There’s a famous line in the movie, Jerry Maguire.
It’s become an enduring part of pop culture.
You already know which line I’m referencing.
“Show me the money!”
Well, I follow this same line of thought as an investor.
I don’t want a company to tell me how much money it makes.
Numbers on a screen don’t do much. That’s not what pays the bills.
Cash is what pays the bills. It’s all about cash flow.
And that’s a big reason I’m a dividend growth investor.
By buying high-quality dividend growth stocks, like those you’ll find on the Dividend Champions, Contenders, and Challengers list, I’m regularly shown the money.
Actually, I’m regularly shown increasing money.
That’s because these companies are paying cash dividends to shareholders. Those cash dividends are a portion of the profit the companies are producing.
As the profit grows, so do those cash dividends.
If you’re able to collect enough growing dividend income, you can quit your job and do whatever you want in life.
In fact, I used this concept to become financially independent and retire in my early 30s.
And I lay out exactly how I did that in my Early Retirement Blueprint.
If you have a similar dream, make sure to read the Blueprint.
I live off of the five-figure and growing passive dividend income that my FIRE Fund generates on my behalf.
The situation I’m in is something almost anyone else can replicate.
Yes. That includes you!
But it requires being a patient, long-term, intelligent investor.
That means, among other things, performing a thorough quantitative and qualitative analysis on a business before investing a single penny.
Just as important, if not more so, is valuation.
Price is what you pay. But value is what you get for your money.
An undervalued dividend growth stock should present a higher yield, greater long-term total return potential, and reduced risk.
These attributes are relative to what the same stock might otherwise offer if it were fairly valued or overvalued.
All else equal, a lower price will result in a higher yield.
That’s because price and yield are inversely correlated.
This higher yield can lead to greater long-term total return potential.
Total return is comprised of capital gain and investment income. The latter is, of course, boosted by the higher yield.
But capital gain is also given a possible boost via the “upside” available when the price paid is well below estimated fair value. This upside can be unlocked over time if/when the market more correctly prices a stock.
That’s on top of whatever capital gain might come about as a company increases its profit and naturally becomes worth more.
Undervaluation should also reduce risk.
That’s due to the margin of safety. It’s a “buffer” that protects an investor’s downside as much as it improves upside.
Investors should be intelligent, but they can never be prescient. We can’t predict the future.
Because unfortunate events can unfold with any business or in any economy, it’s imperative that an investor pays a price that implies a sizable margin of safety. This offers some protection against unforeseen issues.
Undervaluation can clearly lead to very advantageous dynamics.
Fortunately, it’s not that difficult to value a dividend growth stock.
Fellow contributor Dave Van Knapp provides a great valuation process in Lesson 11: Valuation. Lesson 11 is part of an overarching series of “lessons” on dividend growth investing.
This valuation process can be applied to just about any dividend growth stock out there, which gives investor’s an opportunity to spot undervaluation and take advantage.
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…
Omnicom Group Inc. (OMC)
Omnicom Group Inc. (OMC) is an advertising, marketing, and corporate communications company.
The modern-day incarnation of this company, composed of over 1,500 subsidiaries, can trace its roots back to the late 1800s.
It’s now one of the largest marketing and corporate communications companies in the entire world.
They’ve spent the last century or so building up an enviable company with an impressive amount of diversification, scale, breadth, depth, and experience across their various businesses.
Indeed, they provide services to over 5,000 clients in over 100 countries.
Investing in Omnicom Group is basically like investing in the global economy in one fell swoop. That’s because an Omnicom Group shareholder is gaining some exposure to almost every business that matters across the globe.
The company operates across the following fundamental business disciplines: Advertising, 54% of FY 2018 revenue; CRM Consumer Experience, 17%; CRM Execution & Support, 12%; Public Relations, 9%; Healthcare, 7%.
United States accounts for approximately 52% of total revenue.
So we could look at Omnicom Group as largely an advertising agency.
However, I think the more apt way to view the business is as a comprehensive corporate communications company.
They work with other businesses in order to shape the message and image that’s communicated to their consumers and clients. And they do this in a very holistic way, managing that message from top to bottom.
It’s not just advertising campaigns here. This is a one-stop shop that offers a complete array of solutions.
The proper management and distribution of a message is arguably more critical than ever.
The Internet has allowed for the rapid dissemination of information, which is causing rapid changes in the dynamics of global communication and consumption.
The experience and breadth that Omnicom Group provides should thus become more critical than ever, assuming they can successfully manage these changing dynamics.
This critical nature creates demand. And that bodes well for their ability to pay a growing dividend.
That ability, by the way, looks great.
The company has increased its dividend for 10 consecutive years.
It’s been said that the safest dividend is the one that was just raised.
Well, Omnicom Group increased its dividend only two months ago – by over 8%.
That’s lower than the 10-year dividend growth rate of 14.9%, but it is consistent with more recent dividend raises.
That 8% mark is probably a pretty reasonable expectation for near-term dividend growth.
And that’s a very heavy growth rate when you consider that the stock yields 3.46% right now.
This yield is very attractive in this market.
For reference, it’s more than 60 basis points higher than the stock’s own five-year average yield. This speaks on what I noted earlier about undervaluation and higher yield.
With a low payout ratio of 44.6%, there’s still plenty of room for future dividend raises.
Now, future dividend growth will partially hinge on the company’s ability to navigate the massive changes going on.
That said, we have plenty of data to work with in determining whether or not Omnicom Group is thriving in this era, since the Internet is not exactly new.
I’m going to first look at what kind of top-line and bottom-line growth the company has managed over the last decade, which is a time frame that obviously includes the Internet’s rise to prominence.
