The S&P 500’s 2019 performance was one for the ages.
It was one of the best years ever.
However, we always have to remember that it’s a market of stocks, not a stock market.
Some stocks had a pretty miserable 2019, leading to what now looks like solid opportunities.
Those solid opportunities are created when combining a high-quality stock with undervaluation.
When I think of high-quality stocks, I think of dividend growth stocks.
A lengthy track record of growing dividends is an excellent initial litmus test for business quality.
The Dividend Champions, Contenders, and Challengers list, a data source containing information on more than 800 US-listed stocks that have raised dividends for at least the last five consecutive years, reads off like a who’s who of the business world.
World-class enterprises left and right.
Of course it is.
You can’t pay out rising cash dividends to shareholders for years on end without running a quality business and regularly increasing your profit.
Something has to give at some point.
Now, that initial litmus test should be followed up by an in-depth analysis. That should go without saying.
But high-quality dividend growth stocks can be tremendous long-term investments.
Indeed, I’ve used dividend growth investing to go from below broke at 27 to financially free and retired at 33, as I lay out in the Early Retirement Blueprint.
My real-money FIRE Fund generates the five-figure dividend income I live off of in my 30s.
One of those principles relates to valuation.
Specifically, it’s imperative to value dividend growth stocks and make sure you’re buying them when they appear to be undervalued.
Stocks are like anything else.
You want to get the best deal you can possibly get. The cheaper something is, the better the deal.
However, you have to separate price from value.
While price is what you pay, it’s value that you get 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.
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.
A combination of a high-quality dividend growth stock and undervaluation can lead to incredible amounts of wealth and passive income over the long term.
Fortunately, it’s far from difficult to value dividend growth stocks.
Fellow contributor Dave Van Knapp made it even easier with Lesson 11: Valuation.
That’s one of his many “lessons” that are designed to educate investors on the principles of dividend growth investing that I spoke of earlier.
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…
Pfizer Inc. (PFE)
Pfizer Inc. (PFE) is a global pharmaceutical company that discovers, develops, and manufactures a range of healthcare products.
FY 2018 revenue breaks down across the following two operating segments: Innovative Health, 62%; Essential Health, 38%.
FY 2018 revenue also breaks down geographically as follows: 53%, International; 47%, US.
If we take into account the recent or soon-to-be spin-offs, Pfizer will be moving forward primarily as a global biopharmaceutical company.
The company has 10 different $1 billion drugs under ownership or through alliances, including blockbusters like Lyrica, Ibrance, Enbrel, Eliquis, and the Prevnar family of vaccines.
Their branded drug portfolio is one of the strongest out there. They’ve also long had a deep R&D bench.
And the branded drug portfolio will be their focus from here on out.
Pfizer completed its joint venture with GlaxoSmithKline PLC (GSK) in August 2019.
Pfizer merged its former consumer healthcare segment with GlaxoSmithKline’s consumer healthcare division. Operating as GSK Consumer Healthcare, with products like Advil and Centrum, this is the world’s largest OTC products business. Pfizer owns 32% of the joint venture.
In addition, Pfizer announced that it plans to spin off and combine Upjohn, its off-patent branded and generic established medicines business, with Mylan N.V. (MYL), creating a new global pharmaceutical company.
Structured as an all-stock, Reverse Morris Trust transaction, Pfizer shareholders will own 57% of the combined new company. It’s expected that Pfizer shareholders will get 0.12 shares of the new company for every 1 share of Pfizer that they own. This transaction is expected to close in mid-2020.
I noted at the outset of this article that some stocks had a miserable 2019.
Well, count Pfizer among them.
The stock started 2019 at just over $43/share. It ended 2019 at just over $39/share.
A dismal showing in a year that saw the broader market explosively move higher.
This is why it’s a market of stocks, not a stock market.
Dividend Growth, Growth Rate, Payout Ratio and Yield
It’s also why there’s always an opportunity out there.
This poor stock performance has led to a very juicy yield.
The stock is now yielding 3.74%, which is more than twice as high as the broader market.
It’s also more than 20 basis points higher than the stock’s own five-year average yield.
It’s not just yield, either.
There’s growth to go with it.
They’ve increased the dividend for 10 consecutive years, with a 10-year dividend growth rate of 6.1%.
They’ve been remarkably consistent with those dividend increases over the last decade. Most of them have come in at about the 6% mark. Indeed, the most recent dividend increase was 5.6%.
While the dividend might look messy immediately after the Upjohn spin-off, Pfizer has indicated that the combined dividend total from both companies will be equal to the current Pfizer dividend. This means no dividend cut when you factor in the dividend from the spin-off.
With a payout ratio of 53% before the Upjohn move, we can see the combined dividend from combined operations is very safe.
Of course, investors always invest in where a company is going, not where it’s been.
Revenue and Earnings Growth
The future for Pfizer looks bright, although things will be a little rocky while the transition plays out.
I’ll build out a forward-looking growth trajectory, which will later help us value the stock.
To do so, I’ll first show you what Pfizer 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 profit forecast.
Blending the proven past with a future forecast like this should tell us a lot about where Pfizer might be going.
The company grew its revenue from $50.009 billion in FY 2009 to $53.647 billion in FY 2018.
