Building significant wealth and passive income.
Well, it’s actually very simple.
However, simple does not mean easy.
But I’ve found a strategy that makes it far easier.
That strategy is dividend growth investing.
DGI, which advocates buying high-quality companies that pay growing dividends, cuts through the fog.
I’ve used this strategy as my lodestar in life.
And it helped me go from broke at 27 to retired at 33, a journey I share in my Early Retirement Blueprint.
Almost anyone can do what I did.
I simply saved my money and bought high-quality dividend growth stocks at appealing valuations.
Stocks just like those you’ll find on the Dividend Champions, Contenders, and Challengers list.
And I built my FIRE Fund in the process.
That is my real-money early retirement stock portfolio.
It generates the five-figure passive dividend income I live off of.
Indeed, it’s simple to do what I did.
But it’s not easy to habitually make good choices, routinely live below your means, and courageously buy stocks in the face of volatility.
That’s why I’m providing a compelling long-term dividend growth stock investment idea today.
This idea should make it a bit easier to muster up the courage to put your long-term capital to work.
While buying high-quality dividend growth stocks is simple at the surface, valuation complicates matters.
Valuation plays a huge role in your long-term investment performance.
While price will tell you what you pay, value will tell you what you’re getting for your money.
An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.
This is relative to what the same stock might otherwise provide if it were fairly valued or overvalued.
All else equal, because price and yield are inversely correlated, a lower price results in a higher yield.
A higher yield leads to greater long-term total return potential.
Total return is comprised of capital gain and investment income.
The higher yield boosts the latter.
Plus, there’s the budding “upside” capital gain.
This is the gap between price and value when undervaluation is present.
Adding that possible upside to the higher yield is a one-two combo that is incredibly powerful.
These dynamics should also reduce risk.
These dynamics establish a margin of safety.
This “buffer” protects the investor’s downside against unforeseen events that can erode value.
Think malfeasance, industry disruption, additional regulations.
Because no one has a crystal ball, we must be cautious when investing for the long term.
Valuation is another concept that’s simple but not easy.
It’s simple to compile quantitative data. But it’s not easy to apply that data and estimate intrinsic value.
Fortunately, fellow contributor Dave Van Knapp has made this easier than ever before.
He’s provided the community with Lesson 11: Valuation, which is part of an overarching series of “lessons” on DGI.
This particular piece focuses on valuation, clearly outlining the steps to valuing dividend growth stocks.
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…
AbbVie Inc. (ABBV)
AbbVie Inc. (ABBV) is a global pharmaceutical company with a particular focus on immunology and oncology.
With a market cap of ~$116 billion, AbbVie is one of the largest pharmaceutical companies in the world.
This positions them incredibly well to take advantage of a trifecta of tailwinds.
Those involve a world that’s growing bigger, older, and wealthier.
We know three things for sure.
The global population is increasing. People, on average, are living longer. And global wealth continues to rise.
This undoubtedly means demand for and access to quality pharmaceuticals will grow.
Indeed, it’s this demand and access that is partially responsible for global longevity. People are living longer lives in part due to improved healthcare.
AbbVie’s portfolio of in-demand drugs places them right in the center of that trifecta.
One of those drugs is, of course, Humira.
It’s one of the biggest blockbuster drugs of all time. A dream of every pharmaceutical company. It’s the most widely prescribed autoimmune biologic therapy.
But this dream could very well turn into a nightmare if the company isn’t careful.
That’s because this one drug accounts for a disproportionate amount of AbbVie’s sales – ~61% of FY 2018 total net revenue.
It’s already facing biosimilar competition outside the US.
Investors, rightfully so, are concerned that a major drop in future Humira sales will crush the company’s earnings.
However, there’s some evidence to believe that AbbVie is still a long-term dream of an investment.
Humira still has patent protection in the US (through at least the early 2020s). This allows the company some time to protect future sales (via licensing) while building out the pipeline.
Speaking of which, the pipeline is strong and backed by substantial R&D spending. R&D spending for FY 2018 came in at an adjusted 16% of revenue, which is in line with recent years.
Since the company’s inception in 2013 (after a spin-off from Abbott Laboratories (ABT)), they’ve launched new products that now account for ~25% of revenue.
AbbVie released Orilissa in 2018, the first FDA-approved oral pill specifically developed for women with moderate to severe endometriosis pain in over a decade. It’s already showing a lot of promise.
The company expects to regularly release new products over the coming decade, although it’s unlikely any will be the blockbuster that Humira has been.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Still, with a massive drug that will continue to earn profits for years to come, backed by a solid pipeline of new products, AbbVie is positioned to make a lot of money and return a lot of cash flow back to their shareholders.
That bodes well for the dividend, which has steadily grown since the inception of the company.
The company has increased its dividend for seven consecutive years, which goes back to the spin-off.
While that’s a short track record, the pre-split legacy dividend growth track record dated back decades. So this isn’t a new dividend payer/grower by any stretch.
The five-year dividend growth rate is 17.5%.
Lest you think that’s an anomaly, the most recent increase was almost 12%.
This is a very serious dividend grower here.
And that growth is coming on top of a monstrous yield of 5.47%.
That’s very high no matter how you slice it.
It’s more than twice the broader market.
It’s also more than 220 basis points higher than the stock’s own five-year average yield.
Now, that five-year average is undoubtedly impacted by the nascent nature of the dividend.
But one’s eyes naturally get a bit bigger when you’re combining a ~5.5% yield and double-digit dividend growth. That’s not a combination you see every day.
The payout ratio is also healthy, indicating this dynamic duo of yield and growth isn’t stopping any time soon.
