The stock market is my favorite store, and quality stocks are my favorite merchandise.

I love to go shopping.

Finding sales and buying quality merchandise when it’s marked down is a thrill that most people can relate to.

But it’s especially thrilling when the quality merchandise are stocks.

This is one of the only times in life where shopping could end up making you rich!

I’ve gone to the stock market store many times in my life, and I’ve bought up a lot of quality merchandise on sale.

What do I have to show for it?

My FIRE Fund.

It’s my real-money early retirement stock portfolio that generates five-figure and growing passive dividend income.

Those dividends are enough for me to live off of. And I’m only in my 30s!

I was able to retire in my early 30s by living below my means and smartly shopping, as I recount in my Early Retirement Blueprint.

A lot of people are out there busy shopping. The only mistake they’re making is that they’re buying the wrong merchandise in the wrong stores.

If one instead decides to shop for high-quality stocks in the stock market, they’ll be gaining wealth instead of draining it.

Jason Fieber's Dividend Growth PortfolioHowever, even the stock market has plenty of poor merchandise.

This is one reason why I stick to investing in high-quality dividend growth stocks like those you’ll find on the Dividend Champions, Contenders, and Challengers list.

A lengthy track record is a great initial “litmus test” for business quality.

You can’t fake ever-growing cash dividend payments to shareholders.

The growing profit necessary to pay those dividends is either there or it isn’t. The growing cash dividend payments are either hitting your brokerage account or they’re not.

Furthermore, increasing cash dividend payments are a fantastic source of passive income that one can pay their bills with, allowing them to retire much earlier than normal. This is what I did.

So it’s all about quality.

But it’s just as much about finding those deals.

That’s because the price you pay for a stock has a lot to say about what kind of investment it will be for you.

“Price is what you pay. Value is what you get.” – Warren Buffett

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

That’s all relative to what the same stock would otherwise offer if it were fairly valued or overvalued.

Price and yield are inversely correlated; all else equal, a lower price results in a higher yield.

Higher yield is great because that’s more investment income in your pocket.

That higher yield also leads to greater long-term total return potential.

Total return is simply the sum of capital gain and investment income.

A higher yield obviously boosts the investment income portion of that equation.

Capital gain, however, is also given a possible boost via the available “upside” between a lower price and higher intrinsic value.

If you buy a quality stock while it’s on sale, there’s a good chance it’ll be “repriced” more appropriately down the road. That’s capital gain.

This would be on top of whatever capital gain would naturally come about as a business increases its profit and becomes more valuable over time.

These dynamics should introduce a margin of safety.

That’s a “buffer” that protects your downside against unforeseen negative events.

A favorable gap between price and value limits the odds that you end up “upside down” on an investment, where it’s worth less than you paid.

This reduces risk.

Fortunately, it’s not terribly difficult to spot these sales as a stock market shopper.

Fellow contributor Dave Van Knapp has made it pretty easy to find the discounts through Lesson 11: Valuation.

That’s a valuation template that can be applied to just about any dividend growth stock.

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…

Cardinal Health Inc. (CAH)

Cardinal Health Inc. (CAH) is a major distributor of pharmaceuticals and medical supplies to a variety of healthcare clients.

Cardinal Health Inc. operates under two segments: Pharmaceutical, 89% of FY 2018 revenue; and Medical, 11%.

This company is a critical cog in the US healthcare system.

Through more than 40,000 employees, they distribute pharmaceuticals and medical supplies to more than 100,000 locations.

These products can’t get to hospitals, doctors, pharmacies, or consumers if they’re not being properly and effectively procured and distributed.

Drugs and medical supplies aren’t discretionary products; they’re necessary products in a necessary industry. People often can’t live without these products.

This underscores the importance of Cardinal Health. It’s part of why they’ve gone on to build a business that does over $100 billion in annual revenue.

Moreover, there are only three major companies in the US that distribute in this capacity.

The other two major competitors (which are both larger than Cardinal Health) are McKesson Corporation (MCK) and AmerisourceBergen Corp. (ABC).

That means Cardinal Health is part of an oligopoly.

So it’s limited competition in a critical part of a necessary industry.

It’s not all gravy, though.

A major drawback to this business is that it’s essentially a “middle man”. This greatly limits margins.

