I know of no better store than the US stock market.
Its merchandise is the best you’ll find.
And unlike most other merchandise you possibly could think of, this merchandise can make you wealthy instead of poor.
But just as in any other store, some merchandise is better and cheaper than other merchandise.
This is a role I’ve taken to heart as an investor over the last decade.
I used it as a guiding light as I went about building my FIRE Fund.
That’s my real-money stock portfolio.
It produces enough five-figure passive dividend income for me to live off of.
Yet I’m nowhere near a traditional retirement age.
This portfolio and the passive income it produces actually allowed me to retire in my early 30s.
My Early Retirement Blueprint spells out how this occurred.
To be honest, I owe a lot of my success to the investment strategy I’ve used to get here.
It advocates buying and holding shares in world-class enterprises that pay reliable, rising cash dividends.
Dividend growth stocks are some of the highest-quality stocks in the market.
You can find hundreds of examples by perusing the Dividend Champions, Contenders, and Challengers list.
This list which contains invaluable information on US-listed stocks that have increased dividends each year for at least the past five consecutive years.
As great as this strategy is, though, you still have to approach this high-quality merchandise with an eye toward deals.
That means being mindful about what you’re getting for your money.
After all, price is only 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.
Repeatedly getting good deals on the best merchandise in the world can, and almost certainly will, lead to a tremendous amount of wealth and passive income over time.
The good news is, finding those deals isn’t that difficult.
Fellow contributor Dave Van Knapp made this endeavor much easier with his Lesson 11: Valuation, which is part of an overarching series of “lessons” on dividend growth investing.
It lays out a straightforward valuation template that you can apply 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…
Merck & Co., Inc. (MRK) is a leading global pharmaceutical company that produces a range of medicines, vaccines, and animal healthcare products.
Founded in 1891, Merck is now a $192 billion (by market cap) healthcare behemoth that employs more than 70,000 people across the world.
The company operates across two reportable segments: Pharmaceutical, 90% of FY 2020 sales; and Animal Health, 10%. Insignificant sales occur in unreported segments.
Their core areas of focus are: diabetes, infectious diseases, oncology, vaccines, and animal health.
The US is the company’s largest market, accounting for over 40% of worldwide sales.
Some of the company’s key drugs include Keytruda, Januvia, Gardasil, and ProQuad.
Keytruda, their wonder cancer drug, is the company’s most important product. It’s by far the top-selling drug in their portfolio.
This single drug made up almost 30% of the company’s worldwide sales for FY 2020. That compares to nearly 25% of company revenues for FY 2019.
So this drug is becoming a larger piece of a growing pie. The company’s biggest product is also one of its fastest-growing products. That’s a great position to be in.
Also, Keytruda isn’t only Merck’s best-selling drug. At almost $15 billion in sales for FY 2020, it’s one of the top drugs on the planet – second only to Humira. And it’s forecasted to be the best-selling drug in the world by the middle of this decade.
Based on its growth, that seems likely: Keytruda sales grew by an incredible 30% YOY for FY 2020.
This drug is on patent through 2028 in the US and EU.
Merck is an incredibly profitable business operating inside of an incredibly profitable industry.
And with the world’s demand for quality medicine sure to rise over time as the planet grows larger, older, and wealthier, Merck has tailwinds that are gusting its way.
That bodes well for the company’s ability to continue making more money and paying out larger dividends.
Dividend Growth, Growth Rate, Payout Ratio and Yield
They’ve already increased their dividend for 10 consecutive years.
The five-year dividend growth rate is 6.3%, which is something they’ve been pretty consistent with.
Indeed, the most recent dividend increase, announced in November, came in at 6.6%.
This growth comes attached to the stock’s current yield of 3.36%.
That yield, by the way, is nearly 50 basis points higher than the stock’s five-year average yield.
And the dividend remains protected by a payout ratio of 43.7%, using adjusted FY 2020 EPS.
This is a very appealing combination of yield and growth.
I consider the “sweet spot” for a dividend growth stock to be a yield of between 2.5% and 3.5%, backed by a mid-single-digit (or better) dividend growth rate.
This stock is right there.
Revenue and Earnings Growth
All that said, and as great as the dividend looks, these metrics are looking what was.
But investors are more concerned about what will be.
We’re risking today’s capital for tomorrow’s returns.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will later help us to estimate the stock’s intrinsic value.
I’ll first show you what the company has done over the last decade in terms of its 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 like this should give us a very good idea as to where the business is going.
Merck’s revenue is basically flat between FY 2011 and FY 2020, moving from $48.047 billion to $47.994 billion.
However, I think it’s more appropriate in this case to zoom in and look at more recent top-line growth. Keytruda came on the scene in 2015, and Merck’s revenue is up more than 20% since FY 2015.
