This article first appeared on Dividends & Income on Friday.

Industries left and right are under duress right now.

The hospitality and travel industries have been particularly damaged.

The pandemic has been like a global natural disaster, hitting almost everywhere – all at the same time.

This means that finding undervalued stocks is more than simply looking at price relative to value.

We also have to be careful about the industries we’re investing in.

Unless you want to see dividends dry up along with profit, it’s imperative to stick to industries that are less affected by the global health crisis.

And if you’re anything like me, you love to see those dividends continue to roll in like clockwork.

Not only that, I want to see those dividends continue to grow.

That’s what dividend growth investing is all about.

It’s about investing in high-quality enterprises that are paying reliable and rising cash dividends.

Perusing the Dividend Champions, Contenders, and Challengers list will show you many of these enterprises.

That list has data on more than 800 US-listed stocks that have raised dividends each year for at least the last five consecutive years.

I’ve used the dividend growth investing strategy to go from below broke at age 27 to financially free at 33, as I describe in my Early Retirement Blueprint.

In fact, by leveraging this strategy, I built a six-figure stock portfolio in only a few years – without a college degree or high-paying job.

That portfolio is my FIRE Fund.

I call it that because it allowed me to achieve financial independence and retire early.

It’s chock-full of high-quality companies paying those reliable and rising dividends.

Jason Fieber's Dividend Growth PortfolioAnd it generates enough five-figure passive dividend income for me to live off of.

As great as dividend growth investing is, it’s not without its nuances.

One still needs to do their analysis on businesses, even those that are high quality.

Also, valuation is critical.

Price is only what you pay. Value is what you actually 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.

Carefully selecting a dividend growth stock in a thriving industry, and buying when it’s undervalued, could set you up for fantastic long-term investment results.

Fortunately, estimating a stock’s intrinsic value isn’t onerous.

Fellow contributor Dave Van Knapp has made it even easier with the introduction of Lesson 11: Valuation.

Part of a more comprehensive series on dividend growth investing, Lesson 11 lays out 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…

Pfizer Inc. (PFE)

Pfizer Inc. (PFE) is a global pharmaceutical company that discovers, develops, and manufactures a range of healthcare products.

Founded in 1849, Pfizer is now a $187 billion (by market cap) healthcare giant that employs over 88,000 people worldwide.

Approximately 46% of sales come from the US, with the remainder being from international markets.

Pfizer has a broad portfolio of drugs, including blockbusters Ibrance, Eliquis, Xeljanz, and Lyrica – all with over $1 billion in annual sales. The company also has the Prevnar family of vaccines.

All in, the company has eight brands with over $1 billion in annual sales.

Negating some of the concerns regarding patent cliffs, Pfizer also maintains an impressive pipeline through its R&D. As of April 2020, they have 21 compounds in Phase 3.

And via a partnership with BioNTech SE (BNTX), they’re aggressively attempting to develop a vaccine for the current coronavirus pandemic.

If we take into account the recent or soon-to-be spin-offs, Pfizer will be moving forward primarily as a global biopharmaceutical company with a focus on branded drugs.

Toward that end, Pfizer completed its joint venture with GlaxoSmithKline PLC (GSK) in August 2019.

This JV saw Pfizer merge 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 this JV.

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 named Viatris.

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 the second half of 2020.

I noted at the outset of this article how important it is for investors to be careful about the industries they’re investing in.

Well, healthcare is one of the few industries that’s clearly fit for long-term investing here.

The need for treatments doesn’t suddenly disappear.

If anything, major healthcare firms like Pfizer stand to benefit from the current situation. Their vaccine work is evidence of that.

This bodes well for the firm’s ability to continue growing its profit and its dividend.

Dividend Growth, Growth Rate, Payout Ratio and Yield

As it stands, Pfizer has increased its dividend for 10 consecutive years.

The 10-year dividend growth rate is 6.1%.

That’s solid when you pair it with the 4.50% yield the stock offers right now.

This yield, by the way, is 100 basis points higher than the stock’s own five-year average yield.

And with a payout ratio of 54.3%, this is a well-covered dividend with plenty of room for future dividend raises.

Revenue and Earnings Growth

All that said, this is looking at what Pfizer has already done.

But it’s ultimately future results that investors are risking today’s capital for.

I’ll now build out a forward-looking growth trajectory for Pfizer, which will later help us estimate intrinsic value.

This trajectory will use Pfizer’s long-term top-line and bottom-line growth as a base.

Then I’ll compare that to a professional prognostication for near-term profit growth.

Blending the proven past with a future forecast in this manner should allow us to extrapolate out a growth path with reasonable confidence.

Pfizer’s revenue is down from $67.809 billion in FY 2010 to $51.750 billion in FY 2019.

I never like to see a revenue decrease.

However, this decrease is due more to various restructuring moves than any kind of issue with Pfizer’s core business model.

Besides the aforementioned JV with GlaxoSmithKline, there was also the spin-off of pets and livestock medicine and vaccinations maker Zoetis Inc. (ZTS) in 2013.

