The word “dividend” used to elicit visions of some old banker, smoking a cigar, counting their cash in some grand office.
I guess you could blame that on the childhood game of Monopoly, which I used to play with some fervor.[ad#Google Adsense 336×280-IA]There was a “Chance” card in the game that showed Rich Uncle Pennybags (himself modeled after J.P. Morgan) collecting a $50 bank dividend, while he was… wait for it… leaning back and smoking a cigar.
So there you go.
But what I’ve realized over time is that dividends are most certainly not reserved for rich old men.
Dividends see no sex, race, color, age, or creed.
All one has to do to collect dividends is invest in wonderful businesses that pay dividends.
It’s incredibly simple.
In fact, I’ve invested in over 100 different high-quality companies that pay dividends, as you can see by checking out my real-life, real-money portfolio.
This portfolio is actually on pace to generate more than $11,000 in dividend income over the next 12 months, which is enough, when combined with other passive income, to pay for my core personal expenses, rendering me essentially retired in my early 30s.
And I built the bulk of that portfolio while working a very regular day job. I spent my entire career in the auto industry, with my career split between time in Michigan and Florida. I was nowhere near Wall Street.
So one doesn’t need to be particularly special to build a portfolio that pays dividends.
Better yet, the dividends my portfolio pays are regularly growing year in and year out.
So I’m not just collecting dividends; I’m collecting increasing dividends.
See, the companies I invest in don’t just pay their shareholders dividends as a rightful share of the profits the businesses generates; these companies generate increasing profit over the long haul, and they share that growing profit with their shareholders via growing dividends.
Indeed, you can load David Fish’s Dividend Champions, Contenders, and Challengers list and see more than 700 US-listed stocks with at least five consecutive years of dividend increases.
I invest in dividend growth stocks like those you see on Mr. Fish’s list because a growing dividend is a great initial litmus test for quality.
After all, you have to do a lot of things right in order to be able to write ever-larger checks to shareholders for years – or decades – on end.
It’s next to impossible to run a poor business, not grow profit, sell terrible products and/or service, and simultaneously pay out growing dividends for years on end.
As such, I think of high-quality dividend growth stocks as the crème de la crème.
But that doesn’t mean one should just buy random stocks off of Mr. Fish’s list and pay whatever price is currently being asked.
There’s most certainly a system to it.
First, one should make sure they’re investing in businesses within their circle of competence.
And one should also fully analyze a company’s quantitative and qualitative aspects, making sure that the business is high quality with competitive advantages.
Finally, it’s incredibly important to value a stock before buying it, making sure that the price paid is below intrinsic value.
Just like pretty much everything else in this world, stocks have a dynamic between price and value.
Price is simply what a stock will cost you.
But value is what that stock is actually worth.
Snagging a price below value means you’re buying an undervalued stock.
And when discussing high-quality dividend growth stocks, this can be beneficial in a number of ways.
You’ll generally be locking in a higher yield, greater long-term total return prospects, and less risk when buying an undervalued dividend growth stock.
That’s all relative to what would otherwise be available if the stock were fairly priced or overvalued.
It’s easy to see how undervaluation works in your favor and how all of these benefits reveal themselves.
Price and yield are inversely correlated, meaning a lower price, all else equal, will result in a higher yield.
This higher yield boosts the long-term potential total return since yield is a major component of total return.
It’s more income now and, potentially, for the life of the investment.
Meanwhile, capital gain, the other component of total return, is also given a boost via the upside that exists between the lower price paid and the higher intrinsic value of the stock.
Value may get lost in the noise in the short term, but it tends to show up strongly over the long run.
And paying less reduces your risk in a number of different ways.
First, paying less means you might just be investing less total capital, risking less of your hard-earned money.
But even if you decide to buy more shares instead of investing less money, you’re still introducing a margin of safety.
If you pay $50 for a stock worth $60, you have a margin of safety worth $10 per share.
That means if the company does something wrong or performs inconsistent with what you had anticipated when you valued the stock, you have a lot of wiggle room before the investment is worth less than you paid.
As you can see, buying a high-quality dividend growth stock when it’s undervalued is generally a very intelligent move.
Repeating this over and over again can lead to a lot of wealth and income over the long run.
But what’s really incredible is that it’s not even all that difficult to value a dividend growth stock.
For instance, fellow contributor Dave Van Knapp put together a great guide to valuing dividend growth stocks, which is part of an overarching series of articles and lessons on dividend growth investing.
With free tools like this at your disposal, you really shouldn’t be paying more than fair value.
However, I’m not going to leave you there.
I’m going to actually discuss a high-quality dividend growth stock that right now appears to be undervalued….
Pfizer Inc. (PFE) is a global pharmaceutical company that discovers, develops, and manufactures a range of healthcare products.
Pfizer is truly a juggernaut in the pharmaceutical space, with exposure across the spectrum of diseases and healthcare.
They have a number of massively successful drugs under their umbrella: Viagra, Lipitor, Lyrica, and Prevnar 13 are just a few highlights.
The company also has a rather large consumer healthcare division that sports products like Advil, Centrum, Robitussin, and ChapStick.
On top of that, Pfizer’s pipeline has proven incredibly worthwhile, with recent launches like Xeljanz and Ibrance proving out the value of research and development (Pfizer is spending more than $7 billion annually on R&D). These two drugs alone did approximately $3 billion in revenue for fiscal year 2016, and they’re both growing at clips well into the double digits.
