As 2021 starts to roll on, investors must be careful with their capital.

The S&P 500 is near all-time highs, yet there are still so many concerns.

Chief among them is the uncertain timeline for the eventual opening of the US economy.

The market’s priced as if everything is back to normal already.

Fortunately, there are still many individual stocks out there still sitting in value territory.

Even in an expensive store, there is almost always cheap merchandise that can be found.

Finding cheap, quality stocks is something I’ve always prided myself on. And that helped me to retire in my early 30s.

As I lay out in my Early Retirement Blueprint, I live off of passive income at a young age.

Actually, it’s a bit better than I’m letting on.

I live off of growing passive income.

My real-money stock portfolio, which I call the FIRE Fund, produces five-figure dividend income.

And this income is growing all by itself.

That’s because I invest in high-quality dividend growth stocks like those you can find on the Dividend Champions, Contenders, and Challengers list.

Jason Fieber's Dividend Growth PortfolioThese stocks pay out reliable, rising cash dividends to their shareholders.

They’re able to do so because the underlying businesses are generating reliable, rising profits.

As such, they tend to make for excellent long-term investments.

However, it’s always important to pay attention to valuation.

Price only tells you what you pay. Value is what you get for your money.

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.

Looking for cheap “merchandise” in an expensive stock market “store” is a worthwhile endeavor that could lead to outsized long-term investment performance.

That endeavor has been made even easier by fellow contributor Dave Van Knapp, via his Lesson 11: Valuation.

Part of a larger series of “lessons” on dividend growth investing, it provides a valuation template that can be widely applied.

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…

Bristol-Myers Squibb Co. (BMY)

Bristol-Myers Squibb Co. (BMY) is a global biopharmaceutical company that is engaged in discovering, developing, and delivering a range of medicines to help people overcome serious diseases.

Founded in 1887, Bristol-Myers Squibb is now a $140 billion (by market cap) healthcare giant that employs 30,000 people.

Bristol-Myers Squibb focuses on oncology, cardiovascular, and immunology treatments.

FY 2019 revenue was centered on two primary drugs that together accounted for almost 60% of sales: Opdivo and Eliquis. Eliquis is jointly developed and commercialized with Pfizer Inc. (PFE).

59% of FY 2019 revenue came from US sales. Non-US accounted for the remaining 41%.

The investment thesis for a global pharmaceutical company is very simple.

With a global population growing larger, older, and richer, demand for and access to top-flight therapeutics is sure to rise. I don’t see a future world in which there is less demand for these drugs.

One knock against Bristol-Myers Squibb has been its drug concentration. It has historically lacked the kind of portfolio diversification that some competitors have enjoyed.

However, the company made a big change in this department by acquiring Celgene Corporation for $74 billion in late 2019.

This greatly expanded and diversified its drug portfolio, and it added blockbuster cancer drug Revlimid to the mix.

This one drug did almost $11 billion in sales last fiscal year, which makes it one of the top-selling drugs in the whole world. It’s the crown jewel for the combined business.

The bigger, and arguably better, Bristol-Myers Squibb now has even greater scale, which is a powerful asset in the biopharmaceutical space.

That bodes well for the company’s ability to continue growing its profit and paying out a larger dividend to shareholders.

Dividend Growth, Growth Rate, Payout Ratio and Yield

Already, Bristol-Myers Squibb has increased its dividend for 12 consecutive years.

The 10-year dividend growth rate is only 3.5%, which is slightly disappointing.

Honestly, the low dividend growth rate has kept me from covering the stock in the past.

That’s especially so with this not being a high-yielding stock.

The stock yields 3.18% right now.

To be fair, that beats the market. And it’s almost 40 basis points higher than the stock’s own five-year average yield.

But with a low-single-digit dividend growth rate, I’d need a much higher yield to make sense of the numbers.

Well, there’s been a recent acceleration in the dividend growth rate, with the most recent dividend increase coming in at almost 9%.

And I think the new business will be able to sustain something closer to this level going forward.

The payout ratio, using the midpoint of the most recent non-GAAP EPS guidance for FY 2020, is only 31.1%.

That makes it an incredibly safe dividend, and that makes sense when you consider the ~9% dividend bump that came in only a month ago.

Revenue and Earnings Growth

Now, that’s all looking at what was.

But it’s what will be that today’s investors care about.

We invest for tomorrow’s rewards, not yesterday’s results.

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

I’ll first show you 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 together with a future forecast in this manner should allow us to extrapolate out a growth path with a reasonable degree of accuracy.

Bristol-Myers Squibb has increased its revenue from $19.484 billion in FY 2010 to $26.145 billion in FY 2019.

That’s a compound annual growth rate of 3.32%.

