This article first appeared on Dividends & Income
Prudential Financial, Inc. (PRU) and its subsidiaries provide a wide range of insurance, investment management, and other financial products and services to individual and institutional customers throughout the USA and many other countries.
Prudential is significantly undervalued at the moment, and as a result it is paying a much higher yield than historically normal for the company.
Is Prudential a good investment? Let’s find out. We’ll start with its dividend record, then examine the company itself, its financials, and finally its valuation. Everything is summarized at the end of the article.
Prudential’s Dividend Record
Prudential has a strong dividend record. Highlights include the high yield (over 6%), consistently fast dividend growth rate (above 10% per year), and the “safe” dividend safety score.
It is unusual to see both high yield and fast dividend growth in the same company. But Prudential has achieved it, making PRU a high-yield, fast-growth company.
The dividend safety score of 75 from Simply Safe Dividends indicates that they have found few factors that suggest that Prudential will cut its dividend in the near future.
Prudential’s dividend-increase streak stands at 12 years. The company cut its dividend during the Great Recession in 2008 but has been raising it every year since.
[Source of all yellow-bar charts: Simply Safe Dividends]
The dividend’s CAGR (compound annual growth rate) since the raises restarted in 2009 was 19% per year. This year’s increase was 10%.
Prudential’s yield is high not only because of its steadily rising dividends, but also because its stock price took a major hit when the Covid pandemic struck. Stock yield mathematically moves inversely to price, as shown on this year-to-date chart for Prudential, on which you can clearly see that price and yield changes are nearly mirror images of each other:
Prudential’s Business Model and Company Quality
Prudential has been in business for over 140 years. It is one of the largest U.S. financial services companies, with operations in the USA, Asia, Europe, and Latin America. It employs around 50,000 people world-wide.
Prudential’s principal operations are composed of the following reporting segments:
- U.S. Businesses: Workplace Solutions (retirement and group insurance); Individual Solutions (annuities and life insurance); and Assurance IQ – accounts for 44% of earnings
- International Businesses (mostly in Japan, expanding in Europe and emerging markets) – accounts for 43% of earnings
- Prudential Global Investment Management (PGIM) – accounts for 13% of earnings
Prudential’s Global Investment Management business serves as an asset manager to both institutional and retail investors, with over $1.6 trillion in assets (80% of which is invested in fixed income assets).
Prudential has more than over 50 million customers in over 40 countries. It is one of the 10 largest asset managers in the world, trailing such companies as BlackRock, Vanguard, Fidelity, and a few others.
As a recent example, the city of Atlanta recently selected Prudential Retirement as the record keeper for its defined contribution retirement plans.
One of Prudential’s long-term strategies is to rotate from mature markets to developing markets with greater growth prospects and favorable demographic trends. It has already experienced some success with this strategy, as its international segment now nearly equals its domestic segment in earnings.
The rotation strategy allows Prudential to expand its business in markets with growing economies and rising affluent and middle class, such as Latin America, China, Southeast Asia, and Africa. Those markets have low insurance penetration with a growing demand for protection and savings products.
(Source: Investor presentation)
Morningstar awards Prudential no moat. They state that life insurers generally do not have favorable competitive positions. Competition is fierce, with many websites for consumers to compare costs of policies. Many products are essentially commodities. In addition, it is hard for insurers to know whether their products are priced correctly, because insurance payoffs may be years down the road.
Prudential’s third-party ratings on quality factors are middle-of-the-road.
As just seen in the table above, Value Line gives Prudential an OK financial strength grade of B++. In a recent presentation, the company described its financials as “rock solid.” In this section, we’ll do our own analysis.
Return on Equity (ROE) is a standard measure of financial efficiency. ROE is the ratio of profits to shareholders’ equity.
The average ROE for all Dividend Champions, Challengers, and Contenders is 15%, and it runs about the same for S&P 500 companies. Prudential’s ROE has not generally been that high.
In its recent Q1 investor presentation, the company claimed an ROE of 12%, which would rate as OK on my normal rating scale. We will see next that whle Prudential’s ROE runs in a mediocre range, its ROE is not artificially inflated by high debt levels.
Debt-to-Capital (D/C) ratio measures how much a company depends on borrowed money. Companies finance their operations through a mixture of debt, equity (new shares), and their own cash flows.
