The S&P 500 remains just a few points off of its all-time high.
The broader stock market is close to a new record, yes.
But numerous individual stocks are languishing near multi-year lows.
How does this happen?
Well, you just need to remember one axiom.
The stock market is a market of stocks.
There are hundreds of individual businesses in the S&P 500.
Some businesses are doing better than others at any given time.
And some stocks are better investments than others at any given time.
Taking advantage of this market of stocks and finding great opportunities in all market conditions helped me build my FIRE Fund.
That’s my real-money stock portfolio.
It generates the five-figure passive dividend income I live off of.
Yes. I live off of dividend income.
No. I don’t have a job.
Seeing the stock market as a market of stocks and investing intelligently into individual opportunities allowed me to retire in my early 30s, as I lay out in my Early Retirement Blueprint.
I’m talking about dividend growth stocks.
These are stocks that pay their shareholders reliable and growing cash dividend payments.
Those reliable and growing cash dividend payments are funded from reliable and growing profit.
And as the collective owners of any publicly traded company, shareholders have their right to their fair share of profit.
It thus shouldn’t be a surprise that high-quality dividend growth stocks tend to outperform the broader market over the long run.
Check out the Dividend Champions, Contenders, and Challengers list to see what I mean.
That list contains invaluable information more than 800 US-listed stocks that have raised their dividends each year for at least the last five consecutive years.
High-quality dividend growth stocks can make for excellent long-term investments.
However, you have to make sure you pay the right price.
It’s a market of stocks. And not all stocks are attractively valued at all times.
While price is what you pay, it’s value that you get.
Valuation at the time of investment can play a critical role in the long-term success of an investment.
An undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and reduced risk.
That’s relative to what the same stock might otherwise offer 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.
This higher yield leads to greater long-term total return potential.
Total return is, after all, the sum of investment income and capital gain.
Boosting yield gives you more potential investment income.
Capital gain gets a potential boost, too, via the “upside” between a lower price and higher intrinsic value.
Putting the two together is a massive boon for your possible long-term rate of return.
All of this should also reduce risk.
Undervaluation introduces a margin of safety.
That’s a “buffer” that protects an investor’s downside against unforeseen issues.
You want to limit your downside, while simultaneously maximizing your upside.
These dynamics are clearly favorable to the long-term investor.
The great news is, it’s not difficult to spot these dynamics and take advantage of opportunities.
Make sure to read Lesson 11: Valuation.
Part of fellow contributor Dave Van Knapp’s comprehensive series of “lessons” on dividend growth investing, Lesson 11 teaches you how to value 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…
Marathon Petroleum Corp. (MPC)
Marathon Petroleum Corp. (MPC) is a US independent petroleum product refiner, marketer, and transporter.
With a corporate history dating back to the late 1800s and now employing more than 60,000 people, Marathon Petroleum is the largest petroleum refinery operator in the United States. They have refining capacity in excess of 3 million barrels per day.
The company owns and operates 16 refineries in the in the Gulf Coast, Mid-Continent and West Coast regions of the US.
They’re the general partner and majority limited partner unitholder in two midstream companies, MPLX LP (MPLX) and Andeavor Logistics LP (ANDX). This gives them a strong midstream footprint in the Marcellus, Permian, and Bakken fields.
They also lay claim to the nation’s second-largest company-owned and -operated convenience store chain, primarily under the Speedway brand.
They report operations across three segments: Midstream, 44% of FY 2018 operating income; Refining, 40%; and Retail, 16%.
Energy is a critical aspect of modern-day society. Without energy as we know it, society would completely break down.
Companies like Marathon Petroleum are committed to providing the necessary components that allow consumers, businesses, and even the government to function.
Marathon Petroleum has incredible scope and breadth across its business. They’re a major player in both midstream and downstream energy.
This bodes well for their ability to manage the cyclicality of the energy industry, as well as the ability to continue to pay growing dividends year in and year out.
As it sits, the company has increased its dividend for nine consecutive years.
That’s as long as the dividend growth track record could possibly be, as Marathon Petroleum was spun off from Marathon Oil Corporation (MRO) in 2011.
The five-year dividend growth rate is a heady 19.0%.
Notably, there hasn’t been a material deceleration in dividend growth – even the most recent dividend increase came in at over 15%.
With a payout ratio of 43.0%, there’s still plenty of room for more dividend increases.
However, the payout ratio has climbed a bit in recent years, so I wouldn’t expect that massive double-digit dividend growth to persist for much longer.
But that’s okay.
The stock is yielding 3.52% right now.
That’s a market-smashing yield.
It’s also more than 100 basis points higher than the stock’s own five-year average yield.
With a yield that high, dividend growth investors don’t need humongous dividend raises to make sense of a stock.
So the dividend metrics are fantastic.
All well and good, but we ultimately invest in where a company is going, not where it’s been.
As such, we need to estimate the future growth of a company. This allows us to discount that future growth back to today, giving us the ability to approximate the intrinsic value of a business (and its stock).
