Note from DTA: Jason typically submits his Undervalued Dividend Growth Stock of the Week a few days before our Sunday publish date. The relatively short window of time between when he submits his article and when we publish it typically doesn’t matter. However, in the case of this week’s pick, it could. In short, Jason’s pick reported earnings on Thursday, after Jason had already submitted his article, and the stock went on to pop nearly 10% that day. With this in mind, the following article reflects pre-earnings announcement numbers…

Undervalued Dividend Growth Stock of the Week

Truly great products and/or services practically sell themselves.

And with a world that’s rapidly growing older, richer, and more populated, truly great products and/or services are highly likely only going to become more popular as they sell more of themselves.

This is just one reason I like to invest in high-quality dividend growth stocks.

Businesses that have a demonstrable track record of rewarding their shareholders with growing dividends for years on end are able to build that track record because they’re also increasing their underlying profit all the way along.

After all, you can’t write a check that can’t be cashed.

And so you can’t routinely write bigger checks that can’t be cashed.

Well, a company that’s able to increase its profit to the point of being able to simultaneously write ever-larger checks is probably in that position because it’s selling truly great products and/or services.

Logic would follow that a company can’t regularly increase its profit and send out ever-larger checks to shareholders if it’s selling truly poor products and/or services.

As such, a lengthy track record of dividend growth tends to be a good litmus test of not just business quality, but also the quality of products and/or services the business is selling.

When you do anything in life, you should aim to be the best.

Likewise, when you invest, you should aim to invest with the best.

I’ve used that mantra to build out the real-life dividend growth stock portfolio that I control, one which generates five-figure and growing passive dividend income on my behalf.

If you want to see what hundreds of dividend growth stocks look like when they’re all in one place, check out David Fish’s Dividend Champions, Contenders, and Challengers list.

Perusing that list – which contains pertinent data on more than 800 US-listed stocks with at least five consecutive years of rising dividend payments – will reveal a “who’s who” of some of the best businesses in the world.

None of them got there by accident.

And none of these companies will end up in your portfolio by accident, either.

But today’s article might be able to help you.

That’s because I’m going to reveal and discuss a high-quality dividend growth stock that appears to be undervalued right now.

This could be just the compelling and actionable investment idea you need for your own portfolio.

While a high-quality dividend growth stock can be a fantastic long-term investment, it’s undervaluation that really seals the deal.

Price is what you’re going to pay for something, but it’s value that you’re going to be getting in return.

Price is only what something costs, but value tells you what something is actually worth.

When undervaluation appears to be present, it means the price is notably below value.

And when dealing with high-quality dividend growth stocks, undervaluation can bring about significant benefits to the long-term investor.

An undervalued dividend growth stock should offer a higher yield, greater long-term total return prospects, and less risk.

This is all relative to what the same stock might offer if it were fairly valued or overvalued.

The higher yield comes about because price and yield are inversely correlated; all else equal, a lower price will result in a higher yield.

Higher yield, of course, means more passive income… both now and over the long run, potentially.

That higher yield then also positively impacts long-term total return, as total return is comprised of an income component (via dividends or distributions) and a capital gain component.

We can see how the income side of the equation is positively influenced.

But the capital gain side of the equation also has a chance to see a boost, due to the “upside” that exists between price and value (when undervaluation appears to be present).

If a stock that’s worth $50 is bought at $30, there’s $20 worth of upside there that could be realized by the market, which is on top of whatever organic upside that may occur as the business increases its profit and becomes worth more as a result.

In this same example, that greater upside also tends to mean less downside.

There’s a margin of safety often present when a high-quality dividend growth stock is purchased when it’s undervalued.

And this reduces your risk.

Buying a $50 stock for $30 means you have a very large “buffer” that protects your possible losses, as it would take a major negative change in the stock’s value before your investment is upside down (worth less than you paid).

With all of this in mind, investing in a high-quality dividend growth stock when it’s undervalued can be an excellent long-term investment decision.

The great thing about it is that valuing a dividend growth stock before purchase isn’t some impossible idea. It’s not a trick.

Fellow contributor Dave Van Knapp has made this very easy for novice and experienced investors alike, publishing a guide to valuing dividend growth stocks.

This guide can serve as an invaluable resource when it comes time to value a stock before investment.

Now that you see the benefits of all of this information, let’s dig in…

JM Smucker Co. (SJM) manufactures and markets a variety of branded food products, beverages, pet foods, and pet snacks.