Meanwhile, earnings per share moved from $1.79 to $4.69 (adjusted) over this same time period, which is a CAGR of 11.30%.

I used adjusted EPS for FY 2019. The company took a number of unusual charges in the fiscal year that artificially skewed results.

This is very good top-line and bottom-line growth, in my view.

Looking forward, CFRA believes that Bristol-Myers Squibb will compound its EPS at an annual rate of 10% over the next three years.

This would basically be a continuation of the status quo.

They cite the Celgene acquisition as giving the combined business a healthy pipeline and a portfolio of developed drugs with promising long-term growth potential. Regarding the pipeline, the company has over 50 compounds in development as of November 2020.

The acquisition broadened and scaled the business, catapulting them into a true biopharmaceutical powerhouse.

However, this acquisition did come at great cost. The additional debt load and increased ongoing costs (via SG&A) are not insignificant concerns. These headwinds will likely weigh on the business, limiting growth to a degree.

It’s also worth noting here that patents on Revlimid begin expiring in 2022, with unrestricted competition slated to begin in 2026.

I think CFRA’s near-term EPS growth projection is fair.

And that would portend similar dividend growth, which speaks to the acceleration I noted earlier. A dividend growth rate at, or near, the double-digit mark is awfully nice when you’re pairing with a 3%+ starting yield.

Financial Position

Moving over to the balance sheet, the company has a solid financial position.

However, this position has markedly deteriorated after the Celgene acquisition, due to debt funding much of the transaction.

Bristol-Myers Squibb has long had a fortress balance sheet. But they definitely leveraged the balance sheet to scale the business.

Long-term debt, for example, went up more than sevenfold between FY 2018 and FY 2019.

The long-term debt/equity ratio is 0.84, while the interest coverage ratio is under 4.

That latter number is concerning; however, the Celgene acquisition completed in late 2019, prompting a state of flux for the balance sheet. I think the interest coverage ratio will rise as things smooth out and normalize.

Profitability is robust.

Over the last five years, the firm has averaged annual net margin of 13.45% and annual return on equity of 18.86%.

These numbers are great. But I believe they can, and will, get better.

There really is a lot to like about Bristol-Myers Squibb.

I haven’t covered it before because of modest dividend growth. But this could be a dividend growth monster that’s just now awakening.

And with global scale, R&D, IP, and patents, there are competitive advantages in place to protect the business.

Of course, there are risks to consider.

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

There exist near-term concerns over patent protection around Revlimid.

The weakening of the balance sheet must be rationalized by a lot of growth from the acquisition, which has yet to be proven out.

Any major changes to healthcare in the US, particularly as it relates to drug pricing, would impact this business.

And while the drug portfolio has broadened out, Bristol-Myers Squibb remains concentrated around only a small handful of highly successful drugs.

With these risks spelled out, I still think this stock could make for a fantastic long-term investment.

I think that’s particularly true with the valuation being attractive right now…

Stock Price Valuation

The stock is trading hands for a P/E ratio of 9.79, based on the guidance midpoint for FY 2020 non-GAAP EPS.

I’m using that guidance because of unusual charges that have caused massive recent fluctuations to GAAP EPS.

If that’s anywhere near an accurate look at the valuation, the stock is extremely cheap.

But we can also look at cash flow and move past the adjustments.

The current P/CF ratio of 11.0 is well below its three-year average of 14.1.

And the yield, as noted earlier, is materially 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 10% discount rate and a long-term dividend growth rate of 7%.

This is a slightly lower DGR than I’ve assigned to some of the other biopharmaceutical stocks I cover.

Comparing this to the company’s long-term EPS growth rate, the recent dividend raise, and CFRA’s near-term EPS growth projection, it’s downright conservative.

I think this conservative stance is warranted.

While the Celgene acquisition is exciting, it is unproven, encumbered the balance sheet, and exposes Bristol-Myers Squibb to near-term patent issues.

The company could certainly outpace my mark, but I’d rather err on the side of caution.

The DDM analysis gives me a fair value of $69.91.

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 what I think is a conservative valuation analysis, 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 BMY as a 3-star stock, with a fair value estimate of $68.00.

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 BMY as a 4-star “BUY”, with a 12-month target price of $75.00.

I came out very close to where Morningstar is at. Averaging the three numbers out gives us a final valuation of $70.97, which would indicate the stock is possibly 15% undervalued.

Bottom line: Bristol-Myers Squibb Co. (BMY) is a global biopharmaceutical company that just took on an exciting acquisition which could propel future growth on the back of one of the world’s best-selling products. With a market-beating yield, accelerating dividend growth, a low payout ratio, more than a decade of consistent dividend increases, and the potential that shares are 15% undervalued, dividend growth investors should consider this stock before it races higher.

-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 BMY’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 79. 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, BMY’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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