The legendary investor Peter Lynch used to have a simple investing rule.

He wouldn’t invest in any idea that he couldn’t illustrate with a crayon.

Sounds crazy? 

Not really.

The crazier thing is investing in something you don’t understand.

That would be like marrying someone you don’t know. Or taking a job blindly.

Fortunately, some of the best investments out there can easily be illustrated with a crayon.

And I’d argue the dividend growth investing strategy makes these investments even more obvious.

Check out the Dividend Champions, Contenders, and Challengers list to see what I mean.

That list, which has compiled data on more than 800 US-listed dividend growth stocks, is chock-full of easy-to-understand business models.

Better yet, these are businesses that are making a ton of money.

Best of all, they’re sharing a large percentage of that profit directly with their shareholders, via growing cash dividend payments.

I’ve invested in dozens of these businesses myself.

The result of that investing is my FIRE Fund.

It’s my real-money early retirement portfolio.

It generates the five-figure passive dividend income I need to live off of.

Jason Fieber's Dividend Growth PortfolioThat’s rendered me financially independent.

I was able to retire in my early 30s because of that passive income.

And I lay out how almost anyone can do the same thing, in my Early Retirement Blueprint.

While simplicity is fantastic, valuation is critical.

Even a remarkable business can be a mediocre investment if you pay way too much for it.

Undervaluation should always be sought out.

I’ll tell you why.

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

That’s relative to what the same stock might otherwise provide if it were fairly valued or overvalued.

All else equal, a lower price will result in a higher yield.

Price and yield are inversely correlated.

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

Total return is the sum of investment income and capital gain; the former is positively impacted by the higher starting yield.

Plus, there’s the possible capital gain “upside” that exists in the gap between price and value.

If you’re able to take advantage of a stock market’s mispricing, there’s capital gain that could be yours when the market more accurately prices a stock.

These dynamics should reduce risk.

This occurs through the introduction of a margin of safety.

That margin protects your downside against unforeseen issues that could degrade the value of a business.

It can minimize your downsize while maximizing your upside.

Undervaluation is obviously advantageous.

Fortunately, valuation is also somewhat of a simple concept to understand.

And fellow contributor Dave Van Knapp made it even simpler with Lesson 11: Valuation.

Part of a larger series on dividend growth investing, this particular lessons homes in on how to value dividend growth stocks and how to spot undervaluation.

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…

Ingredion Inc. (INGR)

Ingredion Inc. (INGR) is a global ingredients solutions provider for a variety of industries.

Founded in 1906, and headquartered in Westchester, Illinois, the company turns raw materials like corn, tapioca, potatoes, grains, fruits, and vegetables into value-added ingredients and biomaterials for the food, beverage,
paper, and personal-care industries. They also provide products for the global animal feed and corn oil markets.

Some of their products include industrial starches, high-fructose corn syrup, dextrose, and refined corn oil.

FY 2018 sales are geographically segmented as follows: North America, 60%; South America, 16%; Asia Pacific and Europe, 14%; and the Middle East and Africa, 10%.

Product segments are as follows: Starch Products, 45% of FY 2018 sales; Sweetener Products, 36%; and Co-products and others, 19%.

The company is globally exposed to a wide variety of industries. And they’re positioned such that a number of end products can’t properly exist without these value-added ingredients and biomaterials.

This is a great example of a simple business model. It would take me 60 seconds to draw it out with a crayon.

Yet it makes a ton of money, and it’s been doing so for more than a century.

Dividend Growth, Growth Rate, Payout Ratio and Yield

This bodes very well for their ability to pay a sustainable and growing dividend, something they’ve proven adept at and committed to.

They’ve increased their dividend for eight consecutive years.

While it’s a good track record, it would be much more impressive had the company not kept the dividend static for a two-year period during the Great Recession. They had been regularly growing the dividend since at least 2003.

However, I give them a pass on this.

They didn’t cut the dividend. And this was the biggest financial calamity my generation has ever seen.

I think this shortened track record belies the probability of the dividend growing for many years into the future.

The five-year dividend growth rate is 11.6%.

Obviously, that’s well in excess of inflation. It’s a very strong growth rate.

And that comes on top of a 2.98% yield.

That’s an attractive income play in this low-yield environment.

Notably, it’s almost 110 basis points higher than the stock’s own five-year average yield.

This speaks on the relationship between valuation, yield, and total return that I went over earlier.

And with a payout ratio of only 43.5%, this is a sustainable dividend with plenty of room for more growth.

The dividend metrics are great.

Long-time shareholders should be pleased with what’s transpired thus far.

Revenue and Earnings Growth

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

And in order to estimate the intrinsic value of this stock, we’ll need to build out a forward-looking trajectory of business and dividend growth.

I’ll rely on some historical data, showing you what the company has done over the last decade in terms of top-line and bottom-line growth.

Ingredion grew its revenue from $3.672 billion in FY 2009 to $6.289 billion in FY 2018.

That’s a compound annual growth rate of 6.16%.

Meanwhile, earnings per share increased from $0.54 to $6.17 over this period, which is a CAGR of 31.08%.