This company is about as iconic as it gets.

Brands like Smucker’s, Jif, Crisco, Folger’s, Meow Mix, and Kibbles ‘n Bits jump right off the page.

I’ll first say that I have a bit of a personal affection for this company’s brands.

I’ve eaten a lot of PB&J sandwiches in my time. I mean, a lot.

In order to live as frugally as possible, so that I could save and invest as much and as often as possible, I turned to PB&J as the ultimate “cheap comfort food” many times in my life.

It’s delicious. Peanut butter is full of protein and healthy fats. It’s cheap. It’s easy. It’s fast.

And there are millions of other people out there who feel just like I do. Perhaps they’re not approaching it from the same frugal angle as I did, but millions of people out there enjoy this company’s products every single day.

When you think of high-quality peanut butter, you immediately think of Jif.

When you think of high-quality jam, you immediately think of Smucker’s.

When you think of high-quality at-home coffee, you immediately think of Folger’s.

As I noted earlier, high-quality products and/or services practically sell themselves.

Well, the company has the #1 market share in: peanut butter, fruit spreads, at-home coffee brand, and dog snacks.

Jif and Smucker’s do a lot of heavy lifting for JM Smucker Co. and its shareholders.

That said, the company has spent recent years broadly diversifying itself across branded food products, beverages, and the pet space.

As such, it’s actually its coffee product category that generated the bulk of fiscal year 2017 sales (34%). The pet food and pet snacks generated another 29% of sales, while peanut butter and fruit spreads combined for 15%.

So as you can see, this company is a lot more than its namesake fruit spreads.

I like to think of this company as (approximately) 1/3 coffee, 1/3 food products, and 1/3 pet foods.

With coffee never more popular than it is today, and with people seemingly never more committed to the happiness and well-being of their pets, the company has done well to make big inroads into these spaces.

Meanwhile, the company has also done very well to reward their shareholders with growing dividends.

JM Smucker Co. has paid out an increasing dividend for 20 consecutive years.

And they’ve grown their dividend at an annual rate of 9.8% over the last decade.

That’s a very appealing growth rate, and it’s certainly well in excess of inflation.

However, recent dividend increases have slowed a bit. The most recent increase was only 4%.

This is likely in large part due to the fact that the company has grown its dividend faster than the underlying profit over the last decade.

With a payout ratio now sitting at 65.7%, one should probably expect dividend growth to roughly mirror earnings growth over the near term. The former trailing the latter just slightly (in order to push that payout ratio down a bit) wouldn’t be surprising, but the company’s free cash flow continues to comfortably cover the dividend.

But what’s also happened here is that the valuation of the stock has come way down recently (which is why this stock is being discussed today), pushing the yield up as a result.

And so investors are looking at a stock that offers a much higher starting yield today, which offsets some of that lower near-term dividend growth. Said another way, this stock offers more dividend income and perhaps a bit less dividend growth, relative to where it was a few years ago.

The stock offers a yield of 2.93% right now.

For perspective, that’s almost 80 basis points higher than the stock’s five-year average yield.

So we see that dynamic between lower valuation and higher yield playing out right before our very eyes.

Of course, we need to know a lot more than this to actually determine whether or not the stock is undervalued, as well as to what degree, if any, it might be undervalued.

In order to estimate valuation, we need to know the growth of the company. Looking at what a company has done over the long haul (using the last 10 years as a proxy) should allow us to start to build some forward-looking expectations.

We don’t invest in where a company has been (we invest in where it’s going), but a good look at the past tells us a lot about the growth profile of a business.

Combining this information with a forecast for near-term growth, blending the two together, gives us about the best idea we can possibly have about a company’s growth, which will help us value the business and its stock.

Revenue for the company has improved from $2.525 billion to $7.392 billion between fiscal years 2008 and 2017. That’s a compound annual growth rate of 12.68%.

Mighty impressive; however, one has to keep in mind that a number of acquisitions were made over this period.

The largest of which is the 2015 $5.8 billion acquisition of Big Heart Pet Brands, and that acquisition gave the company an immediate and large presence in the pet foods and pet snacks space.

The company increased its earnings per share from $3.00 to $5.10 over this same stretch, which is a CAGR of 6.07%.

That relative profit growth (rather than absolute revenue growth) is a better indicator of the company’s health and growth profile.

Not as impressive as the top-line growth exhibited over the last decade, but I don’t think the bottom-line result is necessarily all that disappointing.

