Let’s say you were investing in stocks 30 years ago.
If someone asked you what kind of changes you’d like to see occur so that investing were much easier, you’d surely wish for two things: lower transaction fees, and greater/easier access to information.
Well, 2018 is here. And both of these wishes have been granted.
And you can buy stocks for as little as a few bucks per transaction. In many cases, it’s totally free to invest.
It’s quite literally never been easier to be an investor than it is in 2018.
That means there’s nothing stopping you from saving capital, intelligently investing for the long haul, and making your financial dreams come true.
I started investing in early 2010. And I’ve seen some positive changes just in the short time period since then.
Moreover, even though I’ve been investing for less than nine years, I’ve already radically transformed my life.
I went from below broke in 2010 to financially free in 2016 – becoming an early retiree in my early 30s, as I lay out in my Early Retirement Blueprint.
But I saw that things were clearly more favorable than ever for investors, and I took advantage of that.
Another thing I took advantage of is the investment strategy that is dividend growth investing.
This long-term investment strategy advocates investing in high-quality, blue-chip companies that have lengthy, proven track records for growing revenue, profit, and (most importantly) dividends.
You can find almost 900 examples of dividend growth stocks by looking over the Dividend Champions, Contenders, and Challengers list. It’s the most robust resource for these stocks that I’m aware of. And it’s free!
This strategy can allow you to sleep well at night, preserve (and grow) your capital, and set yourself up with a reliable source of growing passive income that you can one day live off of.
By living below my means and investing my excess capital into high-quality dividend growth stocks, I built up my FIRE Fund, which is a real-life and real-money stock portfolio that’s valued at well into the six figures.
And I built it on a middle-class income in just a few short years.
That portfolio generates the five-figure and growing passive dividend income I need to sustain myself and live my early retirement lifestyle.
But while I built that portfolio by saving my money and buying dividend growth stocks, it wasn’t a random, uninformed process.
I did my due diligence with every stock, which included performing fundamental analysis, evaluating qualitative aspects (like competitive advantages), assessing risk, and estimating intrinsic value.
It’s that last part that is particularly important.
Price is what you’ll pay for a stock, but it’s value that you end up getting in exchange for your money. The latter gives context to the former; without knowing the latter, the former is practically meaningless.
And when investing in dividend growth stocks, you should always aim to buy high-quality dividend growth stocks that appear to be undervalued at the time of investment.
An undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and less risk.
These advantageous dynamics are relative to what the same stock might otherwise offer if it were fairly valued or overvalued.
The higher yield plays out due to the inverse correlation between price and yield; all else equal, a lower price will result in a higher yield.
That higher yield goes on to positively impact total return, because total return is comprised of investment income (dividends or distributions) and capital gain (stock price appreciation).
Well, you can see right off the bat that you’re looking at greater long-term total return potential due to the additional investment income that a higher yield provides.
Furthermore, the capital gain component is given a boost via the “upside” that exists between price and value.
If you pay a price that’s well below estimated intrinsic value, you’re looking at the potential for additional capital gain if/when the stock market more accurately prices your stock investment.
While the market isn’t necessarily good at accurately pricing stocks over the short term, price and value do tend to more closely correlate with one another over the long run.
And that upside is on top of whatever capital gain you’d naturally be looking at as a company becomes worth more over time (as it increases its profit).
This all has a way of translating into less risk.
You introduce a margin of safety when you pay less than estimated intrinsic value.
Because a valuation is always an estimation, you want to err on the side of caution.
And a margin of safety protects you against ending up with an investment that’s worth less than you paid, just in case the investment thesis goes wrong through any variety of ways (management missteps, new competition, unforeseen events, etc.).
Of course, it’s also just plain better to risk less capital, either on a per-share basis or across the total transaction (buying a fixed number of shares).
Fortunately, these advantageous dynamics aren’t impossible – or even all that difficult – to spot.
Fellow contributor Dave Van Knapp made that “spotting” process even easier by divulging a great valuation system that can be more or less applied to just about any dividend growth stock out there.
That system is part of an overarching series of articles on the dividend growth investing series as a whole; he refers to these articles as individual “lessons”.
The lesson that focuses on valuation specifically is 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…
Altria Group Inc. (MO) is one of the world’s largest tobacco companies. It is the largest cigarette manufacturer in the United States.
The company operates across the following subsidiaries: Philip Morris USA, U.S. Smokeless Tobacco, John Middleton, Ste. Michelle Wine Estates, Nu Mark, Nat Sherman, and Philip Morris Capital. In addition, the company holds a 10.2% interest in Anheuser-Busch InBev (BUD).