Obviously, we’re looking at incredible numbers here.

But they’re skewed by two major factors.

First, FY 2009 marks the trough of the Great Recession.

So the starting numbers are artificially low.

Second, Corn Products International acquired National Starch for ~$1.3 billion in 2010, resulting largely in the company as we know it today after a corporate name change to Ingredion Inc. in 2012.

That means a lot of the revenue growth we see above wasn’t organic.

For perspective, FY 2011 showed a large bump in revenue after this acquisition – up over 42% compared to FY 2010.

Looking at more recent results shows more muted growth.

Indeed, revenue for FY 2018 was almost flat compared to FY 2011.

The same could be said for EPS.

On the flip side of that coin, the last year or so has been particularly challenging for the firm.

I’m not sure the last 5-6 quarters accurately represent the company’s long-term prospects.

Higher input costs, weather-related issues, and currency exchange headwinds have all acted as recent, if temporary, headwinds.

I usually show a forward-looking near-term profit forecast from CFRA.

However, in this case, CFRA does not provide such a forecast.

But I believe the future is actually quite bright for this company.

The headwinds I just noted are not permanent issues, nor are they indicative of any extensive business problem.

Adding to that, CFRA does note in its report on the business that it believes the currency exchange headwind, in particular, will soften very soon. Currency exchange is something that can turn from a headwind to a tailwind very quickly – and then back again.

Then there’s the $125 million cost savings program Ingredion announced in 2018.

Broad reductions in costs, particularly as they relate to SG&A expenses, should aid bottom-line growth.

Ingredion has also been actively broadening and strengthening its higher-value specialty ingredients portfolio.

This focus has been bolstered recently by the acquisition of Western Polymer, a US-based company that makes native and modified potato starches for food and industrial applications.

That’s a margin-improving focus that adds to their competitive advantages.

Management recently guided for $7.20 in adjusted EPS at the top end for FY 2019, which would represent ~4% YOY growth.

It’s not stellar. But it’s not bad for a quality company going through a bit of a rough patch.

Financial Position

Moving over to the balance sheet, we can see further evidence of the company’s fine position.

I wouldn’t classify the balance sheet as excellent, but it is solid across the board.

The long-term debt/equity ratio is 0.81.

Furthermore, there hasn’t been any marked deterioration of late. That stands in contrast to many companies across all industries loading up on debt over the last 5-10 years.

The interest coverage ratio, at just under 9, is also very good.

Profitability is extremely impressive for the industry, in my view.

Over the last five years, the firm has averaged annual net margin of 7.23% and annual return on equity of 18.10%.

Making the metrics even better is the fact that there’s been a noticeable improvement in recent years.

These numbers compare very favorably to a competitor like, say, Archer Daniels Midland Co. (ADM).

Overall, there’s a lot to like about Ingredion.

It’s a simple business model and a well-run company across the board. And I’d argue it’s even better today than it was five or ten years ago.

However, there are always risks to consider.

Competition, litigation, and regulation are omnipresent risks to every business.

The company has exposure to volatile input costs and currency exchange rates.

Also, high-fructose corn syrup makes up ~10% of the company’s sales. This ingredient in particular is facing public backlash due to health concerns.

And there is a general tilt away from too many ingredients. Foods that are simpler are trending now.

But at the right valuation, this could be an excellent long-term investment.

With the stock down 25% over the last year, I think the valuation is now compelling…

The stock’s P/E ratio is 14.57.

That compares well to the broader market.

It’s also substantially lower than the stock’s own five-year average P/E ratio of 17.4.

All other basic valuation metrics are well off of their respective recent historical averages.

And the yield, as noted earlier, is significantly higher than its own five-year average.

So the stock does look cheap at first glance. But how cheap might it be? What would a reasonable estimate of intrinsic value look like?

Stock Price Valuation

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 middling DGR seems appropriate here.

It’s obviously far below what the company has made good on over the last five years.

And the low payout ratio would portend much more of that where it came from.

But I think recent struggles and broader industry risks should be considered.

A growth acceleration within the next year or two seems likely, but I’d rather err on the side of caution.

Even with disappointing near-term results, a 7% DGR isn’t too high a hurdle to clear for this company when looking out over a longer time frame.

The DDM analysis gives me a fair value of $89.17.

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 analysis concludes undervaluation.

And that’s even with a rather conservative valuation model.

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 INGR as a 5-star stock, with a fair value estimate of $125.00.

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 INGR as a 3-star “HOLD”, with a 12-month target price of $93.00.

I came out low. Not a surprise. I was being cautious here. Averaging out the three numbers gives us a final valuation of $102.39. That would indicate the stock is possibly 22% undervalued.

Bottom line: Ingredion Inc. (INGR) is a high-quality company operating a very simple business model. The future arguably looks even better than the past. With a ~3% yield, a low payout ratio, almost a decade of dividend raises, and the potential that shares are 22% undervalued, this dividend growth stock is a classic “Peter Lynch idea” on sale.

-Jason Fieber

Note from DTA: How safe is INGR’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 99. 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, INGR’s dividend appears safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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