The US stock market has largely shrugged the pandemic off.

With the S&P 500 actually up on the year, you’d hardly notice a health crisis at all.

That’s good news for those already heavily invested, but it’s disheartening for those still investing their savings and looking for good deals.

But fear not.

Jason Fieber's Dividend Growth PortfolioWhile the market is up, many individual stocks are down on the year and still present compelling long-term value.

Finding value in every market is important.

It’s something I’ve taken great care to do as I’ve built out my personal portfolio, which I call the FIRE Fund.

That real-money portfolio generates enough five-figure passive dividend income for me to live off of.

In fact, as I lay out in my Early Retirement Blueprint, I was able to retire in my early 30s and start living off of dividend income.

I put myself in that position by using dividend growth investing to my advantage.

This strategy advocates buying and holding shares in world-class businesses that pay reliable and rising cash dividends.

They’re able to do so because they’re regularly increasing their profit.

And they’re regularly increasing profit because they’re providing the products and/or services the world demands.

You can find hundreds of such stocks on the Dividend Champions, Contenders, and Challengers list.

But it’s not enough to buy the right stocks.

You also have to consider how much you’re paying.

Price is what you pay. But value is what 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 the right business, at the right valuation, can have a profound effect on your wealth over the long run.

Fortunately, getting this combination correct isn’t all that difficult.

The valuation part of the equation has been made much easier with Lesson 11: Valuation.

Provided by fellow contributor Dave Van Knapp, this is part of a comprehensive series of “lessons” on dividend growth investing that aims to teach the ins and outs of the strategy.

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…

Gilead Sciences, Inc. (GILD)

Gilead Sciences, Inc. (GILD) is a biopharmaceutical company that develops and markets therapies to treat a variety of life-threatening diseases.

Founded in 1987, Gilead is now a $75 billion (by market cap) global drug company that employs more than 11,000 people.

The company’s three primary disease areas are viral diseases, inflammatory diseases, and oncology.

Their HIV franchise accounted for approximately 74% of FY 2019 sales. Biktarvy, which treats HIV, is their most important drug, making up about 21% of total FY 2019 sales.

The investment thesis for any global drug company is quite simple.

In a world that’s growing older and larger, demand for quality pharmaceutical treatments is almost certain to rise.

Along with that, the world is growing wealthier. That means rising access to these treatments.

These demographic trends work to Gilead’s favor.

In turn, that bodes well for growing profit and dividends.

Dividend Growth, Growth Rate, Payout Ratio and Yield

Gilead has increased its dividend for six consecutive years.

The company’s a bit new to the dividend growth game, but they’ve been remarkably consistent.

Their three-year dividend growth rate is 11.1%.

I think it’s very much worth noting that Gilead increased its dividend by 8% right on schedule, back in March 2020.

That was right when the pandemic was taking hold in the United States. Gilead never skipped a beat.

This growth comes on top of a market-smashing yield of 4.47%.

That’s almost 160 basis points higher than the stock’s own five-year average yield.

And the dividend looks easily covered with a payout ratio of 43.9% of adjusted TTM EPS.

This is a safe, market-smashing dividend that comes with with double-digit dividend growth.

Definitely a lot to like about the dividend.

Revenue and Earnings Growth

However, these are backward-looking metrics.

Ultimately, investors are putting up today’s capital for tomorrow’s results.

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

I’ll 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 for profit growth.

Blending the proven past with a future forecast like this should give us some confidence in being able to tell where things might be going.

Gilead grew its revenue from $7.949 billion in FY 2010 to $22.449 billion in FY 2019.

That’s a compound annual growth rate of 12.23%.

Really impressive stuff here. I usually look for a mid-single-digit top-line growth rate from a mature business like this. Gilead did much better than that.

Earnings per share advanced from $1.66 to $4.22 over this period, which is a CAGR of 10.92%.

Some margin compression has occurred here. Buybacks offset some of that – the outstanding share count down by ~27% over the last 10 years.

Looking forward, CFRA is anticipating that Gilead will compound its EPS at an annual rate of 6% over the next three years.

The company’s HIV franchise, backed by Biktarvy, is the linchpin of the investment thesis.

Notably, as of the end of 2019, the company’s strong pipeline had 104 active clinical studies. 27 of these were Phase 3 clinical trials.

