You only live once.
It might be banal, but it’s also quite clearly true: we do only live once (as far as we know).
Well, the underlying act of inspiring oneself to make the most of the one, short life we’re given is sound, but the way people tend to go about fulfilling that is totally wrong.
I propose a very simple solution: financial independence.
If this one, short life we’re given is to be properly maximized, I can’t think of a better way to accomplish that than to become financially independent and actually own the very little time you’re given.
That’s exactly what I set out to do back in early 2010.
Even though I was below broke and worth less than an infant, I used that rallying cry to justify saving and investing my way toward financial freedom and making the most of my remaining days.
And it worked: the FIRE Fund I built by living below my means and investing my excess capital into high-quality dividend growth stocks now generates the five-figure and growing passive dividend income I need to cover my personal expenses, rendering me financially free in my 30s.
You can see how that journey unfolded by checking out my Early Retirement Blueprint, which is a step-by-step guide that just about anyone can follow to their own early retirement dreams.
This long-term investment strategy prioritizes the existence of a lengthy track record of rising dividends from a company, for that serves as a great initial “litmus test” of business quality, real profit growth, and managerial commitment to the shareholders.
You can find more than 800 US-listed dividend growth stocks by looking through the late, great David Fish’s Dividend Champions, Contenders, and Challengers list.
Every stock on that list has increased its dividend each year for at least the last five consecutive years.
Growing dividends, of course, serve to provide a lot of information about a business.
But what’s really fantastic about growing dividends is how efficient they are at underpinning financial independence.
Growing dividend income is about as passive as it gets. Plus, you have inflation protection built right in.
That means you can go about your life, gleefully covering your expenses with the knowledge that rising expenses (largely due to inflation) will be more than offset by rising passive dividend income.
Indeed, many of the highest-quality dividend growth stocks out there are actually increasing their dividends much faster than US inflation, which increases a shareholder’s purchasing power.
But as great as all of this is, you have to be intelligent when it comes time to invest.
You have to do your due diligence before ever buying a stock.
That involves analyzing fundamentals, identifying competitive advantages, and weighing out risks.
Arguably most important, you also have to value a stock.
Value gives context to price. Without knowing value, price means almost nothing.
This is true of everything in life, but it’s particularly relevant when talking about dividend growth stocks.
An undervalued dividend growth stock should offer an investor a higher yield, greater long-term total return potential, and less risk.
All else equal, a lower price will result in a higher yield. Price and yield are inversely correlated.
That higher yield goes on to positively affect investment income, since you’re collecting more dividends or distributions on the same invested dollar.
However, it also positively affects total return, leading to greater long-term total return.
That’s because total return is comprised of investment income and capital gain.
The former is given a boost right off the bat.
Meanwhile, capital gain is also given a boost via the “upside” that exists between a lower price paid and higher intrinsic value.
While the market isn’t necessarily very good at accurately pricing stocks over the short term, price and value tend to more closely correlate over the long run.
And if/when that favorable gap between price and value closes, that’s capital gain.
Plus, that is on top of whatever organic capital gain that comes about as a business becomes worth more when it increases its profit.
These dynamics also reduce risk.
It’s obviously less risky to pay less for an asset than to pay more for that same asset.
You introduce a margin of safety when you buy a stock for a price that’s much less than it’s estimated to intrinsically be worth.
And this protects your downside, just in case the investment thesis is somehow wrong.
If something does go wrong, a margin of safety protects you against the investment ending up being worth less than you paid.
However, it’s surprisingly not that difficult to ascertain an estimate of intrinsic value on just about any dividend growth stock out there, putting these favorable dynamics in your corner.
Fellow contributor Dave Van Knapp put together a fantastic valuation system that can effectively be used as a template for valuing most dividend growth stocks.
This valuation system is part of an overarching series of “lessons” on dividend growth investing as a whole.
And that system is shared in 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…
AbbVie Inc. (ABBV)
AbbVie Inc. (ABBV) is a global pharmaceutical company with a particular focus on immunology and oncology.