Marlboro, the company’s flagship US cigarette brand, has a ~43% share of the market. In total, Altria controls just over 50% of the US cigarette market, making them the largest domestic player.
Although its cigarette sales are confined to the US, it does have exposure to international sales via its numerous other subsidiaries, as well as its sizable interest in Anheuser-Busch InBev.
With exposure to cigarettes, wine, and beer, this is a “sin stock” for the ages.
Altria’s dominant position in selling addictive products is a huge competitive advantage due to the way that cigarettes sport inelastic pricing properties: pricing increases do not tend to cause major drops in demand.
And since the US doesn’t allow cigarettes to occupy traditional advertising space, new entrants are basically forever locked out of the market. This limits competition, creating an oligopoly with rational pricing.
However, traditional tobacco products, like cigarettes, have been under siege for years: new awareness of health concerns, increased regulation, and a substantial amount of litigation are challenges that Altria has had to seriously contend with.
And the rise of technology (through products like e-cigarettes) have completely changed the industry.
While e-cigarettes might at first be thought of as an existential threat to the likes of Altria, I’d argue it’s a tremendous opportunity.
Absent these changes, Altria was looking at volume trends (on traditional cigarettes) that were slowly but surely chipping away at its business model. E-cigarettes give the company a viable and sustainable path to long-term growth.
Altria is adapting to these new tech trends via its MarkTen e-cigarettes, as well as its exclusive license to sell Philip Morris International Inc.’s (PM) iQOS products in the US.
But Altria’s smokeable products still accounted for almost 88% of Q2 2018 revenue, so this transition is still very much a slower, long-term move.
While that transition is playing out, though, Altria remains a dominant and extremely profitable company.
That bodes well for the dividend, which is what we’re all here for.
Altria has a rich dividend history that continues to impress.
They’ve increased their dividend for 49 consecutive years.
And with a 10-year dividend growth rate of 11.3%, age isn’t slowing them down.
To wit, the company increased their dividend twice in 2018.
A 14.3% dividend increase that was announced less than two weeks ago puts the YOY dividend growth at over 20%.
The only issue one might take with the company’s dividend is the payout ratio.
It’s sitting at 82.7% right now, when looking at the new quarterly dividend of $0.80 against adjusted TTM EPS (factoring out a large one-time tax gain for Q4 2017).
However, that payout ratio is pretty much right in line with the 80% payout ratio that Altria’s management targets.
Indeed, this is a company that’s very friendly to shareholders in terms of returning cash. It’s a cash cow, which is made more possible by the fact that a small percentage of its operating cash flow is impacted by capital expenditures.
That is never more evident than when you look at the yield.
The stock is offering a yield of 5.44% right now. That’s huge in this market.
Plus, that yield is more than 150 basis points higher than the stock’s five-year average yield. This speaks to the points made earlier on undervaluation.
These dividend metrics put this stock in the pantheon of dividend growth stocks out there. It’s almost in a class all by itself.
The most reliable dividend is, of course, the one that was just increased. And since Altria increased its dividend twice this year, with the most recent increase coming just days ago, we have a pretty sure bet here.
But in order to determine where this dividend might go in the future, we need to look at what kind of business growth we might expect from Altria moving forward.
And in order to gauge that, we’ll look at what Altria has done over the last decade (using that as a proxy for the long haul). We’ll then compare that historical result to a near-term professional forecast for profit growth.
Looking at the known past and estimated future in this manner should tell us quite a bit about where Altria might be going as a business, which will in turn tell us something about the dividend.
All of this information will later aid us in valuing the business and its stock, too.
Altria has grown its net revenue from $19.356 billion to $25.576 billion between fiscal years 2008 and 2017. That’s a compound annual growth rate of 3.14%.
That’s actually pretty impressive considering the litany of obstacles in the way of this company’s top-line growth trajectory.
And this period is a pretty good look at growth, too, due to the fact that Altria spun off Philip Morris International in 2008. So this is more or less the growth of the company as it exists today.
Earnings per share increased from $1.48 to $3.39 over this period, which is a CAGR of 9.65%.
Again, this is impressive. This is all while the company contends with the billions it pays out as part of the Master Settlement Agreement.
I used diluted EPS from continuing operations for FY 2008 (due to the aforementioned spin-off). And I used adjusted EPS for FY 2017 (to factor out the one-time tax gain). This is, in my view, the most accurate look at Altria’s earnings power.
