If you’re a long-term investor who buys stocks, you’re spoiled for choice.

There are thousands of publicly traded companies out there, which is wonderful.

At the same time, though, the sheer number of choices can be overwhelming, especially if you’re new to investing.

Not only that, but many of these thousands of stocks represent equity in less-than-stellar enterprises.

I’ll share with you a very simple mantra that can keep you from getting into trouble with your investments…

If you’re a long-term investor who wants to do well in the stock market, you should aim to buy high-quality stocks when they’re attractively valued.

The issue with this idea is, high-quality stocks are often expensive; it’s difficult to find undervalued high-quality stocks.

But often isn’t always.

There are opportunities in the market.

This is especially true after the recent swoon that’s brought about a very solid correction in the broader market.

But before we go crazy, we first have to define some of our terms here.

When I think of high-quality stocks, I think of high-quality dividend growth stocks.

It’s easy to talk about running a business. It’s easy to talk about customers. It’s easy to talk about profit.

However, it’s a lot more difficult to put your money where your mouth is. It’s a lot tougher to show that profit.

That’s where a cash dividend comes in.

It’s the “proof in the profit pudding”, as I like to say.

And if you’re being paid growing cash dividends, for years and years on end, you can bet there’s a pretty strong business at the root of that.

A lengthy track record of regularly increasing cash dividend payments to shareholders is a great initial litmus test of business quality.

For more on what that looks like with real-life businesses, check out the Dividend Champions, Contenders, and Challengers list – a document containing invaluable information on more than 800 US-listed stocks that have raised their dividends each year for at least the last five consecutive years.

I’ve been an advocate of dividend growth investing for many years now, but I’m eating my own cooking here.

By living below my means and systematically investing in high-quality dividend growth stocks at appealing valuations, I went from below broke at 27 years old to financially free at 33.

Jason Fieber's Dividend Growth PortfolioI built up my FIRE Fund in the process, which is my real-life and real-money dividend growth stock portfolio that generates the five-figure and growing passive dividend income I need to cover my essential expenses without having a job.

As noted earlier, one will often find the highest-quality dividend growth stocks trading for valuations that reflect their inherent quality.

They’re often expensive.

But it does behoove one to always pay attention to valuation, even when dealing with quality businesses.

Price is what you pay, but value is what you get for your money.

And if you pay a price that’s too high for a stock, you’re putting yourself at a disadvantage.

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

That’s 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 inverse relationship between price and value; all else equal, a lower price will result in a higher yield.

You end up with greater long-term total return prospects as a result, since total return is comprised of investment income (via dividends or distributions) and capital gain.

A higher yield means more investment income on the same invested dollar.

And that’s before factoring in the additional capital gain potential due to the “upside” that’s available between a lower price paid and higher intrinsic value.

While the stock market might not accurately price every stock at every given moment, which can lead to these undervalued opportunities, price and value do tend to correlate fairly closely over the long run.

Buying when there’s a favorable dislocation between price and value sets you up for that upside, as well as the higher yield.

This should reduce risk, too.

It’s obviously less risky to pay less money for the same exact asset; paying less means you’re risking less capital.

A margin of safety is also introduced when you buy an undervalued stock, as that protects your downside from any number of adverse situations that can occur after investment: new competition, mismanagement, additional regulation, litigation, etc.

You want to maximize your upside while simultaneously minimizing your downside.

Fortunately, these undervalued conditions aren’t terribly difficult to spot.

To help individual investors with that quest, fellow contributor Dave Van Knapp put together a great piece that discusses a valuation process that can be applied to just about any dividend growth stock out there.

Part of an overarching series of articles that introduce and teach the strategy of dividend growth investing, Lesson 11: Valuation is definitely worth reading.

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…

3M Company (MMM)

3M Company (MMM) is a diversified global manufacturing conglomerate.

Founded in 1982, the company now operates across five business segments: Industrial, 33% of FY 2017 sales; Safety & Graphics, 19%; Healthcare, 18%; Electronic & Energy, 16%; and Consumer, 14%.

Geographic distribution of FY 2017 sales are as follows: US, 39%; Asia Pacific, 31%; Europe, Middle East
and Africa, 20%; and Latin America and Canada, 10%.

Just over 60% of the company’s sales are generated from outside the US.

