The S&P 500 is up about 20% over the last year.

It’s been an incredible run for US equities.

However, not all stocks move in lockstep.

There are a number of stocks that are flat, or even down, over the last 52 weeks.

And this could be your opportunity to jump on one of these stocks that have been left behind. 

Stock prices are generally driven by underlying earnings over the long term.

As earnings rise (or fall), stock prices react accordingly.

But there are times when earnings and prices become severely mismatched.

This leads to undervaluation or overvaluation, depending on how the mismatched leans.

Pouncing on a high-quality stock when it’s undervalued can lead to tremendous investment results over the long haul. 

This pouncing is something I’ve repeatedly done on my way to building the FIRE Fund.

Jason Fieber's Dividend Growth PortfolioThat’s my real-money stock portfolio.

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

Indeed, I achieved financial independence and retired at the age of 33 by opportunistically investing in this manner, as I lay out in my Early Retirement Blueprint.

To be more specific, though, I’ve used dividend growth investing to my advantage.

This investment strategy espouses buying shares in world-class enterprises that are reliably growing their earnings and paying shareholders rising cash dividends.

You can find hundreds of examples of what I mean by perusing the Dividend Champions, Contenders, and Challengers list.

Buy a high-quality dividend growth stock when it’s undervalued, hold for the long term, and reinvest growing dividends.

Before you know it, you might be sitting on a massive amount of wealth and passive income.

It’s a simple strategy, but it’s no less powerful because of it’s simplicity.

Undervaluation is a key part of the formula.

After all, price is only what you pay. It’s value that you get.

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.

Price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.

That higher yield correlates to greater long-term total return potential.

This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.

Prospective investment income is boosted by the higher yield.

But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.

And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.

These dynamics should reduce risk.

Undervaluation introduces a margin of safety.

This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value. It’s protection against the possible downside.

It’s pretty clear to see how these benefits work to an investor’s advantage.

Fortunately, it’s not that difficult to spot and take advantage of undervaluation.

Fellow contributor Dave Van Knapp has made that easier than ever through his introduction of Lesson 11: Valuation, which is part of an overarching series of “lessons” on dividend growth investing.

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…

Philip Morris International Inc. (PM)

Philip Morris International Inc. (PM) is the world’s largest publicly traded tobacco company, engaged in the manufacture and marketing of tobacco and related products.

Fiscal year 2018 sales break down geographically: Asia, 35%; European Union, 31%; Middle East & Africa, 14%; Eastern Europe, 10%; and Latin America and Canada, 10%.

The company’s global market share is an estimated 28%, ex China and US.

This large share of the global market is largely due to the strength and ubiquity of their Marlboro brand, the #1 cigarette brand in the world.

The Marlboro brand alone comprised over 35% of the company’s total cigarette volume last year.

On one hand, investing in a tobacco company like Philip Morris International seems like a no-brainer.

We’re talking about an addictive consumer product that has some of the highest margins out there.

However, there’s an elephant in the room.

That’s the viability of cigarettes as a business model moving forward.

There are two important aspects to keep in mind, though.

First, there’s no sudden demise of the cigarette business here.

The company sold just over 740 billion cigarettes last fiscal year, which was down 2.8% over the prior year.

It’s pretty likely that volumes will continue to decline. But this is a modest decline.

It’s modest enough to allow rising prices to squeeze more money the remaining volume.

Second, the invention of e-cigarettes has been just the innovation this industry needs.

And the modest decline in traditional cigarette volumes has given the company time to build out and invest in its own form of innovation.

That innovation has taken shape in the form of their flagship IQOS (I quit ordinary smoking) system.

It’s the future of Philip Morris International.

This is heat-not-burn technology that is designed to reduce the the levels of harmful chemicals ingested from traditional cigarettes, all while still producing the same smoking experience.

For perspective, the company’s heated tobacco shipments increased by 14.2% last fiscal year, to 41.4 billion units.