In addition, the recent $21 billion acquisition of Immunomedics could pay off handsomely, with key cancer drug Trodelvy receiving FDA approval in April 2020. This drug is expected to have $3.5 billion in sales by 2026.

However, the forecast for slowing growth is rationalized by incoming generic HIV competition and the continued shrinking of the HCV market.

Regarding the latter, Gilead has, in some ways, become a victim of its own success.

After developing a cure for hepatitis C, they basically eliminated one of their key markets. While certainly great for humanity, the stock’s valuation started collapsing five years ago as the realization of slowing sales from a big market came to pass.

The market priced out these big revenue numbers indefinitely, creating unreasonable expectations and a valuation that was too high.

Sales started to stabilize around FY 2018, but the stock’s valuation has not stabilized in the same manner. The valuation continued to fall.

And that’s where the opportunity lies. This valuation is about as low as I’ve ever seen it on this business.

Just as expectations and the valuation were too high back in 2015, it seems the opposite has occurred now.

It’s not my favorite pharmaceutical company in the whole world, but low expectations have punished this stock beyond what’s reasonable.

Even with an EPS growth rate near 6%, that allows for a like dividend growth rate. And with a ~4.5% yield, you can get to a double-digit total return pretty easily. Gilead simply doesn’t have to do much to make it worthy of investment dollars.

Financial Position

Moving over to the balance sheet, they have a rock-solid financial position.

The long-term debt/equity ratio is 0.98, while the interest coverage ratio is over 6.

These numbers are just okay on their own.

However, Gilead ended FY 2019 with over $24 billion in total cash on the balance sheet. That’s actually greater than long-term debt during the same period.

The recent Immunomedics acquisition impacts the balance sheet by way of a cash reduction and debt increase, but Gilead is exchanging balance sheet strength for cash flow.

Profitability is quite robust, although the margin compression is something that I’d like to see corrected.

Over the last five years, the firm has averaged annual net margin of 33.26% and annual return on equity of 50.59%.

Gilead became a victim of its own success over the last few years.

But I think the punishment has been overdone at this point, creating an opportunity to get into a highly profitable drug company with a rock-bottom valuation.

And with durable competitive advantages like scale, patents, inelastic demand for products, technological know-how, R&D, and entrenched relationships, the business is in a great competitive position.

Of course, there are risks to consider.

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

I view all three of these risks as being elevated in the pharmaceutical industry.

The slowing HCV market and incoming generics for HIV threaten Gilead’s sales base.

There’s integration risk with Immunomedics.

And there’s the risk that the pipeline doesn’t produce enough results to overcome slowing sales from older drugs.

Overall, I view Gilead as a quality business that’s been almost left for dead at this point.

With the stock down almost 30% from its 52-week high, it looks attractively valued…

Stock Price Valuation

The stock is trading hands for a P/E ratio of 9.82, based on TTM adjusted EPS.

That’s significantly lower than where the broader market is at.

It’s also materially lower than the stock’s own five-year average P/E ratio of 16.6.

Sales have also been discounted.

The P/S ratio of 3.3 is well off of its five-year average of 4.3.

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

I’m setting the bar very, very low here.

That DGR is less than half of what Gilead has averaged over the last three years. It’s much lower than the 10-year EPS growth rate. And it’s even lower than CFRA’s near-term EPS growth projection. With a modest payout ratio, they could easily eclipse this.

But I’d rather err on the side of caution with so many moving parts, especially with such a large and unproven acquisition just now playing out.

The DDM analysis gives me a fair value of $71.14.

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 after I set the bar so low, the stock still looks noticeably 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 GILD as a 4-star stock, with a fair value estimate of $75.00.

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 GILD as a 3-star “HOLD”, with a 12-month target price of $69.00.

I came out on the low end, but I think we’ve all put up conservative assumptions. Averaging the three numbers out gives us a final valuation of $71.71, which would indicate the stock is possibly 18% undervalued.

Bottom line: Gilead Sciences, Inc. (GILD) is a global drug company that earns billions of dollars and just took on an exciting new acquisition. Low expectations have created a rock-bottom valuation. With a 4.5% yield, double-digit dividend growth, a low payout ratio, and the potential that shares are 18% undervalued, this is a unique opportunity that dividend growth investors should take a close look at.

-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 GILD’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 70. 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, GILD’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.

This article first appeared on Dividends & Income

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