This article first appeared on Dividends & Income
“You can’t have your cake and eat it too.”
We’ve all heard that before, and it often rings true in life.
If you eat your cake, you won’t have any cake left.
Well, I know of a way to have your cake and eat it.
Not only that, you could end up with more cake year after year.
Dividend growth investing.
This investment strategy allows you to eat cake (dividends) while also keeping your cake (stock).
Plus, high-quality dividend growth stocks that are regularly and reliably growing their dividends feed you with more cake year in and year out.
That’s because dividend growth investing advocates buying and holding stock in world-class enterprises that are regularly growing their profit and paying out rising dividends to shareholders.
I’ll tell you where these magical cakes can be found.
The Dividend Champions, Contenders, and Challengers list contains the names of more than 700 US-listed stocks that have raised dividends each year for at least the last five consecutive years.
Investing in stocks that allow me to eat my cake and have it too allowed me to retire at only 33 years old, as I lay out in the Early Retirement Blueprint.
I’ve built up a six-figure portfolio of high-quality dividend growth stocks, which I call the FIRE Fund.
And this portfolio generates enough five-figure passive dividend income for me to live off of while I’m still in my 30s.
Intelligent investing is, of course, more than picking just the right strategy.
It’s also about picking the right stocks at the right time.
Valuation can play a critical role in the outcome of an investment.
Price is only what you pay. It’s value that 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.
Buying high-quality dividend growth stocks when they’re undervalued can provide you with a phenomenal way to have a lot of cake and eat it too.
Valuation itself isn’t actually all that difficult to get the hang of.
Fellow contributor Dave Van Knapp’s Lesson 11: Valuation has made valuing stocks even easier.
Part of an overarching series on dividend growth investing as a whole, Lesson 11 provides an incredibly useful valuation template.
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…
Prudential Financial Inc. (PRU) is a global, diversified insurance company that offers life insurance, annuities, investment management, retirement plan services, and other financial products and services.
Founded in 1875, Prudential Financial is now a $27 billion (by market cap) financial leviathan that employs over 50,000 people worldwide.
The company serves approximately 50 million customers across 40 different countries.
Prudential Financial reports operations across the following four segments: International Businesses, 43% of FY 2019 pretax segment operating profit; US Individual Solutions, 24%; Workplace Solutions, 20%; and Investment Management, 13%.
This is one of the largest life insurance companies in the US. And with ~$1.6 trillion in AUM, they’re also one of the world’s largest asset managers.
An investment in Prudential Financial is essentially an investment in two different businesses, simultaneously.
You have a very large life insurance business on one side. Then you have a significant asset management business on the other.
Both business models are solid concepts in isolation.
With insurance, there’s a lot of profit to be made from the float – the low-cost, low-risk capital that builds up with the natural lag time between collecting premiums and paying out on claims.
And asset management tends to provide excellent fee income when the assets become sizable. Plus, these assets tend to be sticky, as investors aren’t likely to move these assets around a lot.
However, the combination of the two business models is an appealing proposition, in my view, as the life insurance business is very difficult to gauge profitability on. That’s due to the long-tail risk nature of policies; a life insurance company won’t know the cost of the sold product for many years.
I think the financial diversification here reduces uncertainty and helps to protect the company’s dividend – a dividend which is formidable.
Dividend Growth, Growth Rate, Payout Ratio and Yield
The stock yields a monstrous 6.35% right now.
To put that into context, it’s more than three times higher than the broader market’s yield.
This yield is also almost 300 basis points higher than the stock’s own five-year average yield, which is a remarkable spread.
But there’s not just yield to be found here. There’s also growth.
The company has increased its dividend for 12 consecutive years, with a five-year dividend growth rate of 13%.
And while the payout ratio currently exceeds 100% on a GAAP TTM EPS basis, that’s largely due to recent write-downs from renewed assumptions around interest rates, asset values, and expected returns.
The company has historically operated with a sub-50% payout ratio. I suspect future results will show a normalization soon, putting the payout ratio back on track.
Revenue and Earnings Growth
It’s precisely those future results that are of most importance, as future growth will determine what the business might currently be worth, as well as what kind of forward returns and income today’s investors could be looking at.
In order to build out a growth trajectory for the business, I’ll first show you what Prudential Financial has done over the last decade in terms of top-line and bottom-line growth.
I’ll then compare that against a near-term professional prognostication for profit growth.
Combining proven results with an informed appraisal should allow us to build out a forward-looking growth trajectory and estimate intrinsic value.
Prudential Financial increased its revenue from $38.414 billion in FY 2010 to $64.807 billion in FY 2019.
That’s a compound annual growth rate of 5.98%.
Very solid. I usually like to see mid-single-digit top-line growth from a mature business like this. They’re right on the mark.
However, not all of this growth was organic.