For further perspective on that, Zoetis is now a $65 billion (by market cap) business.

This spin off reduced revenue, but Pfizer offered a share exchange that reduced its net outstanding share count.

If we look at profit on a per-share basis, we can see that Pfizer increased its earnings per share from $1.02 to $2.87 over this 10-year period.

That’s a compound annual growth rate of 12.18%.

Pretty impressive stuff, but I will say that Pfizer’s messy decade makes it somewhat difficult to get a clear picture of their growth.

Helping to fuel much of that EPS growth has been buybacks.

Pfizer’s outstanding share count is down by almost 30% over the last decade. That’s a very large reduction.

Looking forward, CFRA projects that Pfizer will compound its EPS at a 6% annual rate over the next three years.

CFRA cites increased generic competition for Lyrica after the loss of exclusivity, as well as a drop in Chinese sales for Lipitor.

Indeed, Pfizer’s Achilles’ heel is a patent cliff – many of their drugs are coming off patent over the next few years, including Chantix/Champix in 2020, Sutent in 2021, and Ibrance in 2023. Cancer drug Ibrance is a blockbuster that comprises approximately 10% of Pfizer’s sales.

Offsetting some of this is the company’s deep pipeline, supported by big R&D spending ($8.7 billion in 2019).

And its decision to focus on branded drugs after the upcoming spin-off could improve the pipeline further, resulting in more growth.

I view CFRA’s near-term EPS growth projection to be fair.

Between a recent buyback halt and the patent issues, Pfizer won’t knock you dead with growth.

But a 6% EPS growth rate would support like dividend growth over the coming years.

And pairing that kind of growth with a 4%+ starting yield is compelling in this environment.

Financial Position

Moving over to the balance sheet, Pfizer maintains a rock-solid financial position.

The long-term debt/equity ratio is 0.57, while the interest coverage ratio is north of 11.

Furthermore, they have almost $10 billion in total cash.

Admittedly, the balance sheet did look better five years ago. There’s been some mild deterioration here.

But it’s simply moved from a great balance sheet to one that’s somewhat less so.

Profitability, meantime, is spectacular.

Over the last five years, the firm has averaged annual net margin of 15.82% and annual return on equity of 19.34%.

Pfizer has all the makings of a great long-term investment.

It’s a world-class pharmaceutical company that’s about to reorganize into something even more focused and profitable.

And durable competitive advantages like patents, inelastic demand for products, R&D, massive scale, technological know-how, and global relationships all serve to protect the company.

Of course, there are risks to consider.

Litigation, regulation, and competition are omnipresent risks in every industry.

I think all three of these risks are elevated in the pharmaceutical industry.

The pipeline is strong, but the company’s near-term patent cliff is substantial.

And although the new focus on branded drugs is exciting, there’s still a lot of uncertainty regarding the upcoming spin-off.

Overall, there’s a lot to like about this dividend growth stock.

It’s even more likable when the valuation is attractive, like it appears to be now…

Stock Price Valuation

The stock is trading hands for a P/E ratio of 12.07.

That’s significantly lower than the broader market.

It’s also much lower than the stock’s own five-year average P/E ratio of 21.9, although it’s difficult to make this comparison because of volatile GAAP earnings.

Every basic valuation metric shows cheapness against recent multiples.

The P/CF ratio, for instance, at 13.6, shows a disconnect against the three-year average of 14.3.

And the yield, as noted earlier, is meaningfully 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 9% discount rate (to account for the high yield) and a long-term dividend growth rate of 5%.

That DGR is on the low end of what I normally allow for.

But I think this kind of conservative stance is warranted.

The patent cliff is material.

And both the 10-year proven DGR and the near-term EPS growth forecast from CFRA are in the 6% range, which doesn’t promote enthusiasm for anything more than mid-single-digit dividend growth from here.

That said, this is setting the bar pretty low. There’s not much of an expectation here, so it wouldn’t take much of an effort for Pfizer to surprise to the upside.

However, I’d rather err on the side of caution.

The DDM analysis gives me a fair value of $39.90.

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 very low expectations, the stock still looks 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 PFE as a 5-star stock, with a fair value estimate of $42.50.

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 4-star “BUY”, with a 12-month target price of $41.00.

I came out the lowest, but we’re all in the same neighborhood. Averaging the three numbers out gives us a final valuation of $41.13, which would indicate the stock is possibly 22% undervalued.

Bottom line: Pfizer Inc. (PFE) is a high-quality pharmaceutical company that’s about to shift into something even more focused and profitable. With a massive yield of 4.5%, solid dividend growth, a moderate payout ratio, and the potential that shares are 22% undervalued, this looks like one of the better long-term opportunities in the market for dividend growth investors.

-Jason Fieber

P.S. If you’d like access to my entire six-figure dividend growth stock portfolio, as well as stock trades I make with my own money, I’ve made all of that available exclusively through Patreon.

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 an unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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Source: Dividends and Income