10 years. 10 minutes.
Two very different time frames.
But if you’re not willing to invest in a business for 10 years, you shouldn’t bother with 10 minutes.
That’s why it’s important to invest in companies with a secular growth path.
Long-term secular growth provides fertile ground for growing profit and growing dividends.
This is part of what makes the investment strategy of dividend growth investing so powerful.
It’s a strategy that advocates buying and holding shares in high-quality companies that are paying reliable and rising dividends.
You’ll find many examples of these companies on the Dividend Champions, Contenders, and Challengers list.
Using this strategy helped me to go from below broke at age 27 to financially independent and retired at only 33, as I lay out in my Early Retirement Blueprint.
I built my FIRE Fund in the process.
That’s my real-money stock portfolio.
And it produces the five-figure passive dividend income I live off of.
Dividend growth investing is an incredible way to build wealth and passive income.
It’s also imperative to select the right values.
Price is what you pay. But 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.
Investing in a company with a secular growth path, and buying when the stock is undervalued, can lead to tremendous long-term results.
Fortunately, finding good values isn’t as difficult as it might seem.
Fellow contributor Dave Van Knapp’s Lesson 11: Valuation makes sure of that.
Part of an overarching series of educational lessons on dividend growth investing, Lesson 11 shares an easy-to-follow 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…
General Dynamics Corporation (GD) is a global aerospace and defense company.
Founded in 1899, General Dynamics is now a ~$40 billion company (by market cap) that employs over 100,000 people around the world.
Some of their major platforms include the Stryker combat vehicle, Abrams tank, the Virginia-class nuclear-powered submarine, Gulfstream business jet. In addition, they offer a suite of IT services.
FY 2019 sales are broken up across the following business segments: Aerospace, 25%; Marine Systems, 23%; Information Technology, 22%; Combat Systems, 18%; and Mission Systems, 12%.
Revenue for FY 2019 breaks down geographically as follows: 83%, North America; 17%, ex-North America.
When I think of secular growth, there are few themes that come to mind faster than sovereign defense.
Human conflict has been around since… well, human beings.
From flint spears to submarines, armament and defense has been a characteristic trait of human society, for better or worse.
We’ve been reminded of that with rising tensions between the US and China of late.
As investors, we can clearly see the secular growth path for companies that cater to sovereign defense.
General Dynamics is one such company.
In fact, they’re one of the largest defense contractors in the world, manufacturing a range of large weapons that can’t easily be replicated by a competitor.
Furthermore, their $9.6 billion acquisition of CSRA in 2018 turned it into the largest provider of IT services to the US government.
In a world where warfare is becoming increasingly digital, General Dynamics has positioned itself well.
Meanwhile, with the Gulfstream business, General Dynamics is somewhat less reliant on US defense spending than some of its peers.
The aerospace business gives General Dynamics diversification into unrelated commercial markets.
And it offers some stabilization if/when US budgetary crises or US DoD spending pressures occur, although commerical aerospace is almost certainly going to be weak during the pandemic.
However, seeing as how the US last passed a massive $738 billion defense spending bill, I don’t see any US DoD spending slowdown on the horizon, even with all of the additional debt taken on to support the US economy after pandemic-induced shutdowns.
In fact, the contracts for General Dynamics keep coming.
The DoD awarded the company’s CSRA business a $7.6 billion cloud contract back in August 2019.
Then the company won a $22.2B contract from the U.S. Navy in December for construction of nine Virginia-class submarines.
These aren’t contract that just up and disappear because of our current health crisis.
If anything, these contracts are made to be more certain and valuable during precarious times.
Their unique size and positioning across key platforms ensures future profit and dividends.
Dividend Growth, Growth Rate, Payout Ratio and Yield
As it sits, the company has increased its dividend for 29 consecutive years.
The 10-year dividend growth rate is a stout 10.4%.
With a payout ratio of only 37.1%, this is one of the most secure dividends you’ll find.
That double-digit dividend growth comes on top of the 2.92% yield the stock is offering.
This yield is much higher than what the broader market will give you.
Moreover, it’s almost than 100 basis points higher than the stock’s own five-year average yield.
It’s a very compelling dividend story.
Revenue and Earnings Growth
But this is what’s already happened.
As investors, we put capital at risk for tomorrow’s dividends and results.
