Whenever I think about a situation in life, I tend to go through a pro-con analysis in my mind.

Before I decide on a major choice, I like to ask myself a very simple question.

Do the benefits outweigh the drawbacks? 

There are many choices we’ll face in life where the answer to that question is ultimately no.

However, financial independence is, in my mind, a lifestyle situation that easily passes this litmus test.

The benefits are numerous, almost to the point of being beyond counting. Yet the drawbacks are extremely limited.

Better yet, it’s not all that difficult to achieve this incredible achievement in life.

I can say that from firsthand experience, as it took me about six years to go from below broke to financially independent.

Maybe six years seems like a long time to you. But it goes by in a flash. And the last thing you want is, finding that you’re still in the same spot six years down the road.

In order to make that happen, I simply lived below my means and invested my excess capital into high-quality dividend growth stocks like those you’ll find on David Fish’s illustrious Dividend Champions, Contenders, and Challengers list – a compilation of more than 800 US-listed stocks that have raised dividends each year for at least the last five consecutive years.

Sounds simple? 

That’s because it is.

There’s nothing complicated about saving and investing.

However, it’s difficult to actually execute these steps, every day, in real-time.

But I can say the investing portion of this is fairly straightforward. And dividend growth investing sets you up to succeed right from the start.

High-quality dividend growth stocks are often some of the best stocks in the world due to the very dynamic that’s present when you’re looking at growing dividends year after year. 

You can’t fund growing dividends for years on end without also generating rising profit for years on end.

And you can’t generate rising profit for years on end without doing a lot of things right as a business.

These two concepts are complementary to one another, working hand in hand.

And that growing dividend income can serve as a bedrock of passive income for someone’s life, allowing them to become financially independent once that passive income exceeds personal expenses.

That’s the spot I’m in.

I’m financially independent in my 30s. 

And that’s all thanks to the five-figure passive dividend income my six-figure personal dividend growth stock portfolio produces on my behalf, which is enough to cover my basic expenses in life.

That portfolio might look like a lot to a beginner.

But it’s really just a collection of individual stocks. Individual stocks which represent equity in individual businesses.

A portfolio like that is built one stock at a time. 

And that’s what today’s article is all about.

I’m going to highlight a high-quality dividend growth stock that looks like an appealing long-term investment idea right now.

That means this could be your opportunity to add one stock to your own growing collection.

This dividend growth stock looks like a compelling opportunity not just because the business is high quality, but also because the stock appears to be undervalued.

Undervaluation occurs when the price of a stock is less than its intrinsic value.

And when undervaluation is present, there are a number of massive benefits that can be conferred to the long-term investor.

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

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

The higher yield plays out due to the way price and yield are inversely correlated; all else equal, a lower price will result in a higher yield.

This higher yield likely means more passive dividend income both now and later (on the same invested dollar). Plus, future dividend raises will be based off of that higher yield/higher base of passive income.

Furthermore, due to the fact that yield is one of two components of capital gain, greater long-term total return prospects arrive with a higher yield.

Total return is given yet another boost via the “upside” that exists between price and value when undervaluation is present.

While the market might not necessarily price a stock right over the short term (leading to undervaluation and these benefits), price and value tend to more closely correlate over the long run.

If an investor is able to buy in when an advantageous mispricing has occurred, that upside could lead to greater capital gain than would otherwise be possible, which is on top of the long-term capital gain that would naturally come about as a business becomes worth more (as it increases its profit).

All of this leads to reducing one’s risk, too, as it’s naturally less risky to pay less (versus more) for the same thing.

Undervaluation can build in a margin of safety, which means an investor has some mechanism of protection against downside in case the investment thesis (and valuation) doesn’t work out (due to management errors, new competition, etc.).

With these benefits being numerous and significant, one might think that valuing a dividend growth stock (in order to find those that are undervalued) is a complex task.

Fortunately, that’s not really the case.

Fellow contributor Dave Van Knapp has greatly simplified the process of valuation via his great “lesson” on dividend growth stock valuation, which is part of an overarching series of lessons on the dividend growth investing strategy as a whole.