The world is growing older, bigger, and richer.
No doubt about it. The stats back it up.
With these long-term trends cemented, it’s fairly obvious that a larger, older, and wealthier society will demand greater access to quality healthcare, which includes pharmaceutical products.
Indeed, it’s the very growing demand for and access to quality healthcare (including pharmaceutical products) that has a lot to do with the world growing older and bigger.
AbbVie, as one of the world’s largest pharmaceutical companies, fits into this quite nicely.
The one (big) knock against AbbVie, however, is the fact that its blockbuster drug Humira (the most widely prescribed autoimmune biologic therapy) accounts for such a large percentage of the company’s sales: Humira accounted for approximately 65% of AbbVie’s total net revenue in FY 2017.
But the drug still has strong patent protection (through at least the early 2020s), while AbbVie makes moves to protect the drug’s sales in the future (via licensing).
Moreover, the company’s pipeline is strong, with R&D investment growing 16% in 2017, to $4.6 billion.
AbbVie is on pace to launch more than 20 new products or indications by 2020.
Looking past Humira, their portfolio of on-market therapies, combined with the potential of the late-stage pipeline, is expected to generate more than $35 billion in revenue in 2025.
This bodes well for the company, as well as its ability to pay and increase its dividend.
In that regard, AbbVie has increased its dividend for six consecutive years.
That’s as long as that track record could possibly be, considering the company was spun off from Abbott Laboratories (ABT) in 2013.
Dividend growth since going independent has been stellar: the three-year dividend growth rate stands at 15.5%.
The most recent dividend increase came three quarters early – and it was a monstrous 35.2%.
This puts the current yield at 4.12%, which is very high for this industry.
And that yield is also more than 100 basis points higher than the stock’s five-year average yield.
That aggressive dividend growth might look a bit premature, even bordering on irresponsible, with a high payout ratio of 96.5%.
However, that payout ratio, looking only at GAAP TTM EPS, isn’t accurate, as AbbVie (like most other US-based companies) had to take a massive hit to its Q4 2017 GAAP results after the enactment of the 2017 Tax Cuts and Jobs Act.
Using adjusted Q4 EPS, the payout ratio is sitting at a more comfortable 70.8%.
But even that looks high against what’s likely to transpire over the course of 2018: AbbVie is guiding for diluted EPS to come in at between $6.82 to $6.92 for FY 2018. The dividend (at its current rate) would only consume about 55% of that (at the midpoint).
Of course, that’s pertinent: we invest in where a company is going, not where it’s been.
And that leads us to looking at the company’s long-term top-line and bottom-line growth, which we’ll use as a base to compare to a near-term forecast for future profit growth.
This should allow us to extrapolate out an estimate of where AbbVie is going, which should translate into helping us value the business and its stock.
AbbVie has grown its revenue from $18.790 billion in FY 2013 to $28.216 billion in FY 2017. That’s a compound annual growth rate of 10.70%.
Extremely strong revenue growth here, driven in large part by the growth of Humira sales.
Earnings per share advanced from $2.56 to $5.60 (on an adjusted basis) over this time frame, which is a CAGR of 21.61%.
The near-term EPS growth will certainly be buoyed by a $10 billion buyback that was approved in February. For perspective that amounts to almost 7% of the company’s market cap. AbbVie is taking advantage of that aforementioned tax reform.
This is nothing short of extremely impressive.
AbbVie, factoring out the one-time hits to FY 2017, has become a much more profitable and well-run enterprise over the course of its independent operations.
And that’s starting to quickly manifest itself as 2018 is unfolding; however, the firm will have to successfully navigate the transition away from such a heavy reliance on one drug.
Looking forward, CFRA believes AbbVie will compound its EPS at an annual rate of 22% over the next three years, which would be right in line with what we see above.
Considering the recent numbers, as well as AbbVie’s own guidance for this year, this forecast doesn’t seem terribly aggressive.
But the company wouldn’t have to grow at that rate in order to be a fantastic investment, nor would 22% annual EPS growth be needed to fund large dividend increases.
