There are many terrible ways to approach money management and investing.
Day trading, jumping into crytopcurrency hysteria, and speculating on this week’s hot trend.
Those are all examples of what not to do if you want to build sustainable long-term wealth and passive income.
Meanwhile, it’s so simple and straightforward to do the right thing.
Guess what you’ve never heard anyone say?
“I went broke by investing in high-quality businesses at appealing valuations.”
Nobody has ever said this!
Buy quality, get a good deal, and diversify. It’s that simple.
When I think of high-quality companies, I think of high-quality dividend growth stocks.
The Dividend Champions, Contenders, and Challengers list practically makes my case for me.
That list contains data on more than 800 US-listed stocks that have raised their dividends every year for at least the last five consecutive years.
Many stocks on that list are the blue-chip stocks that have been building wealth for generations.
After all, it’s nigh impossible to pay out growing cash dividends year in and year out without running a fantastic business.
These stocks have done right by me. That’s for sure.
I used the dividend growth investing strategy to go from below broke at 27 years old to financially independent and retired early at 33.
I lay out how that occurred in my Early Retirement Blueprint.
By routinely investing my savings into high-quality dividend growth stocks at appealing valuations, I built out the diversified FIRE Fund.
That’s my real-life and real-money dividend growth stock portfolio.
It generates the five-figure and growing passive dividend income I need to be financially independent and retired early (FI/RE).
DGI is wonderful. It’s almost perfectly suited for financial independence.
Fundamental analysis and valuation are keys to successful long-term investing.
Price is only what you pay, but value is what you get for your money.
An undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and less risk.
This is 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 yield. All else equal, a lower price will result in a higher yield.
Total return is investment income and capital gain. A higher yield should mean more investment income. Thus, greater long-term total return potential.
Plus, there’s the “upside” that’s available between price and value.
The stock market isn’t necessarily great at accurately pricing stocks in the short term, leading to undervaluation opportunities.
Capitalizing on mispricing can lead to upside capital gain, which is on top of capital gain that would naturally materialize as a company becomes worth more.
Investing less absolute money obviously means reduced risk.
Risking less capital (either on a per-share basis or across the entire transaction) is pretty straightforward.
It also introduces a margin of safety.
That acts as a buffer, protecting the investor against unforeseen events that could lead to value erosion.
Maximizing upside simultaneously minimizes downside. We don’t have crystal balls. And so it’s important to be conservative and invest when there appears to be a large margin of safety.
These dynamics are very favorable. And sought after, for good reason.
Fortunately,valuing dividend growth stocks isn’t extremely difficult.
Fellow contributor Dave Van Knapp has made that process even easier via Lesson 11: Valuation.
Part of an overarching series of “lessons” on DGI, it lays out a simple template that can be applied to just about any dividend growth stock.
It greatly simplifies the valuation process, which allows you to take advantage of these dynamics.
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…
Emerson Electric Co. (EMR)
Emerson Electric Co. (EMR) is an industrial conglomerate that designs and supplies product technology and solutions for industrial, commercial, and consumer markets.
Founded in 1890, Emerson Electric is now a global industrial giant with a market cap of almost $40 billion.
The company operates across two core business platforms: Automation Solutions, 66% of FY 2018 revenue; and Commercial & Residential Solutions, 34%.
Emerson Electric’s “bread and butter” is process automation. The company provides the products and services that allow businesses across the spectrum of industries to efficiently automate and optimize their processes. It’s all about getting more out of less.
In a world where automation and increased productivity separate the best from the rest, Emerson Electric has positioned itself as a leading provider of technologies that allow for companies to improve performance.
Think everything from process management software to measurement instrumentation.
The company operates across almost every end market one can think of. Emerson Electric’s exposure varies from automotive to wastewater.
Broad diversification, leadership, and expertise in the technologies that 21st century companies need. It all bodes well for Emerson Electric and its shareholders.