I’ll build out that forward-looking trajectory by first showing you what Marathon Petroleum has done in terms of top-line and bottom line growth since it’s been independent.
Then I’ll compare that to a near-term professional forecast for profit growth.
Combining the known past and estimated future in this manner should allow us to build out an educated growth model.
The company increased its revenue from $78.709 billion in FY 2011 to $96.504 billion in FY 2018.
That’s a compound annual growth rate of 2.95%.
Meanwhile, earnings per share advanced from $3.33 to $5.28 over this period, which is a CAGR of 6.81%.
Pretty solid growth, overall.
But it’s slightly difficult to fully flesh out exactly what kind of growth the company is capable of. The numbers have been lumpy.
This is partly due to the fact that they were spun off in 2011.
In addition, the company closed on its ~$23 billion acquisition of Andeavor in late 2018, catapulting it into a premier midstream and downstream energy player.
Nonetheless, the results thus far indicate much promise.
And things could get much better, especially since the Andeavor acquisition is thought to produce $1.4 billion in synergies by 2021.
Looking forward, CFRA is predicting that Marathon Petroleum will compound its EPS at an annual rate of 21% over the next three years.
They cite synergies, the possession of above-average refining complexity, and the heavy exposure to growing energy complexes.
A 21% growth rate in EPS would far exceed what Marathon Petroleum has produced up until now (as an independent company), but I see the basis for optimism.
That said, I don’t think the company has to put out gaudy growth like that in order to be an attractive long-term investment.
With the yield being at 3.5%, and with the payout ratio still being quite moderate, even EPS growth at half of this predicted level would be more than enough to support incredible dividend growth on top of that yield.
I wouldn’t put it behind Marathon Petroleum to deliver double-digit dividend growth for the near term; however, I’d expect this to enter into a more sustainable groove of high-single-digit dividend growth at some point within the next few years.
Moving over to the balance sheet, they’re in a good financial position.
But it could be a lot better.
The long-term debt/equity ratio is sitting at 0.77, while the interest coverage ratio is under 6.
There has been some slight deterioration in the balance sheet over the last few years, but the accretive nature of the Andeavor acquisition could put the company in a good position to improve their capital structure.
Profitability is competitive for the industry, although I do think net margin could be enhanced.
Over the last five years, the firm has averaged annual net margin of 3.17% and annual return on equity of 18.38%.
Overall, there’s a lot to like about Marathon Petroleum.
But there are risks to consider.
Regulation, litigation, and competition are omnipresent risks for every industry.
There is substantial exposure to volatile commodity pricing here.
The company greatly relies on the MLP model, which has some question marks regarding capital structure and growth models.
Also, there is some black swan risk here in terms of unexpected problems with infrastructure (such as explosions).
With those risks known, I still think this stock makes a lot of sense for the long term.
That’s particularly true when looking at the valuation.
It’s a market of stocks, folks.
Consider that the S&P 500 is roughly flat over the last 52 weeks.
That disconnect has led to an appealing valuation…
The stock trades hands for a P/E ratio of 13.04.
That’s well below that of the broader market’s earnings multiple.
It’s also noticeably lower than the stock’s own five-year average P/E ratio of 14.2.
The P/CF ratio, at 4.6, is significantly lower than its three-year average of 6.3.
And the yield, as noted earlier, is markedly higher than its own recent historical average.
So the stock does look cheap. But how cheap might it be? What would a reasonable estimate of intrinsic value 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 7.5%.
That DGR looks pretty conservative when you consider the low payout ratio and proven dividend growth to date.
Plus, the company is expected to produce massive EPS growth over the next three years.
However, I’m also looking at what Marathon Petroleum has produced in terms of underlying EPS growth as an independent firm.
And with the payout ratio creeping higher, along with the fact that blockbuster EPS growth hasn’t yet materialized, I’d rather err on the side of caution.
Admittedly, the company could surprise us and deliver much stronger dividend raises than this, at least over the next few years.
All the same, I’m modeling in a long-term growth rate here, and it makes sense to be cautious.
The DDM analysis gives me a fair value of $91.16.
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 what could be argued was a wary valuation model, the stock still looks very cheap.
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 MPC as a 4-star stock, with a fair value estimate of $89.00.
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 MPC as a 5-star “STRONG BUY”, with a 12-month target price of $61.00.
I came out pretty close to where Morningstar landed. Averaging out the three numbers gives us a final valuation of $80.39, which would indicate the stock is possibly 34% undervalued.
Bottom line: Marathon Petroleum Corp. (MPC) is a high-quality energy company that is integrated across its midstream and downstream business lines. With a market-smashing yield, a double-digit long-term dividend growth rate, a moderate payout ratio, almost a decade of dividend raises, and the potential that shares are 34% undervalued, dividend growth investors would be wise to take a good look at this stock right now.
Note from DTA: How safe is MPC’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 45. 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, MPC’s dividend appears Borderline Safe with a low risk of being cut. Learn more about Dividend Safety Scores here.
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