The company employs just over 91,000 people worldwide, focusing on applying science across 12 areas of expertise: Automotive; Design & Construction; Manufacturing; Commercial Solutions; Electronics, Mining, Oil & Gas; Communications; Energy; Safety; Consumer; Healthcare; and Transportation.

3M is one of the world’s largest industrial conglomerates, with a market cap that exceeds $100 billion.

They also lay claim one of the world’s longest and best dividend growth track records.

This is a blue-chip dividend growth stock for the ages.

The company has been paying an increasing dividend for 60 consecutive years.

For further perspective, they’ve paid uninterrupted dividends for over 100 years.

I mean, we’re talking wars, recessions, political changes, regulatory changes, demographic changes, business changes, etc.

This company has seen it all, which should give dividend growth investors (all investors, really) some comfort regarding their ability to weather storms and keep pumping out those growing dividends.

The 10-year dividend growth rate is sitting at 9.4%, which is just slightly in excess of EPS growth over this time frame.

As such, the payout ratio has grown just a bit.

At 64.2%, the payout ratio (using TTM EPS that adds back the $1.25 one-time tax hit shown earlier) is slightly elevated – but not worrisome – at this point.

That means I’d expect dividend growth to more or less mirror EPS growth for the foreseeable future. If that 12% mark forecast comes to pass, that’s a lot to like.

The stock now yields 2.86% after the recent drop from just over $200/share to just under $185/share after the Q3 report reduced guidance.

Recent broader stock market volatility should also impacted this stock.

But that’s an opportunity that has led to a higher yield, which is one of the positive points touched on earlier.

This yield is almost 70 basis points higher than the stock’s five-year average yield of 2.2%, which is fairly significant.

It’s also much higher than the broader market, which means you’re getting an above-average yield along with above-average dividend growth. And I’d argue you’re looking at above-average quality, too.

Of course, we invest in where a company is going, not where it’s been.

We’ll take a look at what this company has done over the last decade (using that as a proxy for the long term) in terms of top-line and bottom-line growth, as well as what they’ve done with the dividend.

Then we’ll compare that to a near-term forecast for profit growth, which should tell us quite a bit about the valuation (which we’ll get into toward the end of the article) and future dividend growth.

3M has increased its revenue from $25.269 billion in FY 2008 to $31.657 billion in FY 2017. That’s a compound annual growth rate of 2.54%.

So the top line isn’t super impressive here, but I think it’s important to keep a few things in mind.

First, 3M isn’t a big acquirer, nor are they a serial acquirer. The top-line number here is mostly organic.

Second, 3M, due to its sales mix, is heavily exposed to forex concerns. A strong dollar for a significant period of time impacted reported numbers.

Third, this period is one of toughest periods you could possibly choose to look at, as the first three years basically included the bulk of the Great Recession.

Coming out of FY 2009, the company’s revenue started growing at a faster rate, although more recent years have been troubled by the currency issues.

Meanwhile, they grew their earnings per share from $4.89 to $9.18 over this same period, which is a CAGR of 7.25%.

I adjusted FY 2017 EPS by adding back in the $1.25 one-time tax hit related to the Tax Cuts and Jobs Act that’s immaterial to long-term earnings power.

Bottom-line growth was aided by a combination of expanding margins and share buybacks.

Regarding the latter, 3M reduced its outstanding share count by approximately 13% over the last decade.

Moving forward, CFRA, a major analysis firm, is calling for 3M to compound its EPS at an annual rate of 12% over the next three years.

That would be a strong acceleration of the bottom line, if it were to come to pass.

This forecast is citing tax reform, continued sizable buybacks, and a strong global economy.

While this would be excellent, 3M doesn’t need to compound at 12% annually in order to produce above-average returns and deliver great dividend raises to investors.

Even something closer to 7% to 8% (more in line with what we see above) would be more than enough to get the job done, but a higher growth rate wouldn’t surprise me with tax reform and the last decade being particularly challenging.

That said, I do hope 3M can grow at something closer to 12%. That would be pretty amazing. I’m cautiously optimistic that they’ll come in a bit higher moving forward compared to their historical norm.

Recent results have been solid, but the aforementioned strong dollar continues to impact sales – Q3 2018 results showed sales that were down 0.2% YOY due, in part, to currency. Diluted GAAP EPS still grew 10.7% YOY, however.

Moving over to the balance sheet, the long-term debt/equity ratio is sitting at 1.05.

That’s not particularly high, but it’s actually worse than it looks.

