There are a lot of things to love about collecting a dividend.

One of my favorite things is, it’s a totally frictionless and digital process.

There’s no effort, cost, or time expenditure necessary to receive whatever dividend you’re entitled to (based on your stock investments).

And the fact that it’s digital means, it will occur no matter where you’re at in the world.

This is what allows me to live a life of a global citizen, as I’m currently living in Thailand.

Jason Fieber's Dividend Growth PortfolioThe five-figure dividend income I’m collecting from my FIRE Fund pays for my bills over here – and it’s precisely because the dividend income is totally digital that I can live anywhere.

That sure beats having a job, which means you have to be physically present (as well as expend all of that aforementioned effort, cost, and time) in order to collect your income.

What’s perhaps amazing to some people is the fact that the process I used to set up this lifestyle is actually pretty simple and straightforward.

I’ve even shared that process via my Early Retirement Blueprint, which is a guide that I believe just about anyone can follow to their early retirement dreams.

This process was largely dependent on dividend growth investing, a long-term investment strategy that prioritizes lengthy track records of proven profit and dividend growth.

You can find more than 800 examples of dividend growth stocks via the late, great David Fish’s Dividend Champions, Contenders, and Challengers list – a fantastic compilation of stocks that have raised their dividends each year for at least the last five consecutive years.

If one can build up a diversified portfolio full of high-quality companies that are growing profit and directly rewarding their shareholders with a slice of that growing profit (via growing dividends), you have yourself a pretty great recipe for financial freedom. 

Growing dividends can form a very strong passive income backbone for financial independence.

But you need to make sure you’re building out your diversified portfolio of high-quality dividend growth stocks properly.

That involves making sure you’re doing your due diligence before you invest in any business, investigating fundamentals, competitive advantages, and possible risks.

And perhaps most important, you want to value a stock before any investment consideration is made.

If you don’t know what something is worth, you can’t possibly know what an appropriate price to pay would be. 

Valuation plays a critical role in the performance of any investment, especially over the short term.

As an investor, you’re looking for the “right price”.

That price is one that’s as far below estimated intrinsic value as possible.

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

These dynamics are relative to what the same stock might otherwise offer if it were fairly valued or overvalued.

All else equal, a lower price will result in a higher yield. That’s because price and yield are inversely correlated.

That higher yield positively impacts investment income, which is one component of total return.

So long-term total return potential is given a boost right off the bat.

But total return is given another possible boost via the “upside” that exists between a lower price and higher estimated intrinsic value.

That’s because capital gain is the other component to total return.

And if you set yourself up with a favorable gap to close between price and value, that could result in excess capital gain (and thus greater long-term total return).

I say excess because that “upside” would be on top of whatever capital gain is going to present itself as a business naturally becomes worth more when it increases its profit (as high-quality businesses tend to do) and sees its stock price eventually rise to meet the increased value.

This all has a way of reducing your risk, too.

You introduce a margin of safety when you pay much less than a stock is worth.

If your thesis is wrong, your valuation is off, or if a company does something unexpected, you have a buffer before the investment becomes worth less than you paid.

Maximizing upside simultaneously minimizes downside.

Fortunately, these dynamics aren’t terribly difficult to spot.

You just need a valuation system that works.

Fellow contributor Dave Van Knapp has proposed, designed, and shared such a system, which is part of an overarching series of “lessons” on all things dividend growth investing.

You can freely access that system via Lesson 11: Valuation.

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…

Philip Morris International Inc. (PM)

Philip Morris International Inc. (PM) is the world’s largest publicly traded tobacco company, engaged in the manufacture and marketing of tobacco and related products.

Fiscal year 2017 sales break down geographically as following: Asia, 37.5%; European Union, 28.9%; Eastern Europe,
Middle East & Africa, 23.3%; and Latin America and Canada, 10.2%.

In terms of market domination, the company estimates a 28% market share of the global tobacco market, excluding China.

Investing in tobacco companies has long been a boon for many investors’ portfolios.

That’s because low valuations were brought on by the omnipresent risk of (additional) regulation and litigation, which only added to the concerns over the slow but sure death spiral that traditional cigarette sales started to find themselves in many years ago.

Global governments have long been fighting against tobacco companies, attempting to reduce the public’s use of their products.