The company’s shipment target is 90 to 100 billion units internationally by 2021.

Back in growth mode!

IQOS has been wildly popular overseas thus far.

Meanwhile, the FDA recently approved the sale of their IQOS heated tobacco system in the US. Altria Group Inc. (MO) has the exclusive licensing agreement to market and sell this product in the United States.

This product has a unique and exciting spot in the marketplace, bridging a gap between traditional cigarettes and e-cigarettes.

While e-cigarettes have recently come under fire in the US for their lack of FDA approval, Philip Morris International took the time to painstakingly go through the entire regulatory process to clear its product for sale.

This gives them another differentiating advantage in the marketplace.

Now, one can argue about whether or not someone should smoke (or drink alcohol, eat fatty foods, etc.).

What’s more difficult to argue about is the long-term effectiveness of tobacco companies as investments.

Before being spun off from Altria Group in 2008, the results of the legacy company over many decades are something to behold.

Philip Morris International has admittedly stumbled a bit here and there since that 2008 spin-off.

A strong dollar in recent years certainly hasn’t helped them. That’s because they earn in foreign currencies and then translate the profits into dollars as a US-based multinational that doesn’t actually directly sell products in the US.

Dividend Growth, Growth Rate, Payout Ratio and Yield

But they’re still a free cash flow machine.

That cash flow is, perhaps ironically, protected by strict regulations.

It’s almost impossible for new entrants to enter the marketplace due to current regulations.

You thus end up with rational pricing among an oligopoly with entrenched players.

Those regulations also limit advertising, cutting down on SG&A costs and bolstering margins.

A free cash flow machine like this often means large and growing dividends.

And that’s exactly what you’re getting here.

Yielding 5.52%, the stock offers a yield that is three times higher than the broader market.

This yield is also more than 60 basis points higher than the stock’s own five-year average.

But it’s not just a high yield; this is a dividend that’s growing nicely.

The company has increased its dividend since it was spun off.

That’s 12 consecutive years now.

The five-year dividend growth rate is 4.8%, which is very nice when added on top of such a high yield.

It also exceeds US inflation, meaning a shareholder’s purchasing power is increasing annually.

One knock against the dividend is the high payout ratio.

At 97.5%, it’s very high.

Even for a company that targets a high payout ratio, this is high.

I used GAAP TTM EPS to calculate that number, which does make the payout ratio look worse than it is.

There’s that aforementioned currency issue, primarily.

Plus, the previous investments in IQOS are just now starting to hitting paydirt with the new access to the US market.

The company is guiding for adjusted EPS of $5.16 for FY 2019, which more easily covers the $1.17 quarterly dividend.

The payout ratio is concerning. But I’m comforted by the fact that Philip Morris International, as well as the legacy company it was once part of, has long operated just fine with a high payout ratio. And they look to be on the cusp of something great with their IQOS.

Of course, this is all looking at what’s already transpired.

Revenue and Earnings Growth

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

I’ll now build out a forward-looking trajectory of the company’s growth.

This will later help us value the stock.

I’ll first show you what the company has done over the last decade in terms of top-line and bottom-line growth.

Then I’ll compare that to a near-term professional estimate of profit growth.

Blending the proven past with a future forecast in this manner should allow us to draw some reasonable conclusions about where the company might be going.

The company increased its revenue from $25.035 billion in FY 2009 to $29.625 billion in FY 2018.

That’s a compound annual growth rate of 1.89%.

I think that’s pretty solid considering the drop in traditional cigarette shipment volumes.

Earnings per share grew from $3.24 to $5.08 over this same period, which is a CAGR of 5.12%.

A rather impressive result, in my view.

The decline in smoking might be secular, but this isn’t a dying company by any stretch of the imagination.

A robust share buyback program has definitely helped the bottom line.

The outstanding share count is down by approximately 20% over the last decade.

Pumping out a 5% bottom-line CAGR is pretty amazing for all of the challenges they’re facing. And you’re getting that growth on top of the 5.5%+ yield here.