Thus, I’ll build out a growth trajectory for General Dynamics.
This will partially rely on 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 prognostication of earnings growth.
Blending the proven past with a future forecast in this manner should allow us to reasonably estimate the company’s future growth.
The company grew its revenue from $32.466 billion in FY 2010 to $39.350 billion in FY 2019.
That’s a compound annual growth rate of 2.16%.
I usually like to see a mid-single-digit top-line growth rate from a mature company like this.
They fell slightly short, due to some stalling around the middle of the decade. Much of this was related to budgetary issues, such as the US fiscal cliff.
Earnings per share increased from $6.81 to $11.98 over this period, which is a CAGR of 6.48%.
That’s a little more like it.
A combination of improving profitability and share buybacks helped to propel that excess bottom-line growth.
The outstanding share count is down by approximately 24% over the last 10 years.
Looking forward, CFRA is projecting that General Dynamics will compound its EPS at an annual rate of 9% over the next three years.
They cite the huge backlog – ~$86 billion, which was up 24% YOY in Q1 FY 2019 – and overall volume improvement as key drivers of this growth.
But travel restrictions will hurt the Gulfstream business jet business over the near term.
I think a 9% bottom-line growth rate from General Dynamics is reasonable, if just slightly aggressive.
They don’t really need to generate that kind of bottom-line growth to hand out generous dividend raises, however.
With the low payout ratio, even mid-single-digit bottom-line growth more in line with the last decade would be more than enough to allow them to raise the dividend in the high-single-digit range for years to come.
If General Dynamics is able to grow at 9%, that’d be even better. And dividend raises somewhere around 10% or so for the foreseeable future would be easily possible.
Moving over to the balance sheet, the company is in solid financial condition.
The balance sheet did take a hit from the CSRA acquisition, which saw General Dynamics exchange debt for growth, but they simply moved from excellent financial health to very good financial health.
Profitability is robust. The company regularly posts outstanding numbers for its industry.
Over the last five years, the firm has averaged annual net margin of 9.27% and annual return on equity of 27.18%.
This is a high-quality company with a secular growth path.
And they have durable competitive advantages to protect the business.
They include scale, geopolitical relationships, technological know-how, switching costs, and barriers to entry.
Of course, there are risks to consider.
Competition, regulation, and litigation are omnipresent risks in every industry.
There is limited competition in many of its business lines. However, the company faces a lot of regulation.
The company’s commercial markets will likely be pressured for the near term, hurting the delivery of Gulfstream business jets. This is the cyclical side of the company’s revenue stream.
General Dynamics is also sensitive to changes in the US Department of Defense budget.
Overall, I see this as a wonderful business.
And it’s a particularly appealing investment idea at this time, after a 16% YTD drop in the stock’s price.
Shares now look undervalued…
Stock Price Valuation
The stock is trading hands for a P/E ratio of 12.69.
This is much lower than the broader market.
It’s also materially lower than the stock’s own five-year average P/E ratio of 17.6.
If we look at cash flow, there remains a huge gap.
The P/CF ratio is currently at 14.1, which compares extremely favorably to the stock’s three-year average P/CF ratio of 21.6.
And the yield, as noted earlier, is significantly higher than its 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 7.5%.
This DGR is lower than what General Dynamics has generated over the last decade.
With a low payout ratio and an estimate for 9% near-term EPS growth, I think the company is in a great spot to put out high-single-digit dividend raises for years to come.
The DDM analysis gives me a fair value of $189.20.
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.
My analysis shows a severely undervalued 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 GD as a 4-star stock, with a fair value estimate of $187.00.
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 GD as a 5-star “STRONG BUY”, with a 12-month target price of $203.00.
I came out very close to where Morningstar is at. Averaging the three numbers out gives us a final valuation of $193.07, which would indicate the stock is possibly 28% undervalued.
Bottom line: General Dynamics Corporation (GD) is a high-quality company with a secular growth path, which should ensure higher profit and dividends over the long run. With a 3% yield, almost 30 consecutive years of dividend raises, double-digit dividend growth, a very secure dividend, and the potential that shares are 28% undervalued, dividend growth investors should be seriously considering buying this stock right now.
Note from DTA: How safe is GD’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 97. 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, GD’s dividend appears Very Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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