Warren Buffett is arguably the greatest investor to ever live.
But just imagine how smart the guy who taught Buffett must have been.
Well, that man was Benjamin Graham.
Graham was an author, economist, professor, and successful investor in his own right.
One of his teachings should never be forgotten.
“In the short run, the market is a voting machine, but in the long run, it is a weighing machine.”
Fads come and go. Stocks move up and down on rumors and news.
Investor psychology plays havoc with stock prices.
But this psychology gets subtracted out over long periods of time, and the substance and value of a business comes into view.
I never tried to win any popularity contests.
But I did try to become financially independent by following Graham’s advice.
And it worked out tremendously well!
I became financially independent and retired in my early 30s, as I lay out in my Early Retirement Blueprint.
My FIRE Fund, which is my real-money stock portfolio, generates enough passive dividend income for me to live off of.
Better yet, this passive income continues to grow year in and year out like clockwork.
That’s because I invest in high-quality dividend growth stocks.
Stocks like those you’ll find on the Dividend Champions, Contenders, and Challengers list.
Stock prices move up and down daily, oftentimes in a way that’s totally irrelevant to the operations of a business.
But dividends from high-quality dividend growth stocks tend to only go in one direction: up.
Dividend growth investing has transformed my life for the better.
But it’s important to be an intelligent investor.
As great as high-quality dividend growth stocks can be, valuation at the time of investment is critical.
While price tells you what a stock costs, value tells you what it’s actually worth.
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.
These favorable dynamics also reduce risk.
Undervaluation introduces a margin of safety.
That’s a “buffer” that protects the investors downside against unforeseen issues.
An undervalued high-quality dividend growth stock can be a tremendous long-term investment.
The good news is, finding undervalued high-quality dividend growth stocks needn’t be a difficult endeavor.
Fellow contributor Dave Van Knapp has greatly simplified the process through the introduction of Lesson 11: Valuation.
Part of a comprehensive series on dividend growth investing as a whole, Lesson 11 discusses how to apply simple valuation methods to just about any dividend growth stock out there.
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…
UnitedHealth Group Inc. (UNH)
UnitedHealth Group Inc. (UNH) is the largest managed care company in the United States.
The company offers private health insurance, medical benefits, and related health services.
Their services are offered across all 50 US states, as well as in more than 130 other countries. The company has over 100 million customers over its various business lines.
UnitedHealth Group reports its results primarily across two business platforms: UnitedHealthcare, and Optum.
UnitedHealth Group generated approximately 64% of the company’s total revenue for FY 2018.
This platform provides risk-based and fee-based health plans to customers. Essentially, it’s a private health insurance business model that offers health plans to employers and individuals. The company also offers supplemental Medicare plans and Medicaid program management for state governments.
Optum generated approximately 36% of the company’s total revenue for FY 2018.
This platform provides information technology and related services, primarily to healthcare payers who want to improve the efficiency of the healthcare to their insured populations. The largest business within this platform is OptumRx, a pharmacy benefit manager (PBM) that negotiates prescription drug prices on behalf of healthcare
While some investors might initially think of UnitedHealth Group as a private health insurance company, the truth is that it’s a much more complicated business than that.
They do have a significant insurance business, to be sure. But the company is actually a complex web of services that reaches out to every corner of managed care.
This complex and robust integration across healthcare is a big competitive advantage, especially in an industry that is in and of itself very complicated.
Insurance is a wonderful business model in every industry.
A great insurance company can make a lot of money from disciplined underwriting.
But it’s really the float – the money that builds up from collected premiums before paying claims – that ends up being a fantastic source of capital to earn a low-risk and low-cost return on.
Because US healthcare is so elaborate and expensive, health insurance is practically a necessary component of life.
UnitedHealth Group has built on that attractive insurance foundation with its vertical integration, making its presence necessary across the value chain of US healthcare.
But recent headlines have brutally punished this stock, sending it down 25% from its 52-week high reached back in December 2018.
The voting machine has spoken. This is an unpopular stock.
The headline risk here is the 2020 presidential race.
Senator Elizabeth Warren is rising to the top of some recent polls for the Democratic nomination for president.
Warren, a pretty hardcore progressive, is no friend to private health insurance companies. And she has gone on record as heavily supporting fellow US Senator and presidential candidate Bernie Sanders’ Medicare-for-all single-payer plan.
It remains to be seen what will eventually play out, but the passage of a single-payer healthcare system in the United States would be hugely detrimental to the likes of UnitedHealth Group.
A lot of doomsayers are having their way with this stock.
But the odds of some kind of Medicare-for-all legislation making it all the way to national law remain low.
And the weighing machine tends to have its say over the long run.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Speaking of weight, the growing dividends that UnitedHealth Group continue to pay out are becoming quite hefty.
The company has increased its dividend for 10 consecutive years.
Going back to the 1990s, UnitedHealth Group typically paid a small annual dividend.
But they started paying a reliable and rising quarterly dividend in 2010.
And they’ve sure made up for lost time, with an astounding five-year dividend growth rate of 26.8%.
There hasn’t been much of a recent deceleration in dividend growth, either. The most recent dividend raise was 20.0%.
With a payout ratio of just 32.5%, there’s still a lot of room here for future sizable dividend raises.
The only knock against the stock might be the yield.
At 1.99%, you’re looking at a yield that’s only marginally higher than the broader market.
However, this isn’t a high-yield stock. It’s a stock that offers sky-high dividend growth on top of a yield that’s still higher than the market.
Keep in mind, too, that this yield is almost 60 basis points higher than the stock’s own five-year average yield.
If you’re looking for a solid yield with massive growth, this stock checks those boxes.
The dividend growth to date has been stellar. No doubt.
