I like to think of stocks like springs.
And the valuation at the time of investment is akin to the amount of compression in a spring.
The lower the valuation, the more compressed the spring is.
If you’re able to buy a high-quality stock at a rock-bottom valuation, you could have something along the lines of a spring ready to explosively uncoil.
But it’s not just wealth.
It’s also income.
With the right stocks, you’ll be getting paid more money while you wait for that spring to release.
The “right” stocks?
I’m talking about high-quality dividend growth stocks.
These stocks represent equity in world-class enterprises.
These enterprises are raking in more and more profit by providing the products and/or services the world demands.
And they’re rewarding their shareholders with reliable, rising cash dividends.
More than 800 US-listed dividend growth stocks can be found on the Dividend Champions, Contenders, and Challengers list.
Only stocks that have raised dividends each year for at least the last five consecutive years are listed.
I’ve used the strategy of dividend growth investing to buy many “coiled springs” over the years.
And I built the FIRE Fund in the process.
That’s my real-money dividend growth stock portfolio, which generates the five-figure passive dividend income I live off of.
I was able to go from below broke at 27 years old to financially free and retired in my early 30s by using this strategy.
I lay out exactly how I did that in my Early Retirement Blueprint.
The “coiled spring” effect is easy to understand.
It revolves around valuation.
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 simple: The more undervalued a stock gets, the more of a “coiled spring” it becomes.
Fortunately, these coiled springs aren’t that difficult to find.
Fellow contributor Dave Van Knapp made it even easier with Lesson 11: Valuation.
Part of a comprehensive series on dividend growth investing, this lesson gives you a valuation template that you can apply 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…
Parker-Hannifin Corp (PH)
Parker-Hannifin Corp (PH) is a global manufacturer of industrial motion and control technologies, including pumps, valves, actuators, regulators, sensors, filters, and hoses.
Founded in 1917, they’re now a global powerhouse that employs over 50,000 people. They supply products to over 450,000 customers. No single customer accounted for over 3% of net sales as of last fiscal year.
The company is exposed to almost every significant manufacturing, transportation, and processing industry.
Parker-Hannifin operates through two primary segments: Diversified Industrial, 82% of FY 2019 sales; and Aerospace Systems, 18%. 42% of Diversified Industrial sales were International.
This is one of those companies that flies way under the radar.
Yet their products are virtually necessary in a range of manufacturing processes that bring to life the products and/or services our world depends on.
Everything from packaging materials to jets can trace back to Parker-Hannifin’s motion and control technologies.
This bodes well for the company’s ability to endure, especially in these times of COVID-19.
It also bodes well for their ability to pay a growing dividend.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Speaking of which, Parker-Hannifin has one of the most impressive dividend growth streaks in existence.
I’m not exaggerating.
They’ve increased their dividend for 63 consecutive years.
That puts them in rarefied air. We’re talking less than 10 companies on the planet with a dividend growth track record of 63 years or longer.
Even with that eye-popping dividend growth streak, they’ve shown no real signs of slowing down.
The 10-year dividend growth rate is 13.0%.
I mean, more than 50 years into growing the dividend – and they’re averaging double-digit dividend raises. It’s remarkable.
Now, we are facing a unique challenge with the global pandemic. It’s unprecedented. I would not be surprised to see much smaller dividend increases over the next few years.
But a slowdown in dividend growth is obviously much better than a dividend cut.
Their payout ratio is a lowly 33.5%.
Again, remarkable. More than 60 years into dividend raises – with rather aggressive dividend growth to boot – and the payout ratio is that low. This is a special business.
This gives the company a nice cushion with all of the uncertainty going on.
On top of all of this, the stock yields a very attractive 2.49%.
Notably, that’s almost 60 basis points higher than the stock’s own five-year average yield of 1.90%.
Revenue and Earnings Growth
One thing that has kept me from personally buying this stock before was the perpetually high valuation and low yield.
But with the COVID-19 pullback, this high-quality dividend growth stock came way down in valuation (which has pushed the yield up).
It’s now a much more appealing investment. That’s why I recently initiated a position in the business.
Now, investors are always most concerned about what’s to come, not what’s already happened.
We invest in where a company is going, not where it’s been.
I’ll now build out a forward-looking growth trajectory for Parker-Hannifin, which will rely partially on what the company has done over the last decade in terms of top-line and bottom-line growth.
I’ll also add in a professional prognostication for profit growth.
Combining the proven past with a future forecast like this should allow us to reasonably estimate where Parker-Hannifin is going with growth (including the dividend), which will also help us to estimate intrinsic value of the stock.
The company grew its revenue from $9.993 billion in FY 2010 to $14.320 billion in FY 2019.
That’s a compound annual growth rate of 4.08%.
Solid. That’s the kind of mid-single-digit top-line growth I’d look for from a fairly mature business like this.
However, it’s worth acknowledging that this wasn’t all organic.
The company’s acquisition of CLARCOR, Inc. in 2016 for $4.3 billion was its largest-ever acquisition. And this caused a positive bump in revenue.
Their top-line growth has been solid, but the bottom line has been even better.
Earnings per share increased from $3.40 to $11.48 over this time frame, which is a CAGR of 14.48%.
A combination of margin expansion, share buybacks, and a lower tax rate greatly aided the company’s EPS growth relative to sales growth.