However, the healthcare industry is almost guaranteed to do well over the long run. The US is becoming bigger, older, and wealthier.

Dividend Growth, Growth Rate, Payout Ratio and Yield

Demand for and access to high-quality medical products and pharmaceuticals will never be in short supply. That bodes well for Cardinal Health, its profit, and its ability to pay and raise its dividend.

That ability, by the way, has never looked better.

The company has increased its dividend for 23 consecutive years.

That period stretches right through numerous economic and market difficulties, including the most recent financial crisis and ensuing Great Recession.

The 10-year dividend growth rate stands at a stout 17.5%.

However, more recent dividend raises have slowed into the low-single-digit range.

That reflects some near-term challenges the company has faced, especially on the Medical side of the business.

But with a yield of 3.46%, this stock doesn’t need super high dividend growth in order to offer plenty of total return and aggregate investment income over the long run.

That yield, by the way, is almost 90 basis points higher than the stock’s five-year average.

Meanwhile, a payout ratio of 39.9% (based upon adjusted TTM EPS) indicates no issue whatsoever with dividend coverage.

Investors should be able to sleep well at night regarding the health (pun intended) of Cardinal Health’s dividend.

Revenue and Earnings Growth

The forward growth of that dividend is something we’ll have to estimate, though, which will have a lot to say about what the stock might be worth.

We’ll first look at Cardinal Health’s top-line and bottom-line growth over the last decade. Using that as a proxy for the long haul, this will tell us a lot about the company’s overall growth profile.

And then I’ll compare that to a near-term professional forecast for profit growth.

Blending the known past and estimated future in this manner should give us a very good idea about Cardinal Health’s long-term earnings power.

The company increased its revenue from $99.512 billion in FY 2009 to $136.809 billion in FY 2018. That’s a compound annual growth rate of 3.60%.

This is a very solid growth rate, particularly considering that it started from a large base.

However, much of this growth was due to acquisitions. It wasn’t all organic.

Cardinal Health acquired Cordis, a global manufacturer and distributor of cardiology devices, from Johnson & Johnson (JNJ) in 2015 for $1.9 billion. They then acquired the Patient Monitoring & Recovery division from Medtronic PLC (MDT) in 2016 for $6.1 billion.

These acquisitions have gone on to differentiate Cardinal Health from its two larger competitors. These moves diversify the business away from drug distribution.

Although still a small part of the company’s revenue pie, the medical devices manufacturing and distribution adds breadth. It creates a more robust business in the healthcare space. This is important because healthcare payers and providers have been consolidating, giving them pricing power over distributors. These acquisitions should help margins, too.

Well, that was the plan anyway. It hasn’t worked out quite that well, unfortunately.

Cordis, in particular, has struggled. Cardinal Health recorded a $1.4 billion goodwill impairment in Q4 2018 primarily due to the performance of Cordis.

That’s a pretty significant non-cash charge that greatly devalues the business.

The good news is that Cordis is a rather small part of Cardinal Health. So the impact is minimal.

More good news: the company has been steadily growing its earnings per share over the last decade when you look past a lot of noise.

Earnings per share advanced from $3.18 to $5.00 over this period, which is a CAGR of 5.16%.

Notably, I used adjusted EPS for FY 2018 because the one-time non-cash charge related to Cordis doesn’t accurately reflect earnings power.

I think this is a fairly good result here for a low-margin business.

It’s not outstanding. But it’s more than enough to propel mid-single-digit (or better) dividend growth since the payout ratio is modest.

The excess growth (relative to revenue) was due to buybacks.

Cardinal Health reduced its outstanding share count by almost 13% over the last 10 years.

Looking forward, CFRA is predicting that Cardinal Health will compound its EPS at an annual rate of 5% over the next three years.

I believe this is realistic.

For perspective, Cardinal Health just reported Q2 2019 results and included/increased FY 2019 guidance. The top end of non-GAAP EPS guidance for FY 2019 pins YOY growth at about 3.5% (over the $5.00 reported for FY 2018).

I don’t think 5% EPS growth is blowing anyone’s doors off.

However, the stock is priced for low expectations. It was $75/share in January 2018. Just over a year later, we’re looking at a stock that’s below $53. I’d certainly rather buy Cardinal Health at $53 than $75.