I’ll then compare this historical result to a professional forecast for forward-looking profit growth.
Blending the past with some professional guesswork on the future should give us plenty to work with in terms of drawing out a profit growth trajectory for the business.
And that trajectory should translate over to dividend growth, giving us a good shot at valuing the stock with a reasonable amount of accuracy.
Omnicom Group increased its revenue from $11.721 billion in FY 2009 to $15.290 billion in FY 2018. That’s a compound annual growth rate of 3.0%.
Not excellent. But considering that the first few years of this period included a chunk of the worst economic catastrophe my generation has ever seen, I don’t think it’s bad.
Bottom-line growth was stronger, however, thanks to a combination of buybacks and margin expansion.
Earnings per share advanced from $2.53 to $5.83 over this period, which is a CAGR of 9.72%.
Notably, the company reduced its outstanding share count by almost 27% over the last decade. That’s impressive.
And margin expansion has been vigorous, particularly over the last five years. This is very encouraging in light of the aforementioned large-scale changes.
Looking forward, CFRA predicts that Omnicom Group will compound its EPS at an annual rate of 8% over the next three years.
A slight softening here.
CFRA is modeling in currency headwinds, flat margins, and continued investments in the business (especially in digital transformation initiatives). That has to be balanced against gains in key international markets, a lower tax rate, continued buybacks, and the overall diversification of the business.
I believe this is a reasonable forecast. And it would support dividend growth in this same range. That’s why I earlier observed that the most recent dividend increase is probably a good baseline expectation for near-term future dividend growth.
With a moderate payout ratio and 8% EPS growth, investors could very well expect 8% dividend growth. There’s even some room for upside surprise on the dividend raises.
Moving over to the balance sheet, the quality continues.
Although the long-term debt/equity ratio appears high, at 1.72, this is clouded by a lot of treasury stock (from the aforementioned buybacks).
That treasury stock reduces common equity, which thus makes the denominator in this equation lower. That skews the real picture.
Total cash is ~83% of long-term debt.
Furthermore, the interest coverage ratio is over 8.
I see no issues with the balance sheet here.
Profitability is also robust for the industry.
Over the last five years, the firm has averaged annual net margin of 7.48% and annual return on equity of 44.17%.
ROE is aided by the low common equity.
However, FY 2018 net margin is almost a full 200 basis points higher than it was in FY 2009.
That’s admittedly comparing a strong year to the depths of the financial crisis. But there’s been a clear trend of incredible margin expansion over the last decade.
This shows that Omnicom Group is not having any issues in this new era of marketing.
I think that speaks to one of the most compelling reasons to invest in the business – a sticky client base.
Once a company like Omnicom Group becomes attached to a client’s marketing department, it’s almost nonsensical to go with a competitor due to switching costs (both in time and money) and no guarantee things will improve.
Moreover, since Omnicom Group controls the likes of acclaimed BBDO and DDB, the company can just move a client from one network to another. This would be a far easier solution than switching it up wholesale.
I see this as a fundamentally strong company. It certainly offers a large, growing, and well-covered dividend.
But there are some risks to consider.
This is a highly competitive industry. There are only a few major global competitors, but the competitors that do exist are finely-tuned machines.
Any global economic recession will likely translate to a slowdown in spending, which goes for both consumers and businesses alike. Marketing dollars could dry up, especially if there’s less to market.
Also, the digital marketing landscape continues to quickly evolve. Any missteps by Omnicom Group could have far-reaching and long-term consequences. The company must remain on top of this.
Lastly, litigation and regulation are omnipresent risks for every company.
Overall, I see this as a high-quality dividend growth stock.
And the valuation looks appealing right now…
The P/E ratio is 12.90, which is well below both the broader market and industry average.
That also compares rather favorably to the stock’s own five-year average P/E ratio of 17.1.
The P/CF ratio is right in line with its three-year average.
But the yield, as noted earlier, is significantly higher than its recent historical average.
So the stock does look cheap. But how cheap? What would a reasonable estimate of fair value look like?
I valued shares using a dividend discount model analysis.
I factored in a 10% discount rate.
That DGR is right in the middle of what I usually allow for in the model.
I would argue this is conservative when you look at the payout ratio, historic EPS and dividend growth rates, and the professional near-term forecast for EPS growth.
If anything, I’d say 8% is a more realistic near-term expectation for dividend growth.
However, this is a long-term growth model.
And I’d rather err on the side of caution.
It’s a competitive industry. And the global economy could start to pullback any day now.
I think it’s wise to be conservative here when looking at the long-term picture.
The DDM analysis gives me a fair value of $92.73.
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 conservative look at the valuation, the stock still looks undervalued. It’s perhaps significantly undervalued.
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 OMC as a 4-star stock, with a fair value estimate of $85.00.
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 OMC as a 3-star “HOLD”, with a 12-month target price of $78.00.
I came out slightly high. Averaging out the three numbers gives us a final valuation of $85.24. I think that’s a rational estimate of intrinsic value. That would indicate the stock is possibly 13% undervalued right now.
Bottom line: Omnicom Group Inc. (OMC) is a high-quality company with excellent fundamentals. Its diversification, depth, and breadth in terms of the geographic exposure, industry mix, and client base is incredible. This dividend growth stock offers a ~3.5% yield, payout ratio below 50%, and 10 consecutive years of dividend raises. With the potential that shares are 13% undervalued, dividend growth investors should take a good look at this compelling long-term investment opportunity.
Note from DTA: How safe is OMC’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, OMC’s dividend appears very safe with an extremely unlikely risk of being cut. Learn more about Dividend Safety Scores here.