While speculative mania takes over areas of the stock market, it’s vital to keep something in mind.

Stocks aren’t just digital tickers to play hot potato with.

A share represents a slice of ownership in a real business.

As such, you have to approach stock ownership the same way you’d approach business ownership – because they’re one and the same.

Simply put, owning stock turns you into a business owner.

This is a great thing.

After all, US businesses have been amazing compounding machines over the long run.

Being a part of that system and benefiting from it can transform your life. I can say from personal experience that my life has been massively transformed from stock ownership.

I went from below broke at age 27 to financially free at 33.

Indeed, as I lay out in my Early Retirement Blueprint, I retired in my early 30s.

I now live off of the five-figure dividend income my FIRE Fund generates for me.

This real-money, six-figure stock portfolio was built over the course of about a decade.

It follows the tenets of dividend growth investing.

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

The Dividend Champions, Contenders, and Challengers list contains invaluable data on more than 700 US-listed stocks that have raised dividends each year for at least the last five consecutive years.

I love this strategy because it acts as a great filter.

Jason Fieber's Dividend Growth PortfolioAfter all, only high-quality businesses can pay out rising cash dividends year after year, for decades on end.

You can’t run a terrible operation while simultaneously writing ever-larger checks. The math doesn’t work for very long.

That said, it’s so important to invest in the right business at the right valuation.

The price of a stock only tells you what you pay. It’s value that 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.

Treating stock ownership like business ownership by investing in the right business at the right valuation can positively transform your life over the long run.

Fortunately, getting the valuation part of that equation correct isn’t as hard as it seems.

Fellow contributor Dave Van Knapp put together Lesson 11: Valuation in order to help simplify the valuation process.

Part of a series of “lessons” on dividend growth investing, it provides an easy-to-follow valuation template that can be applied to almost any dividend growth stock out there.

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…

International Flavors & Fragrances Inc. (IFF)

International Flavors & Fragrances Inc. (IFF) is a leading producer of flavors and fragrances that are used in food, beverages, household goods, and personal care products.

Founded in 1833, International Flavors & Fragrances is now a $32 billion (by market cap) global ingredient solutions leader that employs more than 13,000 people.

FY 2019 sales were broken down across three business segments: Scent, 37%; Taste, 34%; and Frutarom, 29%.

Investing in International Flavors & Fragrances is like investing in the entire world.

Why do I say that?

The company sold over 128,000 individual products to more than 38,000 global customers in FY 2019. They’re involved in the manufacturing process for everything from baked goods to lipstick. There’s almost no product out there that this company doesn’t touch in some way.

These aren’t just giant corporations we’re talking about, either. 65% of the company’s FY 2019 sales were to small- and medium-sized businesses.

Also, this is truly a global operation. During 2019, 80% of their combined net sales were to customers outside
the United States.

As long as people continue to consume, well, just about anything and everything, International Flavors & Fragrances should continue to prosper.

That bodes well for their ability to register higher profits and pay out bigger dividends over the long run.

Dividend Growth, Growth Rate, Payout Ratio and Yield

They’ve increased their dividend for 18 consecutive years.

The 10-year dividend growth rate is 11.5%.

This comes on top of the stock’s current yield of 2.43%.

That yield, by the way, is more than 20 basis points higher than the stock’s own five-year average yield.

I will note, however, that there’s been a deceleration in dividend growth.

The good news is, this has lowered the payout ratio.

The payout ratio is now at 56.0%, based on TTM adjusted EPS. That indicates a well-covered dividend.

These dividend metrics are really solid.

I view a yield of between 2.5% and 3.5%, paired with a high-single-digit dividend growth rate, to be the “sweet spot” for dividend growth investors. We’re basically there with this stock.

Revenue and Earnings Growth

As solid as these dividend metrics are, though, they’re looking backward.

Investors are putting up today’s capital in order to reap tomorrow’s rewards (including tomorrow’s dividends).

As such, I’ll now put together a model for the company’s forward-looking growth trajectory, which will later help us to estimate the stock’s intrinsic value.

I’ll show you first what the business has done in terms of top-line and bottom-line growth over the last decade.

Then I’ll compare those results against a near-term professional prognostication for profit growth.

Blending the proven past with a future forecast in this way should give us a good idea as to where the business might be going.

International Flavors & Fragrances has increased its revenue from $2.623 billion in FY 2010 to $5.140 billion in FY 2019.

That’s a compound annual growth rate of 7.76%.

Pretty impressive top-line growth here.

However, the company has been active in the M&A space. And this non-organic growth has had the effect of greatly increasing revenue.

The $7.1 billion acquisition of Israeli flavors and ingredients company Frutarom in 2018 is an example of that. FY 2019 revenue noticeably jumped over FY 2018 revenue.

More recently, the company closed on a merger with Dupont’s Nutrition & Biosciences Business (N&B) via a Reverse Morris Trust transaction that valued N&B at $26.2 billion. This move has catapulted International Flavors & Fragrances into a global ingredients juggernaut.

Earnings per share grew from $3.26 to $6.17 (adjusted) over this 10-year period, which is a CAGR of 7.35%.