Altria has to continually make more out of less – volume drops and rising taxes lead to increasing prices. It’s a situation that’s only sustainable as long as Altria can use technology to its benefit (via e-cigarettes and other products).
Meanwhile, the company’s core products are addictive, so this stems the tide.
Looking forward, CFRA predicts that Altria will compound its EPS at an annual rate of 10% over the next three years, which would obviously be right in line with what’s already transpired over the last decade.
For further perspective on this, Altria’s on pace to record earnings per share of right about $4.00 this fiscal year.
All of these numbers portend double-digit dividend growth for the foreseeable future; however, Altria wouldn’t even have to register anything even close to this in order for the investment to be very appealing here.
With that starting yield of well over 5%, Altria’s growth could almost be cut in half, yet it would still be a very good investment from here.
Altria just doesn’t have to do much right in order to make shareholders very happy. It’s a classic cash cow.
Moving over to the balance sheet, Altria’s running a pretty tight ship.
The long-term debt/equity ratio is 0.85, while the interest coverage ratio is over 14.
The debt/equity ratio is actually inflated by low common equity. Things are better than they look. The balance sheet is solid.
Profitability is, as expected, outstanding. Cigarettes are a high-margin, addictive product.
Over the last five years, the company has averaged annual net margin of 31.02% and average return on equity of 139.81%.
ROE is influenced by the low common equity, and the margin has seen some impacts from tax reform and certain changes in subsidiaries. Still, extremely robust numbers.
This is a prototypical dividend growth stock that has all of the ingredients that any dividend growth investor should want to see: decades of dividend increases, a high yield, double-digit dividend growth, a manageable payout ratio, a responsible balance sheet, huge margins, incredible pricing power, brand recognition, and solid overall business growth.
There are some challenges, to be sure.
Litigation and regulation are omnipresent concerns.
And recent volume trends aren’t great, which means Altria has to respond to changing trends in its industry.
But there’s so much to like here.
There’s even more to like when you look at the valuation.
After two sizable dividend increases this year, along with a 15% drop in the stock price YTD, shares appear pretty compelling right now…
The P/E ratio (using TTM EPS that factors out the tax gain in Q4 2017) is sitting at 15.19.
That’s obviously well below the broader market. And it compares well to the stock’s own five-year average P/E ratio of 18.4.
The P/CF ratio is at 16.4, which is significantly lower than the three-year average ratio of 25.0.
And the yield, as noted earlier, is markedly higher than its own recent historical average.
The stock does look quite cheap here, but how cheap might it be? What would an estimate of intrinsic value come out at?
I valued shares using a dividend discount model analysis.
I factored in an 8% discount rate (to account for the high yield) and a long-term dividend growth rate of just 4.5%.
That DGR is less than half of what the company has demonstrated over the last decade, and it’s obviously well below near-term results and where the company appears to be going over the next few years.
But the obstacles this company faces are pretty unique to this industry. And those obstacles are fairly large.
I like to err on the caution, but this is arguably very conservative. There’s nothing indicating this company won’t absolutely smash these expectations moving forward. The stock price is right about where it was three years ago, but this business is better (and earning more) than it was three years ago.
In addition, I happen to believe the company’s stake in Anheuser-Busch InBev is undervalued.
The DDM analysis gives me a fair value of $95.54.
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.
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.
This is a cash cow, and there’s a ton of cash to be had.
That’s why this stock could be worth so much, assuming the business model doesn’t completely collapse.
In fact, I recently added to my Altria position for the first time in years because of how compelling it looks here.
But in order to add the depth that only additional viewpoints can offer, let’s take a look at what two professional analysis firms have to say about this stock’s valuation.
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 MO as a 4-star stock, with a fair value estimate of $64.00.
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 MO as a 5-star “STRONG BUY”, with a 12-month target price of $61.00.
I came out the highest here, which is why it’s great to see where some other numbers are coming in at. Averaging these three results out gives us a final valuation of $73.51, which would indicate the stock is 25% undervalued.
Bottom line: Altria Group Inc. (MO) is a high-quality dividend growth stock that is quintessential across the board. You have decades of dividend raises, a high yield, double-digit dividend growth, and a manageable payout ratio. Two dividend raises this year, along with a 15% drop in the stock price YTD, have potentially set shares up to be 25% undervalued. Dividend growth investors would be wise to think about stocking up on shares right now.
Note from DTA: How safe is MO’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 85. 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, MO’s dividend appears very safe and extremely unlikely to be cut. Learn more about Dividend Safety Scores here.
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