2021 is finally here.

I’m certainly wishing for a much better year than 2020 was.

And I’m sure you are, too.

Well, I know of one way to get the new year started off on the right foot.

That’s by investing in a wonderful business at a wonderful valuation.

We can’t control everything that goes on around us.

But we can control what we do with our money.

Systematically putting hard-earned capital to work with great businesses can positively and radically change your life.

I’d know.

By doing just that, I went from below broke at age 27 to financially free at 33.

I share exactly how I did so in my Early Retirement Blueprint.

A big part of my success comes down to a specific investment strategy.

It’s dividend growth investing.

This strategy advocates investing in high-quality businesses that pay reliable, rising cash dividends to shareholders.

I built my real-money FIRE Fund using the tenets of this strategy.

That portfolio now produces enough five-figure passive dividend income for me to live off of.

And that income is growing all by itself.

More than 700 US-listed stocks that have raised dividends each year for at least the last five consecutive years can be found on the Dividend Champions, Contenders, and Challengers list.

Jason Fieber's Dividend Growth PortfolioThis strategy takes a lot of the guesswork out of finding wonderful businesses.

After all, you can’t run a low-quality business that loses money year in and year out and simultaneously send out ever-larger cash payments to shareholders.

But it’s not just a matter of finding wonderful businesses.

A wonderful valuation is also extremely important.

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.

Investing in a wonderful business at a wonderful valuation can, and almost surely will, positively change your life.

Fortunately, the wonderful valuation part of the equation isn’t that difficult to pin down.

Fellow contributor Dave Van Knapp has made intrinsic value estimation much easier via Lesson 11: Valuation.

Part of a comprehensive series of “lessons” on dividend growth investing, it provides a valuation template that can be applied to just about any dividend growth stock you’ll find.

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…

Northrop Grumman Corporation (NOC)

Northrop Grumman Corporation (NOC) is a large defense contractor that manufactures and provides a range of sovereign defense products and services.

Founded in 1939, Northrop Grumman is now a $50 billion (by market cap) global defense juggernaut that employs 90,000 people.

Fiscal year 2019 revenue breaks down across the following segments: Aeronautics Systems, 32%; Mission Systems, 26%; Space Systems, 22%; and Defense Systems, 20%.

Approximately 83% of sales are to the US government, mostly via the DoD.

While they have large conventional military programs, like the B-2 Spirit, a lot of Northrop Grumman’s work is based around unmanned combat, like radar, drones, and strategic deterrent systems. The company is also making strides in space, with the $9.2 billion acquisition of Orbital ATK in 2018 greatly boosting their space capabilities.

High-quality defense contractors like Northrop Grumman can make for excellent long-term investments.

These companies produce high-tech, long-cycle, expensive, classified products and services that are absolutely vital to sovereign security. Business is about as guaranteed as it gets.

Plus, this industry operates as an oligopoly, which limits competition and promotes rational pricing. And due to unique dynamics, it’s extremely difficult for new entrants to spring up.

That bodes well for increasing profit and dividends over the long run.

Dividend Growth, Growth Rate, Payout Ratio and Yield

Northrop Grumman has already increased its dividend for 17 consecutive years.

The 10-year dividend growth rate of 12.9% is really strong when you pair that with the stock’s current yield of 1.92%.

This yield, by the way, beats the market and is more than 30 basis points higher than the stock’s own five-year average yield.

The payout ratio is only 39.5%, which easily covers the dividend.

We have a lower-yielding, faster-growing dividend here. That’s perfect for younger investors who have time to let the dividend blossom into a real monster.

Revenue and Earnings Growth

These dividend metrics are great.

However, they’re backward-looking by nature.

It’s ultimately tomorrow’s dividends and returns that matter most. Investors risk today’s capital for tomorrow’s rewards.

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

This trajectory 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 for profit growth.

Combining the proven past with a future forecast in this manner should allow us to chart out a reasonable course for the business moving forward.

Northrop Grumman’s revenue decreased from $34.757 billion in FY 2010 to $33.841 billion in FY 2019.