There are some important catalysts to consider here.

Buybacks, a lower tax rate, and a cost-cutting program should all help stabilize the company.

Moreover, even just 5% EPS can still fuel slightly higher dividend growth because the payout ratio allows for it. I think dividend growth in the 6% to 7% range is a reasonable expectation, although Cardinal Health may remain conservative over the near term on this front.

Financial Position

Moving over to the balance sheet, the company has taken on debt to fuel diversification and growth.

As pointed out earlier, though, this hasn’t worked out as planned.

Cardinal Health has historically had a fantastic balance sheet.

It’s not in any danger or anything of the sort, but there’s been some marked deterioration here over the last five years.

The long-term debt/equity ratio is 1.32.

This is much higher than just a few years ago.

I usually like to include a full-year interest coverage ratio, but the FY 2018 numbers aren’t relevant for this due to the askew GAAP numbers.

With Q2 FY 2019 numbers out, the interest coverage ratio for FY 2019 thus far comes in at over 8.

Again, absolutely nothing to worry about here.

But these numbers are definitely not as good as they were a few years ago. And with the growth that debt was supposed to buy not yet materializing, this is disappointing.

Profitability is as expected for this business.

Cardinal Health operates as a low-margin distributor. Their scale gives them a huge advantage in a market with limited competition. But they need that scale in order to turn a profit.

Over the last five years, the company has averaged annual net margin of 0.93% and annual return on equity of 16.72%.

These numbers have both been negatively affected by FY 2018. However, the company’s profitability is actually quite strong for the industry. It remains to be seen if the Medical segment of the company eventually hinders or helps this.

Cardinal Health operates with massive scale in an oligopoly with huge barriers to entry. It would be next to impossible for a new entrant to compete effectively.

However, risks like regulation and litigation (especially with the medical devices) are omnipresent in the healthcare space.

And Cardinal Health doesn’t have any pricing power. They’re effectively a price taker. Again, they’ve been aiming to improve this via the aforementioned acquisitions, but they’re still largely a distributor.

At the right price, though, this could be a great long-term investment.

Stock Price Valuation

With the stock down almost 27% from what it was in January 2018, I think it’s attractively valued right now…

The stock is trading hands for a P/E ratio of 11.48.

That’s using adjusted TTM EPS that factors out the Cordis impairment.

That’s almost half the broader market.

Taking the adjustment out of the equation, look at the cash flow.

The P/CF ratio is 8.3. That’s substantially lower than the stock’s own three-year average P/CF ratio of 10.5.

And the yield, as shown earlier, is significantly higher than its own recent historical average.

The stock looks cheap. But how cheap? What would a rational estimate of intrinsic value look 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%.

This DGR is on the low end of what I normally account for. It’s certainly much lower than Cardinal Health’s 10-year DGR track record. And the low payout ratio can further expand.

However, the near-term forecast for EPS growth doesn’t allow for much more dividend growth than what I’m including here. I think it’s even possible that near-term dividend growth is lower than this, to be made up for later as the company further stabilizes itself.

The dividend is very safe. It’s really just a matter of how fast the dividend will grow. I think this is a fair expectation over the long run.

The DDM analysis gives me a fair value of $58.12.

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.

I’m being cautious here. Even with that caution, though, the stock still looks decently cheap after the huge YOY price drop.

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 CAH as a 5-star stock, with a fair value estimate of $82.00.

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 CAH as a 3-star “HOLD”, with a 12-month target price of $59.00.

We’re all in agreement that this stock is undervalued, although Morningstar believes it to be strongly so. Averaging the three numbers out gives us a final valuation of $66.37, which would indicate the stock is potentially 21% undervalued right now.

Bottom line: Cardinal Health Inc. (CAH) has immense scale and operates as part of a critical cog in the US healthcare system. With limited competition, almost a quarter century of dividend increases, a low payout ratio, a market-beating yield, and the possibility of shares being 21% undervalued, this dividend growth stock should be strongly considered for the health of your portfolio.

-Jason Fieber

Note from DTA: How safe is CAH’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 89. 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, CAH’s dividend appears very safe with an extremely unlikely risk of being cut. Learn more about Dividend Safety Scores here.