Changing packaging, increased taxes, and even outright litigation has stymied top-line growth, which meant that tobacco companies had to figure out ways to improve profit in the face of such challenges.

The low valuations, high yields, and ingenuity of tobacco companies have long overcome these challenges, perhaps to the surprise of many, leading to great total returns over a very long period of time for many investors in major tobacco companies.

However, the long-term picture still seemed cloudy, due to the very fact that less cigarettes were being sold worldwide, year after year.

Even Philip Morris International itself refers to a “smoke-free future” in some of its campaigns and official press releases.

But tobacco companies were given a massive lifeline more than a decade ago, after the advent of the e-cigarette led to exponential consumer adaptation.

Indeed, Philip Morris International saw its traditional cigarette sales drop from 812.9 billion cigarettes in 2016 to 798.2 billion cigarettes in 2017.

This is part of a larger, more long-term trend. That’s obviously not what you want to see as a long-term investor.

But Philip Morris International is more aware of this than anyone else, and they’ve been aggressively investing in alternative products for years.

Their flagship product in that space is iQOS, which heats (instead of burns) specially designed heated tobacco units. This products releases a vapor without burning tobacco.

So we see where traditional cigarette sales are heading. It’s a race to the bottom.

Check this out, though: heated tobacco unit shipments in 2017 totaled 36.2 billion in 2017, compared to 7.4 billion in 2016.

We see where the future is. It’s a “smoke-free future”… kinda sorta.

And this should lead to long-term viability, and even growth, as it pertains to Philip Morris International as an enterprise.

This is good news for dividend growth investors.

And I have more good news here.

Philip Morris International has already increased its dividend for 11 consecutive years.

That’s for as long as could possibly be, after being spun out from Altria Group Inc. (MO) in 2008.

And this is largely under an old paradigm that wasn’t as advantageous as it sits now.

The 10-year dividend growth rate stands at 8.03%.

The dividend growth has, however, decelerated quite markedly in recent years… until 2018.

The company increased its 2018 dividend unexpectedly largely and early, with this year’s increase coming in a full quarter earlier than normal.

And at 6.5%, that increase was quite a bit larger than the increases over the last few years.

This stock now yields a massive 5.65% after that increase.

That kind of yield isn’t easy to come by in this market.

Furthermore, the current yield is more than 120 basis points higher than its five-year average.

The only issue might be the payout ratio.

Looking at adjusted TTM EPS (factoring out the one-time impact from the 2017 Tax Cuts and Jobs Act), the payout ratio is now sitting at 96.6%.

That’s awfully high.

Looking at free cash flow gives us a better picture, with the FCF payout ratio sitting at closer to 90%.

Still, the payout ratio is higher than I’d like to see, even for an industry where you often see higher payout ratios of 80%+.

I think that’s why this year’s dividend increase coming in so early and large was a surprise.

I’d never decline extra money. But one could argue they could have been a bit more conservative there.

The dividend metrics do offer a lot to like, though, especially in terms of that yield.

But in order to get an idea of what to expect for future dividend growth (since we invest in where a company is going, not where it’s been), we’ll want to look at what kind of top-line and bottom-line business growth the company has generated over the last decade (using that as a 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 allow us to extrapolate some kind of trajectory about the company’s growth, which will more or less translate to dividend growth.

This will, in turn, greatly aid us when it comes time to value the business and its stock.

Philip Morris International has increased its revenue from $25.705 billion in FY 2008 to $28.748 billion in FY 2017. That’s a compound annual growth rate of 1.25%.

Not excellent, but it’s honestly not terrible when you consider their core product has been in secular decline for years.

Meanwhile, earnings per share advanced from $3.31 to $4.48 over this period, using adjusted EPS for 2017 due to the aforementioned reasons. That’s a CAGR of 3.42%.

Also not excellent.

The excess bottom-line growth has been driven by share buybacks that saw the company reduce its outstanding share count by ~25% over the last decade.

Philip Morris has, in my view, simply faced growth issues. This hasn’t been helped by a corporate structure that headquarters them in the US with sales that occur outside the US (leading to wild fluctuations in GAAP EPS after currency exchange rates are factored in).

However, as I just noted, we invest in where a company is going, not where it’s been.

And the future appears to be quite a bit brighter than the recent past in this case, with a very unique and very large paradigm shift that’s happening as we speak.

Looking out over the next three years, CFRA believes Philip Morris International will compound its EPS at an annual rate of 9%.