That’s a compound annual growth rate of 0.78%.
Certainly not excellent.
However, I will note that the past decade has been somewhat tumultuous for the company.
Besides the aforementioned moves, there was also the spin-off of pets and livestock medicine and vaccinations maker Zoetis Inc. (ZTS) in 2013.
This reduced revenue, but the way the company offered a share exchange also reduced its net outstanding share count.
Looking at profit growth on a per-share basis, Pfizer increased its earnings per share from $1.23 to $3.00 over this 10-year period.
This is a CAGR of 10.41%.
I’m using adjusted EPS for FY 2018 due to short-term noise that artificially skewed GAAP EPS for this year.
The outstanding share count is down by approximately 15% over the last decade, which has helped propel some of the excess bottom-line growth.
And the company’s shift to a focus on biopharmaceuticals should improve margins, which are already high.
Looking forward, CFRA is anticipating that Pfizer will compound its EPS at an annual rate of 6% over the next three years.
CFRA cites healthy growth in what will be the primary biopharmaceutical business. They believe that Pfizer’s diversified drug portfolio and robust pipeline give it an advantage over smaller players. And they also think the generic spin-off helps Pfizer’s organic revenue growth picture.
Headwinds, though, include expected large drops in revenue from Lyrica and Enbrel due to generic and biosimilar competition.
That 6% EPS growth forecast would be right in line with the Pfizer’s long-term dividend growth rate.
Based on everything I see here, I think that’s a reasonable expectation for Pfizer’s growth ability.
That goes for both the bottom line and the dividend (after factoring in the upcoming Upjohn spin-off).
Moving over to the balance sheet, Pfizer has a rock-solid financial position.
The long-term debt/equity ratio is 0.52, while the interest coverage ratio is almost 13.
And the long-term debt/equity ratio is artificially higher because of the sizable amount of treasury stock on the balance sheet (due to the buybacks). Absent that, this ratio would be even lower.
Profitability is robust. With the upcoming focus on biopharmaceuticals, the remaining Pfizer could become even more profitable than it already is.
Over the last five years, Pfizer has averaged annual net margin of 21.53% and annual return on equity of 16.68%.
There’s much to like about Pfizer.
It’s a world-class pharmaceutical company. The bench of branded drugs is deep and wide. And the stock offers a very appealing yield right now.
Durable competitive advantages include patents, inelastic demand for products, R&D, massive scale, technological know-how, and global relationships. It’s a mighty company.
Litigation, regulation, and competition are omnipresent risks in every industry.
But I think all three are of particular concern in the pharmaceutical space.
While patents protect the business, patent cliffs are always an issue with drug companies. When a venerable drug comes off patent, this creates a rise in competition and drop in profit. It also means that they must constantly develop new drugs.
There’s also the uncertainty regarding the upcoming Upjohn spin-off, although that’s offset perhaps just as much as the opportunity it could be.
Stock Price Valuation
Overall, though, this could be a fantastic long-term investment at the right valuation.
After a terrible 2019, I believe the valuation is currently compelling…
The stock is trading hands for a P/E ratio of 14.24.
That’s way off of the broader market’s P/E ratio (near 20). It’s also materially lower than the stock’s own five-year average P/E ratio of 21.9.
However, I will note that Pfizer’s P/E ratio jumps around a lot. The company’s reported GAAP EPS can zoom up and down quickly. This makes comparisons difficult.
But even if we look at valuation multiples on other areas of the business, like sales, we see a stock that is, at worst, fairly valued.
And the yield, as noted earlier, is higher than its 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 an 6% long-term dividend growth rate.
This DGR is right in line with the company’s own long-term average.
Furthermore, with the 6% forecast for EPS growth over the foreseeable future, it seems reasonable to expect the status quo here.
I don’t think we’re going to see much in the way of a marked acceleration or deceleration in dividend growth. That’s after accounting for the inclusion of the upcoming Upjohn spin-off.
But with a yield that’s twice as high as what the broader market offers, 6% dividend growth seems like plenty.
The DDM analysis gives me a fair value of $40.28.
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.
Pfizer’s stock appears to be roughly fairly priced. In a market that arguably looks expensive after a ~30% move up in 2019, the stock is relatively attractive.
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 PFE as a 4-star stock, with a fair value estimate of $46.00.
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 PFE as a 3-star “HOLD”, with a 12-month target price of $43.00.
My valuation might be conservative. Averaging the three numbers out gives us a final valuation of $43.09, which would indicate the stock is possibly 6% undervalued.
Bottom line: Pfizer Inc. (PFE) is a high-quality company with durable competitive advantages. With an exciting upcoming spin-off, a yield more than twice as high as the S&P 500, a modest payout ratio, strong dividend growth, and the potential that shares are 6% undervalued, this looks like a relatively attractive stock in an otherwise elevated market.
Note from DTA: How safe is PFE’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 75. 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, PFE’s dividend appears Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
Retire Early With $3 Wonder Stock? [sponsor]
Ever dream of retiring 5... 10... 15 years early with help from one blockbuster stock? No guarantees, but tech futurist Luke Lango believes a tiny, under-the-radar $3 gem holds the key to disrupting the entire electric vehicle industry. You don't want to miss this... Get full details here.