A typical D/C ratio for a large, healthy company is 50%. D/C is a measure of financial risk. All else equal, stocks with high D/C ratios are riskier than those with low D/C ratios.
Prudential’s reliance on debt is lower (better) than average, running in the neighborhood of 40% for the past few years. This is a positive factor.
And as noted earlier, Prudential has a good investment-grade credit rating. Over-reliance on debt does not appear to be a problem.
Operating margin measures profitability: What percentage of revenue is turned into profit after subtracting cost of goods sold and operating expenses?
Per recent research, typical operating margins for S&P 500 companies have been in the 11-12% range.
Prudential’s operating margins have been declining for the past few years, from average levels to below-average levels.
That said, the company has implemented a cost-saving and efficiency program that it expects will both save money and improve customer experiences.
(Source: Investor presentation)
As you can see from the slide, the program was earnings-negative in 2019, but should flip this year to about neutral, then be accretive to earnings starting next year and beyond. The program should help improve margins going forward.
Earnings per Share (EPS) is the company’s officially reported profits per share. We want to see if a company has had years when it officially lost money, or if its earnings are steadily increasing, declining, or flat.
Prudential’s earnings record is mostly positive but uneven. In the past 10 years, one year was negative, five years showed growth, and three years showed decline.
Free Cash Flow (FCF) is the money left over after a company pays its operating expenses and capital expenditures. Whereas EPS is subject to GAAP accounting rules (and therefore includes non-cash items), cash flow is a more direct measure of dollars flowing through the company. FCF is the cash that a company has available for dividends, stock buybacks, and debt repayment.
Prudential generates significant positive cash flow. While it trends up and down from year to year, overall this FCF record paints a positive picture for dividend investors.
Share Count Trend shows whether the company’s outstanding shares are increasing in number, decreasing, or remaining flat.
I like declining share counts, because the annual dividend pool is spread across fewer shares each year. By retiring its own shares, the company is investing in itself, expanding each remaining share into a larger piece of the pie, and improving all per-share statistics.
Prudential has a steadily declining share count. Over the past nine years, it has reduced outstanding shares by 14%.
That said, in its Q1 presentation, the company noted that it has suspended share buybacks under the pressure of the Covid-induced recession. I consider that to be a prudent move.
Here is a summary of the items above:
Prudential’s financial picture, as condensed in the table above, is one of the more colorful I have seen. Excellent categories are mixed with below-average ones. Overall, I have no quarrel with Value Line’s B++ grade, which is their 4th-highest of nine grade levels.
Prudential strikes me as a conservatively managed company in a highly competitive business, which is actually pretty good when you think about it. There is no way it will ever come to dominate insurance, but it seems fully capable of holding its own. The field itself – when you include asset management – seems destined for long-term growth.
Prudential’s Stock Valuation
Valuation is separate from company quality and dividend record. We want to buy stocks that are undervalued whenever possible. I use four valuation models, then average them out.
Model 1: FASTGraphs Basic. The first step is to compare the stock’s current price to FASTGraphs’ basic estimate of its fair value.
The basic model utilizes a fair-value reference line based on a price-to-earnings (P/E) ratio of 15, which is the historical long-term P/E of the stock market.
In the following chart, the fair-value reference line is orange, and the black line is Prudential’s actual price. I circled PRU’s current P/E ratio, which is 6.3, along with the P/E of 15 used to draw the orange reference line.
According to this model, Prudential is massively undervalued. To calculate the degree of undervaluation, we make a ratio of the actual P/E to the reference P/E.
Calculating Valuation Ratio from FASTGraphs
Actual P/E ratio / Reference P/E ratio
6.3 / 15 = 0.42
That suggests that Prudential is undervalued by over 50%.
We use the valuation ratio to calculate the stock’s fair price: Divide the actual price by the valuation ratio. That gives us $64 / 0.42 = $152 for a fair price.
Model 2: FASTGraphs Normalized. In the second valuation model, we compare Prudential’s current P/E to its own 5-year average P/E.
The reference line is now blue, and this model paints a more modest picture of Prudential’s undervaluation. The blue reference line is shifted to PRU’s average valuation of 9.2, which is closer to the stock’s actual price.
