I love acquiring quality when it’s on sale.
That goes for anything… from food to stocks.
Now, that isn’t to say I’m always simply looking for the cheapest price out there.
Cheap isn’t always good, especially if it’s not accompanied by value (and/or quality). Said another way, paying a low price isn’t necessarily a good idea if you’re buying something that likewise isn’t worth very much.[ad#Google Adsense 336×280-IA]For example, you could pay $500 for a very basic laptop and realize that you actually paid a hefty price.
All the same, you could snag a top-of-the-line laptop for $750 and know that you scored a great deal.
And that’s really the rub: price and value are definitely not synonymous.
Price is what you pay; value is what something is worth.
Only once you know the latter can you possibly determine whether or not the former is appropriate.
This is just as true with stocks as it is with anything else, if not more so.
I’ve spent the last six years of my life buying high-quality dividend growth stocks, building up the six-figure portfolio that now spits out enough passive (and growing) dividend income to almost completely cover my core personal expenses.
But I didn’t just buy random stocks at random prices.
That’d be like going to the grocery store and buying random food at random prices.
No, I first of all stuck to quality stocks.
And when I think of quality, I first think of stocks that can be found on David Fish’s Dividend Champions, Contenders, and Challengers list – a list of more than 700 U.S.-listed stocks, each with at least five consecutive years of dividend increases.
These dividend growth stocks come to mind pretty quickly when I think of quality stocks because of the very nature of growing dividends.
After all, just think of all the things a company has to do right in order to pay and increase a dividend for decades on end.
I mean, these are essentially checks that these companies are writing to their shareholders – and these checks are getting bigger and bigger every year.
And so these companies have to produce the growing profit necessary to make sure those checks get cashed; this profit has to grow in kind, for years and years.
When I think of a quality company, I think of one that can grow profit regularly from one economic cycle to the next, and there’s no greater proof of that happening than a dividend that’s also growing regularly.
But as appealing as dividend growth stocks are, I also don’t want to just pay any price.
I first want to value a stock so as to know what it’s worth.
And then I want to pay a price that’s as far below that value as possible so as to build in a margin of safety.
This actually isn’t all that difficult in practice.
One simply needs to know how to value a dividend growth stock in the first place.
Fortunately, the Internet has made this easier than ever, with a free tool designed to value dividend growth stocks available right here on the site.
It’s one of fellow contributor Dave Van Knapp’s dividend growth stock investing lessons, and it makes valuing dividend growth stocks fairly straightforward.
Once you find a dividend growth stock that’s priced well below what you think it’s worth, you should be pretty excited.
That’s because the stock is likely to come with a higher yield, better long-term total return prospects, and less risk.
Well, all three of these concepts are intertwined.
All else equal, price and yield are inversely correlated; a lower price will almost always mean the yield is higher.
That higher yield not only translates into more income in your pocket but also what’s likely to be a stronger long-term total return.
Yield is one component of total return. Thus, cranking that up right off the bat means the total return prospects over the long run are improved.
And the other component, capital gain, is also potentially cranked up by virtue of the upside that exists between the lower price paid and the higher worth of the stock.
Of course, this all has the effect of reducing risk.
You’re either shelling out less total capital or paying less on a per-share basis.
Most importantly, you build in a margin of safety when you pay less than what a stock is deemed to be worth.
That means a lot can go wrong before you’re really “underwater”.
With all of this in mind, you can see why you should be excited when a high-quality dividend growth stock is available for a price that is less than estimated intrinsic value.
Well, be prepared to get excited…
Emerson Electric Co. (EMR) is an industrial conglomerate that designs and supplies product technology and solutions for industrial, commercial, and consumer markets.
This is a prototypical dividend growth stock if there ever was one.
The company has increased its dividend for 59 consecutive years.
That’s almost six straight decades of not only checks to shareholders but ever-larger checks year in and year out.
Very few companies in the entire world can lay claim to something like that, which makes Emerson Electric truly special.
Founded in 1890, they’ve been paying a bigger dividend for almost half their existence.
And these bigger dividend checks have been backed by ever-growing profit, itself built on the back of an incredibly diversified business model that provides everything from compressors, to process management software, to automated controls. They’re almost everywhere – in terms of both geography and industries.
What’s even better is that the company isn’t just handing out pittance for dividend increases to keep its streak alive: the 10-year dividend growth rate stands at 8.4%, which is obviously well in excess of inflation.
Now, dividend increases can oscillate – sometimes wildly – from year to year due to the cyclical nature of the business, but the long-term average is pretty incredible here.
What’s perhaps just as incredible as that long-term growth rate is the fact that the stock yields a very appealing 3.66% right now.