Said another way, the upside seems to greatly outweigh the downside as it relates to dividend growth, moving forward. The big question simply relates to whether or not AbbVie’s pipeline will more than offset a future drop in Humira sales.
AbbVie’s balance sheet would, at first glance, seem to be outrageously leveraged.
That’s because the long-term debt/equity ratio is sitting at 6.07.
However, that ratio is high due to low common equity, not necessarily an unsustainable amount of long-term debt.
Total cash is almost 30% of long-term debt.
More importantly, the interest coverage ratio is almost 8. That indicates no issues whatsoever with the company’s ability to cover its interest expenses or manage its debt load.
The only issue that might arise here is a large drop in future EBIT (due to a drop in Humira sales that is not offset by new drug sales), which would thus drop that interest coverage ratio.
Profitability is extremely robust, with the company averaging annual net margin of 19.03% and annual return on equity of 117.91% over the last five years – and that’s even with counting big drops in 2014 and 2017 due to hits to GAAP numbers.
Of course, ROE is artificially high due to the aforementioned low common equity, but the company’s margin is enviable.
There’s so much to like here about AbbVie.
It’s a massively profitable company, sporting huge growth and shareholder-friendly dividend growth commitment. They’re buying back a ton of stock. Humira is a blockbuster, which they’re protecting further via licensing. And the pipeline is well developed.
However, this industry is highly competitive, fraught with patent expiration, litigation, and regulation risks. And the current reliance on Humira puts a lot of pressure on management and the pipeline.
All that said, the right valuation could present a great long-term opportunity to dividend growth investors.
The stock does appear to be undervalued at current prices…
A P/E ratio of 17.18 (using adjusted TTM EPS) compares very favorably to the broader market, and it’s also substantially lower than the stock’s own five-year average P/E ratio of 24.4.
Now, that is using an adjusted number against a non-adjusted average.
But the P/CF ratio of 14.2, which isn’t adjusted, is also significantly lower than its own three-year average of 17.5.
And the yield, as noted earlier, is much higher than its recent historical average.
So the stock does look cheap by most basic measures, but what might a reasonable estimate of intrinsic value look like?
I valued shares using a dividend discount model analysis.
I factored in a 10% discount rate and a long-term dividend growth rate of 6.5%.
That growth rate is way below what the company has delivered over the course of its (admittedly short) history, although there’s a huge legacy of dividend growth to look back on via its culture over at Abbott.
But I’m keeping this DGR so low due to the inherent risks that are present when the company is relying so heavily on just one drug. Plus, it seems a lot of dividend growth might be front loaded with that massive dividend increase that came in earlier this year.
As I discussed earlier, though, I think the upside as it relates to dividend growth far outweighs the downside, and this conservative DDM analysis further bakes that in. The historical EPS growth, as well as the forecast for future EPS growth, would seem to support dividend growth far in excess of what I’m modeling in here.
The DDM analysis gives me a fair value of $116.85.
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 with a pretty conservative valuation, the stock appears to be very cheap right now.
However, I admit that my perspective is but one of many.
So we’ll now take a look at what two professional stock analysis firms have valued this stock at, which adds depth to our bottom line.
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 ABBV as a 3-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 ABBV as a 4-star “BUY”, with a 12-month target price of $130.00.
I came out right in the middle. Averaging these three numbers out gives us a final valuation of $115.28, which isn’t far off from where my valuation is. That would indicate the stock is potentially 24% undervalued right now.
Bottom line: AbbVie Inc. (ABBV) is one of the world’s foremost pharmaceutical companies, which positions it well in a world that will only demand more of its products in the future. The reliance on Humira is a concern, but the strong pipeline should offset that moving forward. Robust profitability, huge growth, a recent 35% dividend increase, a $10 billion buyback plan, and the potential that shares are 24% undervalued all add up to a high-quality dividend growth stock that could be just what the doctor ordered for your portfolio.
Note from DTA: How safe is ABBV’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, ABBV’s dividend appears safe and very unlikely to be cut. Learn more about Dividend Safety Scores here.
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