With the world growing larger, older, and wealthier, the demand for access to pharmaceuticals is sure to rise.
All in all, Pfizer is well situated to continue growing its profit and dividend.
The dividend itself has been increased for seven consecutive years.
And it’s growing at a very appealing rate, with a five-year dividend growth rate of 8.4%.
That growth rate is obviously well in excess of inflation.
But it’s made to be even more impressive when you consider the stock currently offers a yield of 3.94%.
So we’re looking a combination of yield and dividend growth that exceeds 12%.
Very nice, indeed.
Consider, too, that the current yield is more than 50 basis points higher than the stock’s own five-year average.
And with a payout ratio of 53.3% (using adjusted EPS for FY 2016), there’s still plenty of room for more dividend increases for the foreseeable future and beyond.
However, in order to determine what kind of dividend increases to expect moving forward, we must first determine the underlying growth rate of the company.
Pfizer can’t increase its dividend if the profit and cash flow isn’t there to support it. As such, dividend growth tends to roughly mirror earnings growth over the very long term.
So we’ll take a look at what Pfizer has done over the last decade in terms of growth, and we’ll then compare that to a near-term forecast for profit growth moving forward.
From fiscal year 2007 to FY 2016, Pfizer grew its revenue from $48.418 billion to $52.824 billion. That’s a compound annual growth rate of 0.97%.
Meanwhile, the bottom line fared similarly, with Pfizer seeing flat earnings per share growth – $1.17 to $1.17 over this 10-year stretch.
But I think it’s important to be mindful of a couple things here.
First, Pfizer is a massive company.
We’re talking about ~$50 billion in revenue per year. While that means plenty of money coming in to write those dividend checks, it’s difficult to generate meaningful growth when you’re already doing so much business.
Second, Pfizer has changed dramatically over the last decade.
The company sold its consumer healthcare unit in 2006 to Johnson & Johnson (JNJ) for $16 billion, which reduced the size of Pfizer at that time. And recent large-scale acquisitions of Hospira and Medivation are just now starting to bear fruit.
Moreover, the company’s had to take substantial impairment charges relating to its Venezuelan operations (a situation echoed by many multinational companies doing business there). And those aforementioned acquisitions had charges of their own.
If you look at adjusted EPS for FY 2016, which came in at 2.40, the CAGR for EPS over the last decade came in at 8.31%.
That’s not totally fair, seeing as how we’re comparing an adjusted result to a GAAP result.
However, that number could be a better indicator of Pfizer’s actual earnings growth, as S&P Capital IQ predicts that Pfizer will compound its EPS at a 9% annual clip over the next three years. S&P Capital IQ believes robust sales from branded products will be complemented by the additions from recent acquisitions.
The company’s fundamentals are otherwise really solid.
All of the financial statements for FY 2016 haven’t been released yet, so the balance sheet data is still from FY 2015.
Looking at that, the long-term debt/equity ratio is 0.45 and the interest coverage ratio is over 8.
This is very, very reasonable for a large pharmaceutical company, especially considering the cash on hand covers more than 75% of the long-term debt. Overall, I find the balance sheet an area of strength for Pfizer.
Over the last five years, Pfizer has averaged net margin of 16.70% and return on equity of 11.75%.
These numbers compare very well for the industry.
Overall, there’s a lot to like here.
Pfizer has a strong stable of branded pharmaceuticals, along with a healthy pipeline (that was made healthier by recent acquisitions). They’re exposed to internal medicine, oncology, immunology, vaccines, consumer healthcare, and generics. So they’re broadly diversified across the pharma spectrum.
However, patent cliffs, regulation, litigation, and the current political environment are all risks that should be seriously considered.
But after factoring everything, the stock looks cheap here…
The P/E ratio (using adjusted EPS) is sitting at 13.56. The five-year average P/E ratio for the stock is 22.3. While the average is using GAAP EPS, there still seems to be a disconnect here. And the current yield, as noted earlier, is substantially higher than its recent historical average.
It does appear to be a good value in an otherwise expensive market, but what, then, might the intrinsic value be?
I valued shares using a dividend discount model analysis. I factored in a 10% discount rate. And I assumed a long-term dividend growth rate of 6%. I think that growth rate is fair when you look at the payout ratio, dividend growth over the last five years, and EPS growth rate forecast over the next three years. The DDM analysis gives me a fair value of $33.92.[ad#Google Adsense 336×280-IA]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 analysis concludes that the stock looks modestly undervalued right now. However, I like to compare my analysis with that of professionals who have taken the time to carefully analyze and value the stock.
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 PFE as a 4-star stock, with a fair value estimate of $37.00.
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 PFE as a 3-star “HOLD”, with a fair value calculation of $34.50.
I came in the lowest, but there’s a definite consensus on the stock appearing to be undervalued right now. Averaging out the three numbers gives us a final valuation of $35.14, meaning the stock is possibly 8% undervalued.
Bottom line: Pfizer Inc. (PFE) is a broadly diversified pharmaceutical firm with worldwide reach, incredible scale, and immense breadth. The stock offers a utility-like yield but with far greater growth potential. Plus, you might just be looking at 8% upside on top of that. If you’re looking for an undervalued high-quality dividend growth stock in the healthcare space with a monster yield, look no further.
— Jason Fieber[ad#agora]