Using the same formulas as in the first step, we get:
- Valuation ratio = 6.3 / 9.2 = 0.68, suggesting 32% undervaluation
- Fair price = $64 / 0.68 = $94
Step 3: Morningstar Star Rating. Morningstar takes a different approach to valuation. They do not use P/E comparisons. Rather, they use a discounted cash flow (DCF) model. DCF is based on the idea that a company is worth all of its future cash flows, discounted back to the present to reflect the time value of money.
Obviously, no one actually knows a company’s future cash flows. Estimates must be used. My experience with Morningstar is that they have a thoughtful, comprehensive, and conservative process for determining the inputs that they use in their DCF formulas.
Here is Morningstar’s valuation of Prudential going back 10 years. I have circled their current assessment.
Morningstar rates Prudential as undervalued by 18%, and they calculate a fair price of $78.
Step 4: Current Yield vs. Historical Yield. My last model compares the stock’s current yield to its historical yield. This relative-yield method of estimating fair value is based on the idea that if a stock’s yield is higher than usual, it may indicate that its price is discounted, because price and yield are inversely related.
This chart shows Prudential’s current yield (green dot) compared to its 5-year average yield (black horizontal line).
[Source: Simply Safe Dividends]
Prudential’s current yield of 6.9% is far above its 5-year average yield of 3.7%.
Calculating Valuation Ratio by Comparing Yields
5-Year Average Yield / Current Yield
3.7% / 6.9% = 0.54
When I use this model, I put a “floor” under the valuation ratio at 0.8, because I think this is the most indirect method of the four models to gauge valuation.
Using 0.8 as the valuation ratio, the fair price under this model is $64 / 0.80 = $80.
Prudential registers as discounted under all four models, and the average suggests a significant undervaluation.
To be conservative, if we throw out the first model as an outlier, the remaining three models still suggest a significant 24% discount to fair value and a fair price of $84 for Prudential.
Beta measures a stock price’s volatility relative to the S&P 500. I like to own stocks with low volatility for two reasons:
- They present fewer occasions to react emotionally to rapid price drops that can induce a sense of fear.
- There is research that suggests that low-volatility stocks outperform the market over long time periods.
Prudential’s 5-year beta is 1.7, which means it stock price has been much more volatile than the market’s. This is a negative factor.
In their most recent report on Prudential, CFRA gathered the recommendations of 15 analysts covering the stock. Their average recommendation is 3.1 on a 5-point scale, where 3 = hold and 4 = buy. This is a neutral factor.
The Bottom Line
- Highly attractive dividend resume: Very high yield (6.9%); steady double-digit dividend growth over the past several years; and good dividend safety score of 75 out of 100 points.
- Longstanding success – over 140 years – in competitive global insurance market. Growing success in international markets, including developing countries with growing middle class. Intelligent strategy to expand business into asset management with a focus on retirement assets.
- Decent financials overall, highlighted by relatively low debt and significant cashflow every year.
- Shares are significantly undervalued.
- Modest profit and efficiency metrics, reflecting highly competitive nature of Prudential’s business.
- High price volatility compared to market (although the stock’s steep decline in reaction to Covid-19 presents attractive valuation now).
- Coronavirus/covid conditions make all projections for any business at least somewhat speculative at this time.
In my opinion, at its current pricing, Prudential is an intriguing dividend-growth stock. It won’t appeal to everyone, but its very high dividend seems to be safe. I will consider it for addition to my Dividend Growth Portfolio when my next dividend reinvestment opportunity rolls around in August.
Nothing in this article is intended to be investment advice. This is not a recommendation to buy, hold, or sell Prudential Financial. Always perform your own due diligence. Check the company’s complete dividend record, business model, financial situation, and prospects for the future. Also consider how well it fits (or does not fit) your own long-term investing goals.
Coming Later this Year: New Dividend Growth E-Book
I am writing my first e-book about dividend growth investing since 2014.
Its title will be Top 30 Dividend Growth Stocks for 2021: A Sensible Guide to Dividend Growth Investing.
With the help of my colleagues at Daily Trade Alert, we have created a website for the new e-book, including descriptions of the book, background information on dividend growth investing, a countdown clock, and progress report.
Please click here for more information about this project. Publication is expected in December.
— Dave Van KnappDividends and Income - Free Newsletter [message from DTA]
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