out tiny dividend increases to keep a streak alive.
No, their 10-year dividend growth rate is 12.7%.
That’s obviously well over the rate of inflation, meaning shareholders are seeing their purchasing power rise year after year (if they just hang on to their shares).
And since the payout ratio is only 40.1%, the company has plenty of room for more dividend raises over the foreseeable future and beyond (absent a complete collapse in the business).
Meanwhile, you’re getting a yield of 3.42% on top of all of that.
That yield, by the way, is more than 100 basis points higher than the stock’s five-year average yield of 2.3%.
Remember what we just went over on price, value, and yield?
Well, you see that playing out right now.
The dividend metrics here, though, are just solid through and through.
More than four straight decades of dividend increases, a yield well above that of the broader market, a modest payout ratio, and dividend growth well in excess of inflation.
Really just not much left to desire here.
But I also mentioned earlier that we don’t want to buy any stock at any price.
That’s why we’ll next get into the underlying business before going on to an estimate of its fair value – we want to find out whether or not the stock appears to truly be undervalued.
Almost every valuation method in existence will require modeling out future growth, since any business is ultimately worth the sum of all future cash flow it can generate.
However, we need to know what’s already occurred in order to estimate what may yet come to pass.
And I like to look at a decade’s worth of top-line and bottom-line growth, which tends to smooth out short-term fluctuations. Keep in mind, however, that Archer Daniels Midland changed its financial reporting schedule to align with the calendar year in FY 2012.
Archer Daniels Midland’s revenue is up from $44.018 billion to $67.702 billion from fiscal years 2007 to 2015. That’s a compound annual growth rate of 4.90%.
The bottom line, however, didn’t fare quite so well on a GAAP comparison basis.
Earnings per share is actually down from $3.30 to $2.98 over this period, which is a CAGR of -1.13%.
We obviously don’t want to invest in businesses that are shrinking. So what happened here?
Well, Archer Daniels Midland recorded record EPS in FY 2007 due to a number of special items that substantially affected their results. These special items included one-time gains in the company’s interests in certain Asian joint ventures, realized security gains, and the sale of certain businesses.
All told, this added $0.98 to FY 2007’s EPS.
Factoring out these substantial one-time gains, EPS compounded at an annual rate closer to 3%.
Still not fantastic due to some margin compression and what’s been a steep drop in the price of some of their commodities over the last year or so.
While a 10-year period is generally a good point of reference for most companies, any business that operates in a cyclical industry may not hold up well.
That’s because one needs to consider what happened over that period. If the period starts with a strong result and ends when the cycle is near the bottom, that could result in a negative growth rate.
That said, S&P Capital IQ is predicting that ADM will grow its EPS at a compound annual rate of 6% over the next three years. ADM’s core business is growing at this rate or better over long stretches, generally speaking. After all, you don’t get more than 40 consecutive years of dividend growth, a 10-year dividend growth rate well into the double digits, and a modest payout ratio otherwise.
One area of a company that says a lot about quality is the balance sheet.
And I’m not disappointed here.
Archer Daniels Midland sports a long-term debt/equity ratio of 0.32 and an interest coverage ratio over 8.
Solid numbers by themselves, but it’s also notable that the company’s balance sheet hasn’t markedly deteriorated over the last decade. While many other company’s have been gorging on cheap debt (you can argue the merits of that either way), Archer Daniels Midland is actually sitting on a debt position that’s similar to what they had 10 years ago.
Profitability, however, is an area where this company doesn’t shine bright.
Now, one must consider that this is just a low-margin industry. And compared to the next-largest competitor, ADM is doing very well. But the profitability still isn’t exactly something to write home about.
Over the last five years, the firm has averaged net margin of 1.97% and return on equity of 7.74%.
The good news here is that after a lull around FY 2012, both numbers have been moving up over the last few years.
As a dividend growth investor, it’s tough to ignore this company.
We’ve got over 40 consecutive years of dividend increases. And more than 100 years of uninterrupted profitability. That kind of stuff doesn’t happen accidentally.
The business model is easy to understand. The products are practically necessary. And the fundamentals are, more or less, solid across the board.
However, the razor-thin margins and nature of commodities are drawbacks. And there’s also the exposure to ethanol, which adds even more variance to results. Any change in government standards there could change the dynamics of that end of the business significantly.
That all said, this is somewhat of a prototypical dividend growth stock. And it appears to be on sale, believe it or not.
The stock trades hands for a P/E ratio of 11.79. And that’s even with EPS that has been depressed as of late. That’s much lower than the five-year average P/E ratio of 15.6 for this stock. And then there’s the yield, which, as mentioned above, is more than 100 basis points higher than what investors have been able to land, on average, over the last five years.
Could have a real deal on our hands, but what’s the stock likely worth?
I valued shares using a dividend discount model analysis with a 10% discount rate and a 7% long-term dividend growth rate. I’m factoring in the modest payout ratio, long-term dividend growth rate, and forecast for EPS growth moving forward. All in all, I expect dividend growth to slow from where it’s been over the last 10 years, but I think the modeled expectation is reasonable. The DDM analysis gives me a fair value of $42.80.
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.
It appears to me that this stock is priced quite a bit lower than its intrinsic value. But am I alone in that opinion?
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 ADM as a 4-star stock, with a fair value estimate of $43.00.
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 ADM as a 3-star “hold”, with a fair value calculation of $36.50.
I like to average out the three valuation viewpoints. That allows three different perspectives and methodologies to come together into one number, maximizing the accuracy. That final valuation is $40.77, which would indicate we have a stock on our hands that is potentially 16% undervalued.
Bottom line: Archer Daniels Midland Company (ADM) has one of the longest dividend growth track records in the world. And with the necessity of their business model, I suspect that continues on for many years to come. The fundamentals are, overall, quite solid. You’re getting an above-average yield supported by a modest payout ratio, which bodes well for future dividend growth. That’s on top of the possibility for 16% upside. This is a compelling opportunity that dividend growth investors should take a strong look at.
— Jason Fieber[ad#wyatt-income]