While it’s high when looking at GAAP EPS because Q4 included an impairment charge, the dividend only sucks up 64.7% of adjusted TTM EPS.
Drilling down further, the dividend accounts for just under 50% of free cash flow. That’s the definition of a well-covered dividend.
Of course, we care more about where the company is going than where it’s been. We invest for future results.
Revenue and Earnings Growth
As such, it’s important to have a good idea of what kind of growth this company will produce moving forward, which will say a lot about what the stock is worth.
In order to build out that future growth trajectory, I’ll first show you what the company has already done historically (since inception).
I will then compare that to a near-term professional profit growth forecast.
AbbVie has increased its revenue from $18.790 billion in FY 2013 to $32.753 billion in FY 2018. That’s a compound annual growth rate of 11.75%.
I typically look for mid-single-digit top-line growth from a mature company. And AbbVie is fairly mature, despite its youthfulness as an independent business.
Meanwhile, EPS grew from $2.56 to $7.91 over this period, which is a CAGR of 25.31%.
I used adjusted EPS for FY 2018. It’s the fairest look at true earnings power.
These are mind-boggling numbers.
But a lot of it is based on the rocket that Humira has been. Again, that rocket is entering a much slower-moving phase. It’s not zero. But it won’t be the growth engine and money-printing machine it once was.
Looking out over the next three years, CFRA is predicting that AbbVie will compound its EPS at an annual rate of 8%.
I think this is a reasonable forecast. It’s about 1/3 of what AbbVie has produced thus far, but the days of 25% EPS growth are probably long gone.
For further perspective on this, AbbVie is guiding for 10% YOY adjusted EPS growth at the midpoint. That’s not too far from 8%. Again, it’s reasonable.
But even 8% EPS growth could easily allow for like dividend growth in that same range. That’s because the payout ratio isn’t stretched.
With FCF covering the dividend twice over, business growth and dividend growth should roughly mirror each other over the long run.
I think it’s sensible to expect that AbbVie will grow its dividend at a high-single-digit level moving forward.
Moving over to the balance sheet, this is a fundamental aspect of the business that sometimes trips up investors.
I say that because the long-term debt looks high relative to common equity (which is now negative).
But common equity is heavily reduced by the treasury stock.
The interest coverage ratio, which indicates the company’s ability to cover its interest expenses, is sitting at about 4.5.
There’s no trouble here.
Notably, total cash adds up to almost 25% of long-term debt.
It’s not a great balance sheet. But it’s not terrible, either.
I usually like to see an interest coverage ratio above 5. They’re right in that range.
I think AbbVie should reduce a little bit of debt and clean things up, though. There’s been some deterioration here since inception.
Profitability, as you might expect, is exceptional.
Over the last five years, the firm has averaged annual net margin of 18.10%.
ROE is N/A because of negative common equity.
Net margin is fantastic. However, it’s even better than it looks.
The average has been negatively skewed by a number of adjustments that have brought down GAAP numbers in certain years. In normal years, AbbVie’s net margin exceeds 20%.
Overall, this is a phenomenal business.
As a dividend growth stock, it’s hard to do better.
It’s not like the market throws you infinite high-quality stocks that offer both a ~5.5% yield and huge dividend growth. And all of that backed by a world-class pharmaceutical operation.
Sure, there are risks.
Regulation, litigation, and competition are omnipresent risks in every industry.
Humira is obviously the biggest near-term risk of all. It’s difficult to tell just how steep of a patent cliff we’re looking at here.
And I don’t think the balance sheet offers a lot of flexibility. If anything, it’s more of a hindrance.
But these risks are why the stock’s valuation is where it’s at. Stocks aren’t cheap when everything is rosy.
The stock is down ~12% YTD, bringing the valuation down to an appealing level…
Stock Price Valuation
It now trades hands for a P/E ratio of 11.83 (using adjusted TTM EPS).
That’s about half the broader market.
It’s also well below the stock’s own five-year average P/E ratio of 26.8, although I am using adjusted numbers here.
For a clearer look at the valuation disconnect, the P/CF ratio is 8.6. That compares to the three-year average P/CF ratio of 14.9.
And the yield, as noted earlier, is substantially higher than its recent historical average.
So the stock looks very cheap. But how cheap might it be? What does a rational estimate of intrinsic value look like?
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 4.5%.
I’m being extremely cautious here with the DGR because of the uncertainty.
They have a golden goose in Humira. But it’s very difficult to tell just how many golden eggs it will lay in the future.
I think it’s wise to be conservative with future estimates.
And this seems to be very conservative, since it’s well under half of the company’s DGR since inception.
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 rather low growth rate projection, the model still shows us a fair value that’s much higher than the current price of the stock.
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 ABBV as a 4-star stock, with a fair value estimate of $102.00.
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 ABBV as a 3-star “HOLD”, with a 12-month target price of $88.00.
I’m a bit surprised I came out high, but that’s why the additional estimates are included. Averaging out the three numbers gives us a final valuation of $105.93. That would indicate the stock is possibly 35% undervalued.
Bottom line: AbbVie Inc. (ABBV) is one of the largest pharmaceutical companies in the world. They’re perfectly positioned to take advantage of a trifecta of global trends. With a ~5.5% yield, double-digit historical dividend growth, a reasonable payout ratio, and the potential that shares are 35% undervalued, this high-quality dividend growth stock could be just the cure for your portfolio.
Note from DTA: How safe is ABBV’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 61. 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, ABBV’s dividend appears safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
**UPDATE** Two days after publication, Simply Safe Dividends downgraded ABBV’s Dividend Safety Score from Safe to Borderline Safe following their announced plans to purchase Allergan in a deal valued at more than $80 billion. You can read more about it here.
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