But I would like to see something closer to 8% to 9% for a smaller company like this (the market cap is under $12 billion).

Looking forward, we may see something closer to that. CFRA is predicting that JM Smucker Co. will compound its EPS at an annual rate of 10% over the next three years.

Part of this forecast is predicated on anticipated synergies from recent acquisitions that haven’t had time to fully integrate into the company’s business quite yet. Ongoing share repurchases will help. And cost cutting should buffer increasing marketing expenses to bolster their brands.

In addition, one huge area of growth potential for this company is the low-hanging fruit that is their international exposure.

The US side of the business accounted for almost 90% of the company’s FY 2017 sales, which leaves a huge runway for international expansion.

But even if they fall a bit short of that 10% expectation, I think, as I noted, 8% to 9% compound annual growth in the company’s EPS would be a very appealing result.

That said, we can see why recent dividend increases have slowed a bit – the 10-year dividend growth rate exceeded the bottom-line growth rate by a few hundred basis points, leading to a higher payout ratio.

Still, the company is set up for high-single-digit dividend growth moving forward, even if they fall a bit short of that 10% forward-looking near-term EPS growth forecast.

Looking at other fundamentals, the company is solid.

Historically, JM Smucker Co. carried around a very strong balance sheet, but it’s taken a hit with the aforementioned Big Heart Pet Brands acquisition.

The long-term debt/equity ratio is 0.65, while the interest coverage ratio is a bit over 6.

These are not worrisome metrics, but they are worse than they were even just a few years ago. And so it shouldn’t be a surprise that the company is actively engaged in paying down debt and cleaning up the balance sheet.

Profitability is fairly robust.

Over the last five years, the company has averaged net margin of 8.41% and return on equity of 9.11%.

Nothing wrong with any of that.

Overall, I believe this company offers investors a lot to like.

They’re dominant in their respective niches. The runway for international growth is very, very long. Recent acquisitions are just now being fully integrated, manifesting their potential. The company is buying back shares, paying down debt, and growing its large and healthy dividend.

That said, the US still accounts for a very large percentage of its sales. They could be more diversified across customers. Recent dividend increases have slowed. And the balance sheet isn’t as healthy as it was a few years ago.

But the valuation seems to be factoring in more drawbacks than benefits, with the stock now down 20% over the last year.

That has pushed the valuation down into what might be a pretty attractive territory…

The stock is trading hands for a P/E ratio of 22.41, which is in line with, or lower than, many far larger and more mature food/beverage companies (companies which perhaps lack JM Smucker Co.’s growth opportunities).

The five-year average P/E ratio for this stock is almost 24, so we see a discrepancy.

Investors are now paying far less for the company’s cash flow and sales, relative to what they’ve been historically paying over the last few years.

And the yield, as shown earlier, is significantly higher than its recent historical average.

So the stock’s valuation does look relatively appealing right now, but what might the intrinsic value of the stock be?

I valued shares using a dividend discount model analysis.

I factored in a 10% discount rate and a long-term dividend growth rate of 7.5%.

That dividend growth rate is much lower than the demonstrated 10-year DGR.

It’s also much lower than the forecast for near-term EPS growth.

FCF continues to comfortably cover the dividend.

And the company’s potential, especially on the international side, is still massive.

But recent dividend growth has slowed and the company has debt to pay down, which means I’m erring on the side of caution when looking out over the long haul.

The DDM analysis gives me a fair value of $134.16.

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.

The stock looks to be undervalued here, perhaps even by a good margin. But my approach and methodology is but one of many, which is why I think it adds value and perspective to compare my valuation to that of what professional analysts come up with.

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 SJM as a 4-star stock, with a fair value estimate of $132.00.

CFRA 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.

CFRA rates SJM as a 3-star “HOLD”, with a fair value calculation of $102.77.

Averaging the three numbers out gives us a final valuation of $122.98, which would indicate the stock is potentially 15% undervalued right now.

Bottom line: JM Smucker Co. (SJM) has some of the world’s most recognizable and popular food, coffee, and pet brands. They have an enviable share of market in a number of key categories. And they’re positioned very well for business improvement and growth acceleration. With the possibility that shares are 15% undervalued on top of a ~3% yield, this is a high-quality dividend growth stock that should be strongly considered for long-term investment right now.

— Jason Fieber

Note from DTA: How safe is SJM’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 91. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, SJM’s dividend appears very safe and extremely unlikely to be cut. Learn more about Dividend Safety Scores here.