Just imagine opening your own business.
Let’s say it’s a burger joint.
You go to 100 investors for capital, and you issue equity in your new business to these investors in exchange for their capital.
All fine and dandy… except these investors are greedy investors.
Not only that, but these greedy investors want those dividend payments to reliably increase, year after year.
That’s an incredible amount of pressure on you and your business to perform in order to make sure those (ever-growing) checks going out can be cashed.
Well, that’s one of the big ideas behind investing in high-quality dividend growth stocks.
Dividend growth investing is such a wonderful strategy because you’re generally investing in some of the best businesses in the world.
That’s because these businesses are living up to the expectations I just laid out – they’re sending out those ever-growing checks to their shareholders.
And many of these businesses have been doing so for decades.
You can see what I mean by checking out the late, great David Fish’s Dividend Champions, Contenders, and Challengers list, which is an incredible collection of data on more than 800 US-listed stocks that have raised their dividends each year for at least the last five consecutive years.
Many of the stocks listed on that list are world-class companies featuring household brands.
Buying and holding a diversified selection of these dividend growth stocks for the long haul can form the foundation of a near-bulletproof portfolio, one that spits out enough growing passive dividend income to fund your entire life and render you financially independent.
In fact, I used this strategy to become financially free at 33 years old, as I laid out in my Early Retirement Blueprint.
Indeed, the six-figure dividend growth stock portfolio I built, which I call my FIRE Fund, generates the five-figure and growing passive dividend income I need to pay for my bills.
As great as this strategy is, and as great as these stocks can be, there’s process you must be aware of.
First, it’s imperative that you perform your due diligence before you ever invest in any business.
And perhaps more importantly, you should be assessing the valuation of the stock.
While price is what something costs, value is what something is actually worth.
Valuation plays a vital role in the performance of any investment, especially over the short term.
It should thus go without saying that you’ll want to pay a price that’s as far below intrinsic value as possible.
Doing so would mean you’re investing in a stock when it’s undervalued.
An undervalued dividend growth stock should present an investor with a higher yield, greater long-term total return prospects, and less risk.
Price and yield are inversely correlated; all else equal a lower price will result in a higher yield.
That higher yield means more dividends or distributions on the same dollar invested.
More investment income is, of course, great.
But that higher yield also positively impacts total return because total return is comprised of two components: investment income and capital gain.
You’re looking at greater long-term total return prospects right off the bat with the higher yield.
But total return is given another possible boost via the potential additional capital gain that’s available from the “upside” that exists between a lower price paid and higher estimated intrinsic value.
If you pay much less than something is worth in the moment, you’re setting yourself up for an advantageous scenario as that value is unlocked and recognized over time.
These dynamics should convert to less risk, too.
That’s because you introduce a margin of safety when you pay a price that’s far below fair value.
Just in case your thesis is wrong, or just in case any myriad of unforeseen issues pop up, you have a lot of room for error before your investment becomes worth less than you paid.
These dynamics are obviously very appealing for any long-term investor.
Fortunately, they’re not that hard to put in your favor.
Fellow contributor Dave Van Knapp penned a series of articles that serve as “lessons” for dividend growth investors.
One of these lessons focused specifically on valuation, greatly demystifying the entire process of how to go about valuing just about any dividend growth stock out there and put these dynamics in your favor.
Lesson 11: Valuation is that lesson, and it’s very much worth a read.
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…
Omnicom Group Inc. (OMC) is an advertising, marketing, and corporate communications company.
You might not have heard of this company. But they’ve surely heard of you.
It’s their job to know you (in terms of who you are as a consumer).
This is the second-largest company (by revenue) of its kind in the world.
And they’ve built up an incredible amount of diversification, scale, breadth, and depth across their various businesses.
They provide services to over 5,000 clients in over 100 countries.
That is incredible breadth. Investing in this business is basically exposing you to the entire global economy by way of hitching your wagon to a company that directly works with and benefits from just about every global company that matters.
Looking at how the business breaks down across those various businesses, Omnicom’s fiscal year 2017 revenue was distributed across the following fundamental business disciplines: Advertising, 53%; Customer Relationship Management Consumer Experience, 18%; Customer Relationship Management Execution & Support, 14; Public Relations, 9%; and Healthcare, 6%.
Omnicom might be thought of as an advertising company.
But I actually think of it as a corporate communications, relations, and image company. They sculpt the message that other companies want to portray to their customers. And they do that in a holistic sense, not focusing solely on advertising campaigns.
In an era where a company’s message is arguably more important and sought after than ever before, a company like Omnicom thus becomes arguably more important and sought after than ever before.
This is especially true in a global market that is dynamically changing rather rapidly, as the Internet gives way to new forms of content creation, consumption, distribution, and marketing.
North America represented 57% of FY 2017 revenue.
So they’re heavily exposed to the larger and more established economies in the West (particularly the US), while also maintaining plenty of exposure to faster-growing economies across the world.
All of this bodes well for Omnicom’s ability to continue paying and increasing its dividend.
That dividend has been increased for nine consecutive years.
The five-year dividend growth rate is 13.9%.
Very strong dividend growth here, which is on top of an appealing yield of 3.18%.
That yield, by the way, is almost 60 basis points higher than the stock’s own five-year average yield.
It is worth noting, though, that there’s been some deceleration in dividend growth. For reference, the most recent dividend increase was approximately 9%.
Still, that’s plenty of dividend growth to look forward to when you’re getting that 3%+ yield.
And with a payout ratio of 50.3%, there’s still plenty of room left for future dividend raises.
In fact, that payout ratio is basically what I consider a “perfect” payout ratio.
A 50% payout ratio is a great harmony. It’s the perfect compromise between keeping profit for reinvesting back into the business for future growth, and returning profit back to shareholders (who collectively own any publicly traded company).