That belief is built on tremendous growth in heated products, along with increased pricing realization and narrower declines in traditional products. A more favorable currency exchange rate is also factored into that.

Philip Morris International doesn’t actually need to grow at that kind of rate to be a solid long-term investment; however, I think investors (including myself; I’m a shareholder) would like to see something greater than ~3.5%.

Somewhere in the middle would, in my opinion, be a big win.

If the company can eke out 6% bottom-line growth, compounded annually, that would allow for dividend growth in that approximate range (on par with this year’s dividend raise).

And when you’re piling that on top of a 5.5%+ yield, that’s setting you up for a lot of long-term aggregate dividend income (and thus long-term total return).

The company’s balance sheet is relatively solid for the industry.

There’s no long-term debt/equity ratio due to negative common equity (owing to buybacks and treasury stock).

But cash and equivalents are almost 25% of long-term debt.

More importantly, the interest coverage ratio, at over 10, indicates no troubles whatsoever with leverage.

Profitability is nothing short of robust. In fact, it’s pretty breathless.

Over the last five years, the firm has averaged annual net margin of 24.99% – and that’s including FY 2017, which featured lower-than-average net margin due to the one-time impacts.

ROE is not applicable, though, due to the negative common equity touched on a few moments ago.

All in all, I think there’s a lot to like about this business and its stock here.

Investing in tobacco was an appealing idea ten years ago due to the addictive nature of cigarettes. You have a captive consumer base. As such, the product is fairly inelastic in terms of pricing.

Moreover, due to the changes in advertising and branding, the dominant players (which obviously includes this company) are made to even more dominant – it’s almost impossible for a new entrant to gain market share.

And that’s just talking about the traditional products.

The heated products actually injects fresh growth into this industry, which is pretty exciting.

Of course, regulation, litigation, and competition are all risks that should be carefully considered.

At the right valuation, though, this could be an excellent investment.

And it’s buying “sin stocks” at cheap valuations is what’s led to great returns for many investors over the years.

Well, a cheap valuation seems to have once again presented itself here…

The stock is trading hands for a P/E ratio of 17.11 (using adjusted TTM EPS).

That’s well below the broader market.

It also compares favorably to the stock’s own five-year average P/E ratio of 19.6 (although that’s looking at GAAP EPS).

The multiple on sales and cash flow are substantially below their respective recent historical averages.

And the yield, as noted earlier, is more than 120 basis points higher than its five-year average.

The stock does look quite cheap here, but how cheap might it be? What might a reasonable estimate of intrinsic value look like? 

I valued shares using a dividend discount model analysis.

I factored in an 8% discount rate (due to the high yield) and a long-term dividend growth rate of just 3.5%.

My modeled DGR is where it’s at due to the high payout ratio and the matching 10-year EPS growth rate.

The most recent dividend increase was, in my opinion, aggressive.

On the other hand, growth does seem to be accelerating, and CFRA’s three-year projection could provide for ample dividend growth that’s well above my estimate.

Erring on the side of caution here, I think a long-term DGR expectation of 3.5% is a conservative look at this stock’s potential, keeping downside limited.

The DDM analysis gives me a fair value of $104.88.

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.

Even a pretty conservative valuation model (extrapolating out past growth into the future, even with a known growth accelerator in the mix) shows us a stock that is very cheap.

But let’s compare my valuation to what that of two professional analysis firms have come up with, which adds depth and perspective to the 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 PM as a 5-star stock, with a fair value estimate of $104.00.

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 PM as a 4-star “BUY”, with a 12-month target price of $91.00.

Averaging out the three numbers gives us a final valuation of $99.96, which would indicate the stock is possibly 24% undervalued.

Bottom line: Philip Morris International Inc. (PM) sells addictive products that are fairly inelastic in terms of pricing. A paradigm shift in this industry has led to exciting new growth product lines. And this company is taking full advantage of that, seeing massive growth in that category. With a 5.5%+ yield, more than a decade of dividend growth, accelerating profit and dividend growth, and the potential that shares are 24% undervalued, dividend growth investors may want to light up their portfolio with this dividend growth stock.

-Jason Fieber

Note from DTA: How safe is PM’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 70. 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, PM’s dividend appears safe and unlikely to be cut. Learn more about Dividend Safety Scores here.

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