Dividend Growth, Growth Rate, Payout Ratio and Yield
And that bodes well for the company’s ability to pay a growing dividend, too.
As it sits, the company has increased its dividend for 62 consecutive years.
That’s one of the longest such track records in the entire world.
And with a payout ratio of 60.9%, it remains a safe dividend that’s easily covered by earnings.
Not only do you get that kind of amazing commitment to a growing dividend, but the stock also offers an attractive yield of 3.14% right now.
That’s pretty much right in line with the stock’s five-year average. But it’s significantly higher than the broader market’s yield, as well as the industry average.
And you can bet the average industrial company hasn’t been able to grow their dividend for more than six straight decades.
It’s basically a dividend that’s about as sure to grow as it gets.
However, the dividend growth of late has been disappointing.
The 10-year dividend growth rate stands at 5.9%.
Not bad. It exceeds inflation for sure. But it’s not great, either.
Worse yet, dividend growth has markedly decelerated in recent years. The most recent dividend increase was only 1%.
A dividend payment is never guaranteed. A dividend raise is even less so.
But Emerson Electric’s dividend is about as close to a guarantee as it gets, so I think it’s important to keep that in mind when looking at the dividend metrics.
In addition, as noted above, they’ve positioned themselves extremely well moving forward. I think this could translate into dividend growth that accelerates and gets back to a long-term norm.
Revenue and Earnings Growth
Let’s now look at the company’s long-term earnings power and trajectory in order to get a better feel for that dividend growth potential.
I’ll first explain Emerson Electric’s long-term top-line and bottom-line growth. And then I’ll compare that to a near-term professional forecast for profit growth.
Blending what the company has already done with what it’s thought to do over the near term should allow us to extrapolate out some expectations.
Emerson Electric’s revenue has declined from $20.915 billion in FY 2009 to $17.408 billion in FY 2018. This is a compound annual growth rate of -2.02%.
A shrinking top line is usually not what I’d like to see.
However, the reason for this isn’t because there’s been an issue with the business model.
Rather, the company has reshuffled its portfolio and business lines in recent years in order to become more streamlined, focused, and profitable.
Most notable was its $4 billion sale of its Network Power business in 2016. That transaction alone dropped revenue by $4 billion per year.
The company has been picking up smaller complementary businesses in recent years as opportunities have popped up.
The most recent example is the acquisition of the Intelligent Platforms division from the struggling General Electric Co. (GE).
Meanwhile, earnings per share grew from $2.27 to $3.22 over this period, which is a CAGR of 3.96%.
I factored out a $0.24 one-time tax benefit for FY 2019 with these numbers.
A better showing on the bottom line over the last 10 years.
The combination of margin expansion and share buybacks have buoyed EPS.
Margins have expanded nicely in recent years, owing to the aforementioned business realignments. For perspective, net margin for FY 2009 came in at 8.24%. It was well over 12% for FY 2018.
The outstanding share count has dropped by 16% over this period, further aiding the growth profile.
In my view, Emerson seems to have finally found its footing with the restructuring its undergone.
I now that sounds funny for a company that’s well over 100 years old, but technologies, businesses, and economies change over time. Sometimes these changes are massive.
A company like Emerson Electric has to adapt to these changes. Their history thus far has proven that they’re adept at adapting, but lulls can happen as things play out.
Moving forward, though, CFRA is anticipating that Emerson Electric will compound its EPS at an annual rate of 10% over the next three years.
So we can see that the forecast is for a nice acceleration looking out over the foreseeable future.
CFRA believes Emerson Electric will continue to expand margins and buy back shares, supported by improving order strength, strong global demand, and a combination of organic and acquisition-related sales growth.
Adding to this is Emerson Electric’s own 2019 guidance, which was provided with the Q4 2018 earnings release.
The company is guiding for 6% to 9% net sales growth and GAAP EPS of $3.55 to $3.70. At the high end, GAAP EPS would be growing at almost 15% YOY compared to GAAP EPS for FY 2018 (after factoring out the tax gain).