In a low-rate environment, that’s really attractive. It’s not only substantially higher than the broader market but also the stock’s five-year average yield of 3.1%.
So a lower price comes with a higher yield, all else equal, right? Well, you’re looking at an advantageous spread of more than 50 basis points right now.
Meanwhile, the payout ratio, at 65.5%, is still pretty comfortable, indicating to me that Emerson Electric will continue to increase its dividend for many more years to come.
And that payout ratio is artificially higher due to temporary headwinds like the strong dollar (more than half of Emerson Electric’s sales occur outside the U.S.) and a very weak energy industry that have conspired to reduce earnings.
Speaking of which, let’s take a look at what this company is doing in terms of revenue and profit, which will help us immensely when it comes time to value the business.
I like to look at the past decade for any company, which should help to alleviate short-term headwinds, focusing more on long-term numbers rather than short-term cycles. We’ll then compare that to a near-term estimate for earnings growth.
Emerson Electric has increased its revenue from $20.133 billion to $22.304 billion from fiscal years 2006 to 2015. That’s a compound annual growth rate of 1.14%.
Not particularly impressive. While a ten-year period should smooth out most short-term issues, it doesn’t always work like that. Aforementioned issues have caused Emerson Electric’s revenue to drop recently; moving the 10-year analysis back just one year looks a lot better.
Nonetheless, the company has had some challenges.
The bottom line has fared much better thanks to strong buybacks, however. Emerson Electric has reduced its outstanding share count by approximately 18% over the last decade, which has helped propel excess earnings per share growth.
EPS moved up from $2.24 to $3.99 over this stretch, which is a CAGR of 6.62%.
Looking out over the next three years, S&P Capital IQ believes Emerson Electric will compound its EPS at an annual rate of 6%. That’s on par with what we see above. S&P Capital IQ believes those aforementioned headwinds (the strong dollar and weakness in O&G) will be more than offset by margin expansion potential and improving construction business.
One area of Emerson Electric’s business that allows it to remain flexible while key markets remain weak is the balance sheet.
While many companies have loaded up on cheap debt over the last decade, Emerson Electric’s balance sheet is even stronger than it was 10 years ago.
As of the end of FY 2015, the company sported a long-term debt/equity ratio of 0.53 and an interest coverage ratio of almost 22.
Profitability is also robust and relatively strong.
Over the last five years, Emerson Electric has averaged net margin of 9.48% and return on equity of 22.67%, the latter of which is impressive when considering the debt load. Both numbers have improved as of late.
So I believe we’re looking at a high-quality business here.
You’ve got almost six straight decades of dividend raises, a stellar balance sheet, solid and improving profitability, and incredible diversification.
Plus, the company has already announced that it’s going to spin off its Network Power business (the transaction will likely close in the fall of 2016). This move could unlock even more value for long-term shareholders.
Sure, there are some near-term issues, as noted. And the company’s business model is cyclical.
But the positives seem to far outweigh any negatives, in my view.
As such, it should be a pretty exciting event if shares were available below what they’re worth.
Be prepared to get excited…
The stock trades hands for a P/E ratio of 17.88 right now, and that’s on depressed earnings. That’s fairly appealing in absolute terms, but it’s made to be even more appealing when considering the five-year average P/E ratio for this stock is 19.1. That P/E ratio is also well below the market, even while this business is about as high quality as they come. Plus, the current yield is significantly above its recent historical average, as noted earlier.
So the valuation is pretty exciting. But what’s the stock likely worth? Just how exciting is this?
I valued shares using a dividend discount model analysis with a 10% discount rate and a 7% long-term dividend growth rate. That long-term dividend growth rate factors in the company’s demonstrated 10-year dividend growth rate, current payout ratio, and forecast for near-term underlying EPS growth (which should improve over time). The DDM analysis gives me a fair value of $67.77.
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 this stock is priced well below what it’s likely worth. And that’s even after the stock has popped almost 9% this year. But am I alone in that perspective? What do some professionals that have taken the time to analyze and value this stock think about it?
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 $48.70.
So I came in on the high end, which is somewhat rare (I’m usually pretty conservative). However, I like to average out these three different valuation opinions so as to blend these different perspectives and methodologies together. That final valuation is $59.49, indicating the stock is potentially 14% undervalued right now.
Bottom line: Emerson Electric Co. (EMR) is a high-quality firm across the board. With 59 consecutive years of dividend increases and many more increases likely to come, this is a prototypical dividend growth stock. Considering a 3.66% yield, an upcoming spin-off, and what may be 14% upside, this appears to be a very compelling long-term investment here.
— Jason Fieber[ad#wyatt-income]