Total cash is almost 1/3 of long-term debt. More importantly, common equity is artificially low to treasury stock weighing total stockholders’ equity.

The balance sheet and company’s financial position are in reality excellent, as exhibited by the interest coverage ratio that’s over 24.

Profitability is robust.

3M has averaged over the last five years annual net margin of 15.75% and annual return on equity of 37.65%.

These are excellent numbers that have both expanded and improved over the last decade.

3M is broadly diversified across the board: geographically, segments, and end markets.

And they use their expertise, global platform, scale, brand power, diversification, technology, innovation, and distribution network to their advantage, building an enviable economic moat around the business.

3M is a leader in R&D, spending about 6% of its sales on R&D. This should allow it to innovate and stay ahead of the competition, patenting their results and bringing value to their customers. They’ve been issued over 110,000 patents across the business. 3M is a leader in IP.

The company is globally exposed to almost every end market that exists. They produce products that end up being used in numerous end applications: appliances, packaging, aerospace, electronics, construction, surgical supplies, telecommunications networks, renewable energy, etc. Investing in 3M is basically investing in the global economy al in one shot.

And they have numerous brands that convey quality and consistency both on the consumer and industrial sides. These brands include the likes of Scotch, Scotchgard, Post-it, Scotch-Brite, ACE, and the eponymous 3M.

As with any business, investing in 3M has risks that should be considered.

Namely, any broader economic slowdown could impact 3M’s sales and profit. While the company is largely insulated from issues with any one customer or end market, issues across the board could cause a drop in sales.

However, the company’s resiliency showed itself during the financial crisis and ensuing Great Recession, which about as tough a test as any (and one not likely to be repeated any time soon). For context, EPS dropped from $4.89 to $4.52 between FY 2008 and FY 2009. And the dividend kept right on growing. Not exactly the end of the world.

Regulatory and legal risks are always present for any business.

And 3M operates in a competitive global marketplace, which is why their innovation is so critical.

All in all, though, I see 3M as a low-risk business, which has usually been evident in its valuation. It’s a premium company that usually commands a premium multiple.

That premium multiple has come down a bit of late, and I’d argue the stock now looks modestly undervalued…

The stock is trading hands for a P/E ratio of 22.43 (using adjusted TTM EPS that factors out the tax hit).

That’s a below-market multiple. And that’s on above-average yield, growth, and quality, as noted earlier.

The P/E ratio is only slightly higher than the stock’s own five-year average P/E ratio of 21.0.

The P/S ratio, at 3.5, is right in line with the five-year average multiple of 3.5.

However, the yield, as shown earlier, is substantially higher than its recent historical average, although I think that partly owes to the fact that the payout ratio has expanded in recent years. So I’d take that with a grain of salt.

So the stock looks slightly undervalued here, which is just the kind of opening you want to look for when you’re aiming to buy one of the best businesses in the world. But how undervalued might it be? What kind of opening might we be looking at? 

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%.

That DGR is on the upper end of what I typically allow for, but I think 3M’s long-term track record warrants it.

Keep in mind, this forward-looking DGR is well below 3M’s long-term demonstrated dividend growth rate. It’s also below the forecast for near-term EPS growth (which should allow for like dividend growth). And it’s roughly on par with the company’s 10-year EPS growth rate, which includes one of the most challenging periods you could throw at it.

The DDM analysis gives me a fair value of $233.92.

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.

My conservative valuation shows a stock that looks at least undervalued. Maybe not monstrously so. But it doesn’t look expensive. That’s for sure.

But we’ll now compare that valuation with where two professional stock analysis firms have come out at, which adds balance, depth, and perspective to our conclusion and final 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 MMM as a 3-star stock, with a fair value estimate of $193.00.

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 MMM as a 3-star “HOLD”, with a 12-month target price of $205.00.

Averaging the three numbers out gives us a final valuation of $210.64, which would indicate the stock is potentially 11% undervalued right now.

Bottom line: 3M Company (MMM) is one of the highest-quality dividend growth stocks out there. There are few businesses that can match its diversification, breadth, scale, or innovation. It’s nearly an unparalleled business. With a rare ~3% yield, 60 consecutive years of dividend increases, a long-term dividend growth rate near 10%, and the potential that shares are 11% undervalued, investors should carefully consider buying this stalwart here.

— Jason Fieber

Note from DTA: How safe is MMM’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 86. 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, MMM’s dividend appears very safe with an extremely unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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