A slight decrease in revenue over a 10-year time frame is not what I typically like to see.

However, this decrease is mostly owed to Northrop Grumman’s spin-off of Huntington Ingalls Industries Inc. (HII) in 2011. This move substantially reduced Northrop Grumman’s revenue base at the time.

Meantime, the company’s bottom line has grown very nicely over the last decade.

Earnings per share moved up from $6.82 to $13.22 over this period, which is a CAGR of 7.63%.

Material buybacks have definitely helped. The outstanding share count is down by almost 44% over this 10-year period.

Looking forward, CFRA is projecting that Northrop Grumman will compound its EPS at an annual rate of 10% over the next three years.

CFRA is anticipating a nice acceleration in growth.

They cite improving margins, their alignment with the DoD’s high priority around space-based assets, higher product volumes, valuable exposure to the F-35 program, and a record backlog of over $81 billion (up 25% YOY in Q3 FY 2020).

It’s heartening to see this kind of forecast.

But even if the company falls slightly short, the low payout ratio gives them the ability to continue growing the dividend at a double-digit rate for the foreseeable future.

There is powerful long-term dividend growth potential here.

Financial Position

Moving over to the balance sheet, the company maintains a good financial position.

I think this is one area of the business that could stand improvement. That said, it’s not bad.

The long-term debt/equity ratio is 1.45, while the interest coverage ratio is just over 6.

Profitability, meanwhile, is quite robust.

Over the last five years, the firm has averaged annual net margin of 8.63% and annual return on equity of 34.06%.

These numbers are comparable to the industry’s best.

This is a great business.

And they’re protected by durable competitive advantages, including classified knowledge, huge scale, barriers to entry, long-term contracts, technological know-how, and high switching costs.

Of course, there are risks to consider.

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

The industry oligopoly limits competition. However, direct government oversight increases regulation.

Geopolitical risks are present for any defense contractor.

US President-elect Joe Biden is a Democrat. A Democratic administration may put pressure on US defense spending.

The company has a lot of space exposure. While this is exciting, it’s also a new frontier that has not yet proven itself to provide durable demand for defense products and services.

Even with these risks, I still believe an investment in Northrop Grumman will do very well over the long term.

And I think the current valuation of the stock sets it up especially well…

Stock Price Valuation

The stock is available for a P/E ratio of 20.69.

That looks slightly high at first glance, but it’s being elevated by a hit to Q4 FY 2019 GAAP EPS from a pension adjustment.

Factoring that out, the P/E ratio is well below both the broader market and the stock’s own five-year average P/E ratio.

Consider that the P/CF ratio is only 9.8, which is much lower than the stock’s own three-year average P/CF ratio of 17.6.

And the yield, as noted earlier, is notably 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 8%.

This DGR is on the higher end of what I allow for, but I think this business deserves the benefit of the doubt.

Keep in mind, the company has exceeded this 8% rate with its long-term dividend growth. The 10-year EPS growth rate is almost at this level. And CFRA’s near-term EPS growth rate projection is well in excess of this mark.

With the company’s positioning in both traditional military programs and new-age, tech-heavy areas, the growth engine is showing no signs of slowing.

The DDM analysis gives me a fair value of $313.20

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.

The stock looks at least modestly undervalued from where I’m sitting.

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 NOC as a 4-star stock, with a fair value estimate of $338.00.

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 NOC as a 5-star “STRONG BUY”, with a 12-month target price of $450.00.

I came out low this time around. Averaging the three numbers out gives us a final valuation of $367.07, which would indicate the stock is possibly 21% undervalued.

Bottom line: Northrop Grumman Corporation (NOC) is a high-quality defense contractor that is positioned well for both current and future sovereign defense needs. With a market-beating dividend, almost 20 consecutive years of dividend raises, double-digit long-term dividend growth, a very low payout ratio, and the potential that shares are 21% undervalued, this looks like a great long-term opportunity 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 NOC’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 80. 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, NOC’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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