Prudential Financial has been mildly acquisitive over the last 10 years, with the most recent example being a $2.35 billion acquisition of Assurance IQ, a DTC insurance platform.
Looking at per-share profit growth should tell us a little more about the true growth profile.
Earnings per share advanced from $5.32 to $10.11 over this period, which is a CAGR of 7.39%.
Again, this is a solid result.
They’re not setting the world on fire with growth, but I think this is very respectable.
A modest 12% reduction in the outstanding share count over the last decade certainly helped to propel this excess bottom-line growth.
It doesn’t appear that their acquisitions have been markedly accretive, but I also don’t think there’s been value destruction here.
Looking forward, CFRA believes that Prudential Financial will compound its EPS at an annual rate of 4% over the next three years.
They cite low interest rates and downward pressure on asset management fees as key headwinds.
In particular, I see the lower-for-longer interest rates paradigm as a problem for Prudential Financial (and similar business models). There’s simply not much of a spread to take advantage of here when looking at life insurance and annuity products. And because of the long-tail risk I noted earlier, it’s difficult to ascertain just how much risk is being taken on.
On the other hand, CFRA notes price hikes, product revamps, expansion, and improved risk discipline as areas to be excited about.
Regarding expansion, even though this is a global firm, Prudential Financial generates most of their revenue from just two markets – the US and Japan.
Prudential Financial is expanding its presence in developing markets, which comes with advantages and disadvantages.
Overall, I think CFRA has a balanced view.
A 4% EPS growth forecast seems reasonable to me. And that would portend like dividend growth over the foreseeable future.
Moving over to the balance sheet, their financial position is strong.
The long-term debt/equity ratio is 0.31.
And credit ratings indicate excellence.
Long-term senior debt features the following ratings: A, Standard & Poors; A3, Moody’s; A-, Fitch.
Profitability appears to be robust.
Over the last five years, the firm has averaged annual net margin of 8.58% and annual return on equity of 10.80%.
There’s a lot to like about Prudential Financial as a long-term investment.
And the business is somewhat competitively protected by its scale across both insurance and asset management.
Their ability to spread risk out across a large firm is an advantage.
Of course, there are risks to consider.
Competition, litigation, and regulation are omnipresent risks in every industry.
Life insurance as a product is difficult when it comes to assessing risk. A company won’t know the cost of that product until many years later, when the claim finally comes in.
The asset management side of the business is under constant pressure to reduce fees.
Low interest rates appear to be here to stay for a long time. This hurts the company’s ability to earn profit from a spread. Both the insurance and asset management sides of the business are harmed by this, and the company is in danger of chasing return/income.
On the other hand, low interest rates makes the company’s stock more attractive on a relative basis.
Lastly, the company has substantial exposure to financial markets. Any major drop in these markets hurts the company via reduced returns and fees on managed assets.
Overall, I see this as a fine long-term investment at the right valuation.
With the stock now down almost 30% from its 52-week high, the valuation appears to be attractive…
Stock Price Valuation
The stock doesn’t have a P/E ratio right now.
That’s due to the aforementioned recent write-downs.
However, other metrics indicate undervaluation.
That includes the P/B ratio. At 0.4, it’s half of its five-year average of 0.8.
Also, the P/CF ratio, at 1.1, is materially lower than the stock’s three-year average P/CF ratio of 3.6.
And the yield, as noted earlier, is significantly higher than its own recent historical average.
So the stock does look cheap based on basic valuation metrics. 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 an 8% discount rate (to account for the high yield) and a long-term dividend growth rate of 3%.
This DGR is on the very low end of what I normally account for.
But I think Prudential Financial warrants this caution.
The near-term EPS growth forecast at 4% isn’t much higher than this. I also think there’s a lot of unknown risk around life insurance in general as a product. Low interest rates and demand for reduced fees in asset management also work against the firm.
A high yield and low valuation should compensate today’s investors for these risks.
The DDM analysis gives me a fair value of $90.64.
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.
This stock looks attractively priced, as it doesn’t have to do much to handsomely reward investors.
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 PRU as a 4-star stock, with a fair value estimate of $78.00.
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 PRU as a 4-star “BUY”, with a 12-month target price of $80.00.
I came out a little high this time, which is surprising. Averaging the three numbers out gives us a final valuation of $82.88, which would indicate the stock is possibly 20% undervalued.
Bottom line: Prudential Financial Inc. (PRU) is a quality firm that offers two appealing business models under one roof. With a market-smashing yield of over 6%, more than a decade straight of dividend increases, double-digit dividend growth, and the potential that shares are 20% undervalued, this looks like a unique high-income opportunity for dividend growth investors.
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 PRU’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, PRU’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.We’re Putting $2,000 / Month into These Stocks
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Source: Dividends and Income