I used adjusted EPS for FY 2019. GAAP EPS numbers of late have been volatile and skewed. This is mostly due to acquisition-related fluctuations (like integration costs).

We can see that bottom-line growth matches up pretty well to top-line growth, indicating that the company hasn’t been making poor choices with its strategy.

Looking forward, CFRA believes that International Flavors & Fragrances will compound its EPS at an annual rate of 8% over the next three years.

This would be a modest acceleration in EPS growth relative to what the company has registered over the last decade.

CFRA has this to say about the company’s near-term prospects: “About 85% of IFF’s sales are recession-resilient, which bodes well during the Covid-19 pandemic.”

CFRA also gives high marks regarding the Frutarom acquisition, noting that this move makes strategic sense and provides International Flavors & Fragrances with exposure to adjacent markets with faster growth than legacy markets.

Building on that in a big way is the merger with Dupont’s F&B business, which only serves to increase the scale of the combined enterprise. This move is also expected to unlock additional value through synergies – ~$300 billion in cost synergies and revenue synergies of ~$400 billion by the end of year three post-close.

The market obviously likes this move – IFF popped 18% on February 1, as soon as the deal closed. (That pop, by the way, is unfortunate. It occurred right as I was in the middle of doing the research and putting this analysis together. The increase in price reduces the level of undervaluation.)

A possible long-term growth catalyst is the geographic sales mix. This company is less tied to the mature US market than what you’d ordinarily see from a global business.

I believe CFRA’s call here is appropriate. It’s not much higher than the 10-year EPS growth rate.

This should translate into high-single-digit dividend growth. When attached to the stock’s current yield, there’s a lot to like about that.

Financial Position

Moving over to the balance sheet, the debt load has grown as a result of the aforementioned M&A activity.

They’ve exchanged balance sheet strength for absolute growth. This comes with pros and cons.

I see the balance sheet as still good, but it’s certainly not as strong as it used to be.

The long-term debt/equity ratio is 0.64, while the interest coverage ratio is just over 5.

This is as of the end of FY 2019.

I suspect the latter number will look better after the company moves past its busy M&A activity and results smooth out; however, the balance sheet will transform over the next 12 months as the Dupont F&B merger is fully realized.

Profitability is robust. And I suspect it can, and likely will, improve in the future.

Over the last five years, the firm has averaged annual net margin of 10.17% and annual return on equity of 16.28%.

This isn’t a sexy tech stock. It’s decidedly boring.

But boring is beautiful. Successful long-term investing is a lot like watching paint dry.

This business is a key part of the manufacturing process for almost any kind of consumer product you could think of. It’s the kind of stock that can just quietly compound your wealth for you over many years.

And with global scale, proprietary formulas, R&D, and switching costs, the company does have durable competitive advantages.

Of course, there are risks to consider.

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

Substantial international sales means currency exchange risk.

The company’s flurry of M&A activity introduces execution and integration risk.

The weakened balance sheet is a concern.

And input costs, like raw materials, can oscillate.

With these risks in view, I still believe this business should make for a fine long-term investment.

That’s especially the case with an undemanding valuation…

Stock Price Valuation

The stock is trading hands for a P/E ratio of 23.09.

That’s based on adjusted TTM EPS.

If you think that’s high, the five-year average P/E ratio for the stock is 31.9.

Let’s also consider that the P/CF ratio of 19.9 is well off of its three-year average of 24.6.

And the yield, as noted earlier, is measurably higher than its own recent historical average.

I valued shares using a dividend discount model analysis.

I factored in a 10% discount rate and a long-term dividend growth rate of 7.5%.

My modeled DGR is lower than the 10-year demonstrated dividend growth rate. It’s also lower than CFRA’s near-term EPS growth projection. And it’s not far off from the 10-year EPS growth rate.

I don’t think this is an unreasonable long-term expectation from the business, especially if the F&B merger is even mildly accretive.

With a modest payout ratio and high-single-digit EPS growth, the dividend should grow at a high-single-digit pace.

The DDM analysis gives me a fair value of $132.44.

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.

My valuation wasn’t overly aggressive, yet the stock still looks like it’s priced below intrinsic value.

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 IFF as a 4-star stock, with a fair value estimate of $130.00.

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 IFF as a 4-star “BUY”, with a 12-month target price of $133.00.

A very tight consensus. Averaging the three numbers out gives us a final valuation of $131.81, which would indicate the stock is possibly 4% undervalued.

Bottom line: International Flavors & Fragrances Inc. (IFF) is a high-quality company that allows shareholders to participate in the upside of nearly all global product consumption. The stock had a massive pop right as I was putting this analysis together, which is rather unfortunate and untimely. But I still think it can be a great long-term investment. With a market-beating yield, double-digit dividend growth, a modest payout ratio, almost 20 straight years of dividend raises, and the potential that shares are 4% undervalued, this is a stock that should be seriously considered on any kind of pullback.

-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 IFF’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 62. 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, IFF’s dividend appears Borderline Safe with a moderate risk of being cut. Learn more about Dividend Safety Scores here.

This article first appeared on Dividends & Income

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