With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…

CVS Health Corp. (CVS) is a pharmacy healthcare provider that operates one of the largest pharmacy retail chains in the US, with more than 9,800 locations across the US and the District of Columbia, Puerto Rico, and Brazil. It’s also one of the largest pharmacy benefit managers in the US, with more than 94 million PBM plan members.

CVS has size and scale that’s virtually unmatched, putting it at an advantage to pretty much every rival and would-be rival out there.

They combine that with a level of convenience that translates into a pharmacy being located at just about every meaningful corner or other location across the country.

This gives their customers the access they desire and need, which is important considering the products the company provides.

This combination of scale, breadth, and convenience positions the company extremely well in a new world where consumers are increasingly shopping online – the thousands of pharmacies that CVS has already built out is the infrastructure that can underpin fast service and delivery.

Meanwhile, CVS plans to eventually turn its pharmacies into hubs where members can be provided various healthcare services and products.

This plan mitigates some of the issues facing their retail locations as shopping moves online – less foot traffic means less retail sales, which is a substantial portion of the company’s sales.

And it further solidifies the company’s role in the healthcare marketplace, moving away from pure retail spaces and toward all-encompassing healthcare outlets.

This plan is boosted by the announced deal to acquire Aetna Inc. (AET), one of the largest managed healthcare companies the US. If combined, the new CVS would easily be one of the largest, most diverse, and most powerful players in all of healthcare, fully vertically integrating themselves across the healthcare chain.

But what does this mean to dividend growth investors? 

Well, we have some good and bad news here.

The good news it that CVS has a fantastic dividend growth track record.

They’ve increased their dividend for 14 consecutive years.

And the 10-year dividend growth rate stands at an incredible 24.2%.

You don’t often see a long-term dividend growth rate that high.

What’s perhaps even more amazing about the dividend growth is that the recent deceleration (which is inevitable) has been surprisingly modest; the most recent dividend increase, for context, came in at over 17%.

With a payout ratio of just 38.9% (based on TTM EPS that backs out a one-time tax benefit for Q4 2017), this is clearly a well-funded dividend with plenty of room to continue growing.

Plus, the stock offers an attractive yield of 2.97%.

That yield is well above the broader market. And it’s almost 130 basis points higher than the stock’s own five-year average yield, which is a massive spread.

The dividend metrics as they sit are fairly amazing.

However, the main issue with the dividend is the fact that the aforementioned acquisition of Aetna will leave the combined entity with more debt than what CVS is comfortable with, which has prompted them to announce that they’ll keep the dividend flat until leverage is acceptable.

In terms of real numbers, the new debt of $45 billion will result in pro forma leverage of 4.6x. The company plans to rapidly deleverage. The target is 3x. Until that target is met, the dividend will be kept flat.

It remains to be seen how this plays out in real-time, but this is something to keep in mind in terms of the long-term dividend growth picture.

While the overall strength of the new business may justify this, due to the long-term potential for business and dividend growth, the short-term pain may not be worth it for some investors.

That all said, the company’s growth as a standalone business has been very strong over the last decade.

We’ll take a look at top-line and bottom-line growth over the last decade, which is a general proxy for the long haul.

And then we’ll compare that to a near-term forecast for profit growth.

Combining the known past and estimated future in this manner should give us a good idea as to what kind of business growth CVS will be delivering, which should translate into dividend growth (notwithstanding the above disclaimer).

The company has increased its revenue from $87.472 billion to $184.765 billion between fiscal years 2008 and 2017. That’s a compound annual growth rate of 8.66%.

Very, very solid top-line growth, well in excess of what I’d expect.

With a mature company starting from a base of almost $100 billion, something in the low single digits would suffice. But the company has clearly exceeded that.

Bottom-line growth looks like this: earnings per share advanced from $2.18 to $6.44 over this period, which is a CAGR of 12.79%.

The company registered a one-time tax benefit for FY 2017. Factoring that out, EPS would have come in at $5.14.

Still, though, we’re talking double-digit EPS growth over the last decade.

Share repurchases – the outstanding share count is down by approximately 30% over the last 10 years – have largely propelled that extra EPS growth.

And with Aetna growing at a somewhat similar rate all by itself, any synergistic benefits at all could see a healthcare company that is full of monstrous potential.