Revenue and Earnings Growth
But investors buy a stock for where it’s going, not where it’s been. The dividend raises of tomorrow is what we ultimately care about.
In order to estimate that future dividend growth, I’m going to build out an overall business growth trajectory.
I’ll first show you what the company has done over the last decade in terms of top-line and bottom line-growth.
And I’ll then compare that to a near-term professional forecast for profit growth.
Combining the proven past with a future forecast like this should tell us a lot about where the company’s growth might be going.
UnitedHealth Group increased its revenue from $87.138 billion in FY 2009 to $224.871 billion in FY 2018.
That’s a compound annual growth rate of 11.11%.
Really impressive growth rate. What makes it particularly impressive is the fact that it occurred off of such a high starting base. It’s difficult to grow $90 billion at that kind of rate over a decade.
However, not all of that is organic.
The company has been regularly acquisitive, especially on the Optum side of the business. These have mostly been bolt-on additions, but they do add up over time.
Meanwhile, earnings per share advanced from $3.24 to $12.19 over this period, which is a CAGR of 15.86%.
Incredible growth, really. It’s outstanding.
Much of this excess bottom-line growth can be traced back to buybacks.
The outstanding share count has been reduced by almost 17% over the last 10 years.
And they’ve already bought back $4.5 billion in stock YTD.
Looking forward, CFRA is anticipating that UnitedHealth Group will compound its EPS at an annual rate of 12% over the next three years.
CFRA believes the United-Optum integration gives UnitedHealth Group unique scale and value in the marketplace, and the company is positioned well to grow faster than its competitors.
However, there’s a lot of uncertainty here regarding the 2020 US presidential election and how that could impact US healthcare regulation.
In addition, Medicare Advantage premiums are forecast to drop next year.
Still, a 12% CAGR for EPS is nothing to sneeze at.
For perspective, UnitedHealth Group increased its EPS at a 15% YOY rate for its most recent quarter (Q2 FY 2019).
This kind of expectation sets up the company for continued double-digit dividend growth for the foreseeable future, after factoring in the low payout ratio.
Outside of a total implosion of the US healthcare system as it currently exists, the company is on track to continue growing its bottom line and dividend at an astounding rate for years to come.
Moving over to the balance sheet, the company maintains a rock-solid financial position.
I think there’s room for improvement, sure, but the company has a balanced capital structure.
The long-term debt/equity ratio is 0.67, while the interest coverage ratio is approximately 12.
Profitability is robust. And margins have recently seen an uptick.
Over the last five years, the firm has averaged annual net margin of 4.49% and annual return on equity of 20.61%.
These numbers trounce major competitor Humana Inc. (HUM).
Overall, I think there’s a lot to like about UnitedHealth Group for long-term dividend growth investors.
The company’s unique breadth, integration, market positioning, and industry know-how put it in a class of its own, creating unrivaled competitive advantages.
And the practical necessity of its products and services in all economic environments make it a fairly recession-proof business.
However, there are risks to consider.
Competition, regulation, and litigation are omnipresent risks for every industry.
Regulation is a principal risk at this point, with the aforementioned presidential race looming over healthcare insurers.
Its monstrous growth rate is something that politicians are pointing to as something that is wrong with the US healthcare system.
In addition, the sheer size of the company works as much for it as against it.
The scale is a big competitive advantage.
But on the other hand, the law of large numbers indicates that the company will have more difficulty in the future with matching some of its past glory.
And while the business model is fairly recession-proof, any large-scale economic recession would almost certainly reduce demand for employer-sponsored health insurance (by virtue of less employment).
With these risks known, I still think the stock could make for an excellent long-term investment.
The stock market voting machine is voting “no” on this stock right now, due in part to the upcoming voting that will sweep the United States.
But with the stock down 25% from its recent high, I think those votes are short-sighted…
Stock Price Valuation
The stock is trading hands for a P/E ratio of 17.78 right now.
That’s a notable discount relative to the stock’s own five-year average P/E ratio of 20.1, not to mention relative to where the broader market is at.
Keep in mind, too, that this company has compounded its EPS at an annual rate of almost 16% over the last decade.
If the next 10 years look anything like the last 10, the PEG ratio is not too far over 1. That’s exceptionally low for a world-class enterprise.
Moreover, the yield, as shown earlier, is materially below 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 two-stage dividend discount model analysis (to account for the low yield and high growth).
I factored in a 10% discount rate.
Then I assumed a dividend growth rate of 11% for the next 10 years, with a terminal dividend growth rate of 8%.
I’m clearly modeling in a dividend growth slowdown compared to what this company has done over the last decade.
There’s a lot of uncertainty here. And much of that prior dividend growth was coming off of an extremely low payout ratio.
But with the expectation for 12% EPS growth for the near term, this company could nicely surprise us with much more dividend growth than I’m showing here.
It’s just that I’d rather err on the side of caution in the current environment.
The DDM analysis gives me a fair value of $300.80.
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 I’d argue is a highly cautious 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 UNH as a 4-star stock, with a fair value estimate of $310.00.
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 UNH as a 4-star “BUY”, with a 12-month target price of $303.00.
We have a very tight consensus here. Averaging out the three numbers gives us a final valuation of $304.60, which would indicate the stock is possibly 41% undervalued.
Bottom line: UnitedHealth Group Inc. (UNH) is a high-quality company with unrivaled scale and valuable integration. It’s an unpopular stock right now, but the weight of the business should bear itself out over the long run. With a solid 2% yield, massive double-digit long-term dividend growth rate, low payout ratio, 10 years of dividend raises, and the potential that shares are 41% undervalued, dividend growth investors would be wise to do their own voting and consider buying this stock.
Note from DTA: How safe is UNH’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, UNH’s dividend appears Very Safe with an extremely unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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