Meanwhile, earnings per share increased from $2.02 to $5.94 over this 10-year period.
That’s a CAGR of 12.73%.
Notably, I used adjusted EPS for FY 2020. That’s due to the fact that FY 2020 GAAP EPS included acquisition costs and intangible asset impairments that aren’t reflective of the company’s actual earnings power.
Share buybacks definitely helped bottom-line growth; the outstanding share count is down by almost 18% over the last decade.
Looking forward, CFRA is forecasting that Merck will compound its EPS at an annual rate of 10% over the next three years.
I view this growth assumption as both reasonable and compelling.
Based on recent results, this is not a stretch for Merck. I don’t see this as a difficult hurdle for them to clear.
And while it would represent a drop compared to their 10-year EPS growth rate, it would still be a very good result that can support like dividend growth. The moderate payout ratio further supports this.
Merck’s pipeline is robust, with 38 programs in Phase 2 and 22 programs in Phase 3. The company has time to develop programs because of the multiyear runway for Keytruda.
I’ll point out that Merck is expecting non-GAAP EPS to come in between $6.48 and $6.68 for FY 2021, which would mark 10.8% YOY non-GAAP EPS growth at the midpoint. That’s right in line with where CFRA is at.
In addition, Merck previously announced they would spin off their women’s health, legacy brands, and biosimilars into a new company called Organon.
Expected to complete in the latter part of Q2 2021, this is exciting Merck shareholders. Spin-offs historically perform well. And it focuses the legacy business.
Merck’s most recent dividend increase, announced in November, came in at 6.6%. This was a solid dividend raise during a pandemic. The future looks even brighter.
Moving over to the balance sheet, the company maintains a great financial position.
The long-term debt/equity ratio is 1.0, while the interest coverage ratio is over 11.
The balance sheet is actually better than it looks. Shareholders’ equity has been artificially lowered by treasury stock, which is due to the aforementioned buybacks. In reality, they have a balance sheet that is more than satisfactory.
Profitability is impressive. And recent numbers have been exceptional. There’s been a pronounced margin expansion since FY 2016. Keytruda’s outstanding performance is largely responsible for this.
Over the last five years, the firm has averaged annual net margin of 13.96% and annual return on equity of 19.44%.
In many ways, Merck has arguably never been better than it is right now. It’s operating at a high level across the board.
And the business is protected by durable competitive advantages, including economies of scale, a global distribution network, patents, IP, and a very large R&D base.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
The business’s biggest opportunity might also be its biggest risk: Keytruda’s massive success is starting to become an overwhelming portion of the company’s sales. This linchpin drug could start to weigh on the business and stock in the future after patent protection comes off.
Any changes to the complex US healthcare system would likely affect Merck.
The company’s pipeline has pressure on it to produce successful drugs in order to support sales and rationalize R&D. There’s always pipeline risk with a pharmaceutical company.
Even with these risks, I believe Merck can be a fantastic long-term investment.
That’s particularly true with the stock well off of its pre-pandemic price of over $90 and the valuation being attractive…
Stock Price Valuation
The stock trades hands for a P/E ratio of 13.01, based on adjusted TTM EPS.
Adjusted EPS makes comparisons difficult, but I think this is representative of where the valuation is at.
We can also move past messy EPS and go straight to cash flow.
The P/CF ratio is 19.0, which is demonstrably lower than its own three-year average of 19.8.
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 7.5%.
This DGR might look slightly aggressive in comparison to the demonstrated five-year dividend growth rate.
However, I’m also looking at the moderate payout ratio, long-term EPS growth, and near-term EPS growth rate forecast.
Simply put, this company is, in many ways, better today than it’s ever been. With Keytruda going stratospheric, the company will have the capability to produce dividend raises that are higher than they were in the past.
I’m assuming a very small acceleration in dividend growth, which is not unreasonable when looking at the totality of the business.
The DDM analysis gives me a fair value of $111.80.
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 reveals a very cheap stock.
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 MRK as a 4-star stock, with a fair value estimate of $100.00.
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 MRK as a 4-star “BUY”, with a 12-month target price of $90.00.
We have a small range here. Averaging the three numbers out gives us a final valuation of $100.60, which would indicate the stock is possibly 30% undervalued.
Bottom line: Merck & Co., Inc. (MRK) is a high-quality company that has one of the best-selling and fastest-growing products in its industry. The fundamentals are great, and they’re only getting better. With a market-beating yield, strong dividend growth, a moderate payout ratio, 10 consecutive years of dividend raises, and the potential that shares are 30% undervalued, this might be one of the very best deals in the market 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 MRK’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 99. 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, MRK’s dividend appears Very Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
This article first appeared on Dividends & IncomeWe’re Putting $2,000 / Month into These Stocks
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