Looking forward, CFRA is predicting that Philip Morris International will compound its EPS at an annual rate of 5% over the next three years.

So we’re looking at a continuation of the status quo, essentially.

I think that’s a fair baseline assumption.

If anything, it sets up shareholders for the possibility of the company executing very well and actually outperforming this prediction.

I say that because we’re just now entering a stretch where the IQOS is widely rolling out after years of development, testing, and seeking regulatory approval.

This EPS growth mark would put the company in a position to very modestly increase its dividend while simultaneously lowering that payout ratio a bit.

I think low-single-digit annual dividend growth is a realistic expectation for the foreseeable future.

Financial Position

Moving over to the balance sheet, the company maintains a solid financial position.

There’s no applicable long-term debt/equity ratio because common equity is negative.

Treasury stock, relating to the robust share buyback program, is substantial.

However, total cash is ~25% of long-term debt.

Furthermore, the interest coverage ratio is over 13.

This is a very good number that indicates no issues whatsoever with leverage.

In addition, the interest coverage ratio has improved in recent years.

Profitability, as you might presume, is excellent.

A cigarette is a high-margin product at its core. It costs little to manufacture relative to what it can be sold for.

Yet the nature of the industry’s heavy regulation supercharges this.

Over the last five years, the company has averaged annual net margin of 24.85%.

Return on equity isn’t measurable due to the negative common equity.

That’s the kind of net margin many companies would love to have.

Overall, I see this as a great business that’s right on the cusp of a blockbuster product breakout.

But there are risks to consider.

Regulation, litigation, and competition are omnipresent risks in every industry.

The former two, in particular, are heightened in this industry.

Plain packaging, for example, is the kind of regulation that threatens the business by way of brand power destruction.

The strong dollar is a risk that is somewhat idiosyncratic to this business because of its structure.

Also, any acceleration in the decline of traditional cigarette shipment volumes would further harm sales and the company’s viability.

With those risks known, I still think this stock looks like a great long-term investment.

Stock Price Valuation

At an appealing valuation, it could be a home run.

Well, with a stock price that’s basically flat over the last 52 weeks as it’s been “left behind”, the valuation looks appealing…

The P/E ratio is 17.69.

That compares favorably to the broader market.

Furthermore, it’s notably lower than the stock’s own five-year average P/E ratio of 20.5.

If we isolate cash flow, the P/CF ratio of 14.1 is way off of its own three-year average mark of 18.0.

And the yield, as shown earlier, is significantly 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 an 8% discount rate (due to the high yield) and a long-term dividend growth rate of just 3.5%.

This 3.5% DGR looks conservative when stacked up against both the proven long-term EPS and dividend growth rates, respectively.

And the IQOS is just now being more widely rolled out, which bodes very well for profit and the dividend.

But I think the payout ratio handcuffs the company.

The high payout ratio doesn’t necessarily endanger the dividend as it sits, but it does limit the growth potential.

As I discussed earlier, I think a low-single-digit dividend growth rate is a realistic expectation for the foreseeable future. I’m simply modeling that in here.

The DDM analysis gives me a fair value of $107.64.

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.

This looks like a hallmark undervalued high-quality dividend growth 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 PM 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 PM as a 4-star “BUY”, with a 12-month target price of $90.00.

I came out very close to where Morningstar is at. Averaging the three numbers out gives us a final valuation of $99.88, which would indicate the stock is possibly 18% undervalued.

Bottom line: Philip Morris International Inc. (PM) is a high-quality company that controls the #1 global brand in its industry. And they’re just now widely rolling out a new product with huge promise for the future viability of the business. With a 5.5%+ yield, inflation-beating dividend growth, more than a decade of dividend raises, and the potential that shares are 18% undervalued, dividend growth investors should strongly consider this high-yield opportunity.

-Jason Fieber

Note from DTA: How safe is PM’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 64. 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, PM’s dividend appears Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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