The dividend metrics are great.
But we’ll have to look at what kind of underlying revenue an profit growth the business is producing in order to get a read on what kind of future dividend growth to expect, which will help us value the business and its stock.
So we’ll see what Omnicom has done over the last decade in terms of top-line and bottom-line growth, before comparing that against a near-term forecast for profit growth.
Looking at an objective long-term result and blending that with an educated opinion on the future trajectory, should give us a reasonable basis for a judgement on the business, its growth, and its value.
Omnicom has increased its revenue from $13.359 billion in FY 2008 to $15.274 billion in FY 2017. That’s a compound annual growth rate of 1.50%.
That’s lower than what I’d expect from the company. I’d typically like to see something approaching 4% (or higher) from a fairly mature business.
However, Omnicom, being as exposed as they are to the global economy, did have a hard time getting some traction coming out of the global financial crisis.
They were still incredibly profitable even during the depths of the crisis, but getting back into growth mode took a few years.
Earnings per share advanced from $3.14 to $4.65 over this period, which is a CAGR of 4.46%.
There was some excess bottom-line growth here, helped along by a significant share buyback program that saw the outstanding share count drop by just over 25% over the last decade.
So growth over the last decade (which includes a particularly challenging period) isn’t quite what I’d like to see, but I think the fact that the company was still making a lot of money (and paying its dividend) during the Great Recession says a lot about the resilience of the business model, which is obviously attractive to a dividend growth investor.
Of course, we don’t invest in where a company has been; we invest in where a company is going.
Looking forward, CFRA is anticipating that Omnicom will compound its EPS at an annual rate of 8% over the next three years, aided by foreign currency tailwinds, growth in some of the key disciplines, and growth in international markets.
In addition, a lower tax rate (as a result of 2017 tax reform in the US) will certainly help Omnicom, as a good chunk of their business is based in the US.
Indeed, Q1 2018 saw YOY EPS growth of 11.8%, greatly outpacing CFRA’s prediction for the near future.
All in all, I think Omnicom is set up for plenty of profit and dividend growth. And that payout ratio allows a lot of flexibility with the dividend.
The balance sheet is actually quite strong, even if it might not appear to be so at first glance.
I say that because the long-term debt/equity ratio (a bellwether metric too many investors pay too much attention to) is quite high – sitting at 1.88.
The number is high not because of a lot of debt; instead, the common equity is low due to treasury stock (related to those aforementioned buybacks).
Meanwhile, cash and equivalents add up to almost 80% of long-term debt.
Moreover, the interest coverage ratio, at over 9, indicates no issues whatsoever with debt or covering interest expenses.
Profitability is more than acceptable, although I think there’s room for margin expansion – the company has been expanding margin pretty consistently since bottoming out in FY 2009.
Over the last five years, the company has averaged annual net margin of 7.07% and annual return on equity of 39.38%.
ROE is bolstered by low common equity, but that net margin is solid – and expanding.
Overall, this is a very fine business across the board.
There’s almost nothing like it in terms of diversification, breadth, and depth.
And I believe that’s exactly why they held up so well during the financial crisis – a time when many companies, including, no doubt, many Omnicom clients, were registering losses and cutting their dividends.
The fundamentals are great, and you’re looking at a big, sustainable, and growing dividend.
That dividend should be protected by the very business model, which is bolstered by a number of world-class advertising agencies under the corporate umbrella. This business model also tends to result in sticky clients, due to the nature of integrating an outside firm into a company’s marketing department.
Plus, the business is improving. Growth is accelerating and net margin is expanding.
But the valuation would indicate a business that’s actually getting worse…
The P/E ratio is sitting at 15.81, which is notably lower than the stock’s own five-year average P/E ratio of 17.5.
That’s strange to me. You’ve got a company sitting in a better spot than it has been over the last five years (and improving), yet it’s priced like it’s in a worse spot (and deteriorating).
Not to mention, this P/E ratio is much lower than the broader market.
And the yield, as shown earlier, is also significantly higher than its own recent historical average.
So the stock is valued lower and yielding higher than what it typically has over the last five years, even while it’s arguably in a much better position today. Seems cheap, but how cheap might it be? What might it be worth?
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 7%.
That DGR is somewhere in the middle of what I normally allow for.
Omnicom seems to more than qualify, with a payout ratio near “perfection”, short-term and long-term dividend growth well in excess of that number, and a forecast for future EPS growth that is also higher than that.
However, I’m weighing that against disappointing growth over the last decade.
And it’s always better to err on the side of caution.
The DDM analysis gives me a fair value of $85.60.
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.
But my outlook is limited to my own views, which is why we’ll take a look at what two select professional analysis firms think about this stock’s valuation.
These additional perspectives will add depth to our conclusion.
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 OMC as a 4-star stock, with a fair value estimate of $85.00.
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 OMC as a 4-star “BUY”, with a 12-month target price of $80.00.
Averaging the three numbers out gives us a final valuation of $83.53, which would mean the stock is potentially 11% undervalued right now.
Bottom line: Omnicom Group Inc. (OMC) is a high-quality company that has the kind of diversification, breadth, and depth that is nearly unrivaled, which should serve to protect that big dividend even in economic downturns. With accelerating growth, improving fundamentals, an above-average dividend, a below-average valuation, and the possibility that shares are 11% undervalued, this dividend growth stock appears to be advertising itself as on sale. Although it’s had a pretty good year thus far, it remains as one of my top 10 stock ideas for 2018.
Note from DTA: How safe is OMC’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 90. 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, OMC’s dividend appears very safe and extremely unlikely to be cut. Learn more about Dividend Safety Scores here.