Net margin in recent years has strikingly improved. Numbers were admittedly depressed by the financial crisis, but net margin for FY 2019 was almost double what it was for FY 2010.
Moreover, the outstanding share count is down by ~19%.
Looking forward, CFRA is projecting that Parker-Hannifin will compound its EPS at an annual rate of 8% over the next three years.
That’s well off of what they’ve done over the last 10 years.
However, we’re kind of flying blind here.
Nobody knows how long the US economy will remain in a state of shutdown due to the global pandemic. The health crisis makes it almost impossible to accurately predict where earnings will be over the next 24-48 months.
But this is a long-term business.
And long-term investing is a marathon, not a sprint.
I’m not sure what Parker-Hannifin will be printing on its earnings reports over the next year, but I’m confident they’ll do extremely well over the long run.
The low payout ratio, long-term track record of high excellence, clear commitment to dividend growth, and necessity of their various products in all manners of manufacturing processes gives me a lot of confidence in this business as a long-term investment.
I think they’re positioned to deliver high-single-digit dividend growth over the long run, even if the near term is bumpy. And if they grow EPS at 8% over the next three years – which would surprise me – all the better.
That’s plenty of dividend growth when you’re getting a starting yield of almost 3%.
Moving over to the balance sheet, Parker-Hannifin maintains a good financial position.
They used to have an even better balance sheet, but it has deteriorated somewhat in recent years. Their aforementioned CLARCOR, Inc. acquisition saw long-term debt jump quite a bit between FY 2016 and FY 2017.
The long-term debt/equity ratio is 1.09, while the interest coverage ratio is almost 8.
Good numbers. They have no issues with financial wherewithal.
But I would like to see the balance sheet improve somewhat in future years.
Profitability is fairly robust.
Management’s efforts to improve operations are clearly evident.
Over the last five years, the firm has averaged annual net margin of 8.24% and annual return on equity of 19.71%.
Both averages are materially higher than where they were 8-10 years ago. Annual net margin averaged 7.59% over the preceding five-year cycle.
This is a great business.
The balance sheet could be better. But it’s otherwise an incredibly well-run enterprise of high caliber.
The short term will be ugly, but this company has seen plenty of ugly periods over the last 100+ years of its existence. And for over 60 of those years, they’ve been paying a growing dividend straight through.
That includes multiple wars, numerous global health crises (like H1N1), political change, stock market crashes, and the recent Great Recession.
They’ve survived all of that while pumping out larger dividends to their shareholders. If any company is fit to do that during this pandemic, it’s Parker-Hannifin.
Scale, technological know-how, switching costs, patents, and brand quality/consistency all work to their favor.
A large installed base of products and a wide distribution network give them the repeat business that stifle competitors.
Of course, there are risks to consider.
Competition, regulation, and litigation are omnipresent risks in every industry.
The very nature of the business means they’re sensitive to any kind of global economic slowdown, which we’re in the midst of as we speak.
They’re also exposed to a number of cyclical industries, especially aerospace. Aerospace is particularly concerning right now due to challenges in aviation from a sharp reduction in global travel.
Input and energy costs can be volatile.
And the recent weakening of the balance sheet has left them in a worse-off position to thrive through the upcoming recession.
Overall, though, I view this to be one of the highest-quality dividend growth stocks out there.
At the right valuation, this could be a phenomenal long-term investment.
With the stock down 37% YTD, the valuation finally looks appealing for the first time in years…
Stock Price Valuation
The stock sports a P/E ratio of 13.46.
That’s not only well below the market, but it’s also markedly lower than the stock’s own five-year average P/E ratio of 19.8.
Then there’s cash flow.
The P/CF ratio, at 9.1, is way off of its three-year average of 15.6.
And the yield, as shown earlier, is substantially higher than its own recent historical average.
So the stock looks cheap when looking at basic valuation metrics. But how cheap might it be? What would a rational 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 8%.
That DGR is at the top end of what I typically use in a DDM analysis.
But I think Parker-Hannifin deserves the benefit of the doubt. If there’s any company that deserves it, it’s Parker-Hannifin.
It’s important to note that this is a long-term projection.
I’m looking at decades here. I fully believe that the next few years are going to be lower than this, but investors buying this stock today will likely be pretty happy with their dividend raises in 2025 and beyond.
The low payout ratio, healthy free cash flow situation, diversified nature of the business, and pristine track record is factored into this.
The DDM analysis gives me a fair value of $190.08.
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.
I’m coming up with a valuation that indicates this stock is very undervalued.
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 PH as a 5-star stock, with a fair value estimate of $195.00.
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 PH as a 4-star “BUY”, with a 12-month target price of $232.00.
I came out very close to where Morningstar did. Averaging the three numbers out gives us a final valuation of $205.69, which would indicate the stock is possibly 46% undervalued.
Bottom line: Parker-Hannifin Corp (PH) is a high-quality company with one of the most impressive long-term track records in existence. With more than 60 consecutive years of dividend raises, a near-3% yield, a double-digit long-term dividend growth rate, a very low payout ratio, and the potential that shares are 46% undervalued, this could be one of the very best long-term dividend growth stock investment opportunities available.
— Jason Fieber
Note from DTA: How safe is PH’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 94. 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, PH’s dividend appears Very Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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