Emerson Electric has spent years paving the way for this. I think they’re in a great spot to put out results that investors have been used to from this company over the last few decades.
Moving over to the balance sheet, it’s a rock-solid backbone for the company.
The long-term debt/equity ratio is 0.35. Great number here.
The interest coverage ratio, at over 14, further indicates solid financial footing.
Profitability is robust. And it’s become more so in recent years, after the aforementioned portfolio realignments.
Over the last five years, net margin has averaged 10.95% per year.
Return on equity averaged 23.00% per year over that same stretch.
These are competitive numbers. Both have improved markedly relative to where they were at a decade ago.
Morningstar gives Emerson Electric a wide economic moat.
I think that’s warranted giving the switching costs. Once Emerson Electric is allowed to install its technologies, they’re basically locked in at that point. And given Emerson Electric’s scale, leadership, portfolio breadth, and expertise, there aren’t many good options to turn to anyway.
Of course, risks are always present.
I see the biggest risk here as a global economic slowdown.
Although that’s a risk for any company, Emerson Electric will thrive on the back of global expansion because of the resulting demand for increased productivity. If things get tight, I can see the demand for automation being greatly reduced because it’s an investment in growth.
That said, Emerson Electric has prospered through every recession that’s ever come about. And I don’t see that changing anytime soon.
This is a prototypical dividend growth stock.
More than 60 consecutive years of dividend raises speaks for itself. If you’re looking for a dividend that’s as close to “guaranteed” as it gets for your retirement, this is it.
Recent dividend raises have been disappointing. No doubt about it.
But the company is poised to deliver far better numbers moving forward, which should translate into bigger dividend raises.
Now could be a great time to get in, before that acceleration starts to play out. You want to board a plane before it takes off.
Well, the stock looks attractively valued for that opportunity right now…
Stock Price Valuation
It’s trading hands for a P/E ratio of 19.38, which is below its five-year average P/E ratio of 20.6.
And I used a disadvantageous GAAP EPS number for that ratio, which factors out the one-time tax gain in FY 2018.
Furthermore, the P/CF ratio, at 13.7, is substantially below its three-year average P/CF ratio of 16.4.
The stock is more than 20% off of its 52-week high of almost $80/share, reached in the fall of 2018. It now looks appealing. But how appealing?
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%.
That DGR is arguably aggressive considering the dividend growth posted up over the last decade.
The company has clearly started to move in the right direction.
More recent numbers have been fantastic.
And the forecast for near-term EPS growth would support this thesis.
This thesis is further bolstered by the company’s own guidance.
Any major recession could throw a wrench into this, but that could be said for any stock.
The DDM analysis gives me a fair value of $69.91.
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.
So I don’t believe the stock is extremely undervalued. But it sure looks appealing here, especially when looking at the quality, dividend growth track record, and drop in valuation from only a few months ago.
But we’ll now compare that valuation with where two professional stock analysis firms have come out at.
This adds balance, depth, and perspective 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 EMR as a 4-star stock, with a fair value estimate of $83.00.
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 EMR as a 4-star “BUY”, with a 12-month target price of $82.00.
Boy, I came out low. The analysis firms have a pretty tight consensus. Nonetheless, averaging out the three numbers gives us a final valuation of $78.30. That would indicate the stock is potentially 25% undervalued.
Bottom line: Emerson Electric Co. (EMR) is a high-quality industrial conglomerate and productivity powerhouse. This is a prototypical dividend growth stock that’s positioned itself well and adapted to 21st century needs. Accelerating growth, more than 60 consecutive years of dividend raises, a market-beating yield, and the possibility of shares are 25% undervalued means this could be just the stock to improve productivity in your portfolio.
Note from DTA: How safe is EMR’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 84. 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, EMR’s dividend appears very safe with an extremely unlikely risk of being cut. Learn more about Dividend Safety Scores here.