But almost just as much so, there’s a lot of integration risk. And one could argue – I would argue – CVS is paying a heavy premium (perhaps too heavy) for Aetna.

CFRA believes CVS will compound its EPS at an annual rate of 8% over the next three years, and that’s factoring in the acquisition.

It’s extremely difficult to try to forecast growth for any company, but it’s practically impossible to make a forecast when you have this kind of acquisition on the horizon.

But the forecast is, in my view, quite conservative. If anything, it’s building in value destruction (instead of accretion), as CFRA had as recently as a few months ago saw CVS delivering 10% growth over the next three years.

But with a very modest payout ratio, strong EPS growth (regardless of the Aetna outcome), and a well-positioned business, the dividend is poised for excellent growth over the long term (even if there’s some turbulence over the next year or so).

The balance sheet is right now another source of strength, although it will likely take a short-term hit if the Aetna acquisition closes.

The long-term debt/equity ratio is 0.59, while the interest coverage ratio is approximately 9.

Fairly good numbers here. Long-term debt is down YOY, but so is cash.

Profitability is robust, especially considering that CVS is almost just as much a retailer as they are a pharmacy. The company’s Retail/LTC segment generated $79.398 billion in sales last fiscal year (against $130.596 billion for the Pharmacy Services Segment).

Over the last five years, the company averaged annual net margin of 3.39% and return on equity of 14.09%.

This is a very solid business in and of itself.

The long-term potential of the Aetna acquisition insulates and protects the business model, allows for extra opportunities within a vertical platform, and at the very least guarantees a relationship with a major customer (Aetna itself). There are long-term accretive possibilities here.

However, the short-term is very uncertain. And a flat dividend for any period of time is not what a dividend growth investor wants to hear. Integration risk, the premium paid, and the evolving nature of the US healthcare system itself are all risks.

That all said, the valuation seems to indicate that many investors aren’t willing to see how it plays out, which could be an opportunity…

The stock’s P/E ratio is a lowly 13.12 right now – and that’s using TTM EPS that factors out the one-time tax benefit for 2017.

For perspective, the five-year average P/E ratio for the stock is 19.9.

The multiple on sales is almost half its five-year average. The company’s cash flow is significantly cheaper than it recently has been, on average.

And the yield, as shown earlier, is well over 100 basis points higher than its own recent historical average.

The stock does look cheap by these accounts, but how cheap might it be? What’s a reasonable estimate of its intrinsic value?

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%.

I’ve lowered the DGR for this stock’s DDM (compared to previous analyses), due to the near-term uncertainty and flat dividend.

The dividend growth would have to be strong over the long run in order to make up for short-term weakness. But I think CVS has the potential for that, especially if there’s any synergy to be had with Aetna.

It’s important to keep in mind that the payout ratio is quite low, and this is a stock that’s been comfortably growing its dividend at a double-digit rate for years now. As such, a 7.5% DGR is awfully conservative.

The DDM analysis gives me a fair value of $86.00.

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.

Based on my valuation, and based on the basic metrics looked, the stock is very cheap. But let’s compare my valuation to what two professional analysis firms have come up with. This will add perspective and depth, which means you readers won’t be relying on only my viewpoint.

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 CVS as a 4-star stock, with a fair value estimate of $99.00.

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 CVS as a 3-star “HOLD”, with a fair value calculation of $93.52.

We can see that I came out on the low end. That makes sense with the conservative analysis I used. But averaging the three numbers out gives us a final valuation of $92.84, which would indicate the stock is potentially 38% undervalued here.

Bottom line: CVS Health Corp. (CVS) is a massive and dynamic player in the healthcare space. And they’re set to become even more massive and dynamic with a pending acquisition. While there’s certainly uncertainty present, the 3% yield, outstanding long-term dividend growth track record, low payout ratio, and potential that shares are 38% undervalued should all more than offset any uncertainty. This could be one of the most undervalued dividend growth stocks available in the market right now.

— Jason Fieber

Note from DTA: How safe is CVS’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 81. 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, CVS’s dividend appears very safe with an extremely unlikely risk of being cut. Learn more about Dividend Safety Scores here.