“Don’t look a gift horse in the mouth”.

It’s an old phrase that I think can often apply to investing.

When you find a quality stock that’s cheap, you might immediately try to find fault with the situation.

But it might make more sense to research the investment without that preconceived negative bias.

And if it really is a gift from the stock market gods, receive it with open arms.

I’ve seen quality stocks go on sale over and over again.

Instead of finding fault, I often found gifts.

And then I bought those stocks.

I’m better off for it, as this attitude helped me to retire in my early 30s.

I lay out in my Early Retirement Blueprint exactly how that happened.

I now live off of five-figure passive dividend income.

My real-money stock portfolio, which I call the FIRE Fund, produces that dividend income on my behalf.

This portfolio was built on the tenets of the dividend growth investing strategy.

Jason Fieber's Dividend Growth PortfolioThis strategy advocates buying and holding shares in world-class enterprises that pay reliable, rising cash dividends to their shareholders.

You can find many, many examples of these stocks by perusing the Dividend Champions, Contenders, and Challengers list.

It’s a fantastic strategy for all investors.

But it’s especially great if you’re interested in becoming financially independent and retiring early.

That’s because safe, growing dividends make for a tremendous source of completely passive income.

But one cannot go about buying any dividend growth stock at any time.

You have to find those gifts.

Specifically, you’re looking for undervaluation.

While price is 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.

An undervalued high-quality dividend growth stock is a gift from the stock market gods.

Fortunately, these gifts are easier to find than you might think.

Fellow contributor Dave Van Knapp put together Lesson 11: Valuation for this purpose.

Part of an overarching series of “lessons” on dividend growth investing, it spells out a simple process that you can use to value most dividend growth stocks.

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…

General Dynamics Corporation (GD)

General Dynamics Corporation (GD) is a global aerospace and defense company.

Founded in 1899, General Dynamics is now a ~$51 billion (by market cap) company that employs over 100,000 people globally.

Some of their major platforms include the Stryker combat vehicle, Abrams tank, the Virginia-class nuclear-powered submarine, and Gulfstream business jet. In addition, they offer a suite of IT services.

FY 2020 sales are broken up across the following business segments: Technologies, 34%; Marine Systems, 26%; Aerospace, 21%; and Combat Systems, 19%.

The US government is responsible for approximately 68% of the company’s revenue.

Investing in a defense business doesn’t require taking a big leap of faith.

One must simply believe that sovereign entities will want to continue protecting their interests.

Unfortunately, part of the human condition is human conflict. This is reality.

And companies that provide the very best defense capabilities will continue to thrive because of our reality. An industry oligopoly only serves to strengthen that thesis.

The company’s unique set of businesses also set them up incredibly well.

While they do manufacture traditional warfare machines like tanks, the company is actually more exposed to the IT side of defense. Their $9.6 billion acquisition of CSRA in 2018 turned it into a major provider of IT services to the US government.

The company’s Technologies business segment, their largest, provides data, cloud, and virtualization services.

Conflict is increasingly becoming digital. That positions the company perfectly.

In addition, the company has a rather significant amount of aerospace exposure via their Gulfstream business. As this entire sector rebounds from the pandemic, General Dynamics should see this area of the company accelerate growth off of a low base.

All of this bodes incredibly well for the company’s future profit growth and dividend growth.

Dividend Growth, Growth Rate, Payout Ratio and Yield

Speaking of that dividend growth, this company has increased its dividend for 30 consecutive years.

Their last dividend increase, announced only weeks ago, was over 8% – during a very difficult period for aerospace. Talk about reliable.

This increase isn’t that far off from the stock’s 10-year dividend growth rate of 10.2%.

Considering that the stock yields 2.72%, this is a very nice combination of yield and growth.

This yield, by the way, is more than 50 basis points higher than the stock’s own five-year average yield.

This attractive, growing dividend is also safe.

The payout ratio is only 43.3%.

I view the “sweet spot” for a dividend growth stock to be a yield of between 2.5% and 3.5%, paired with a mid-single-digit (or better) dividend growth rate.

This stock is squarely in that zone.

Revenue and Earnings Growth

As great as these dividend metrics are, though, they’re looking into the rearview mirror.

Investors are ultimately risking today’s capital for tomorrow’s rewards.

It’s future growth and dividends we care most about.

As such, I’ll now built out a forward-looking growth trajectory for the company, which will later help to estimate intrinsic value.

I’ll first show you what the business 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 in this manner should give us a growth model to work with.

General Dynamics grew its revenue from $32.677 billion in FY 2011 to $37.925 billion in FY 2020.

That’s a compound annual growth rate of 1.67%.

Meantime, earnings per share increased from $6.87 to $11.00 over this period, which is a CAGR of 5.37%.

Excess bottom-line growth was greatly aided by share buybacks – the outstanding share count is down by approximately 22% over the last decade.

On the face of it, this is middling growth.

However, this 10-year window is sandwiched by the US fiscal cliff on one end and a global pandemic on the other.

In my opinion, this gives us a distorted and disingenuous picture of the company’s earnings power.

Looking forward, CFRA is predicting that General Dynamics will compound its EPS at an annual rate of 11% over the next three years.

While perhaps slightly aggressive, I do see that as a better approximation of the company’s true earnings power.

CFRA believes there will be a strong rebound in the Aerospace segment. They see Aerospace revenue returning to pre-pandemic levels by Q4 2021.

In addition to that full Aerospace recovery, there’s the record-high backlog of $89.5 billion the company is enjoying and working through. This backlog grew 9.8% for Q4 2020.

Simply put, there’s no shortage of opportunities for General Dynamics.

Investors don’t need to perform complex calculus here to see that the company is going to be making a lot of money for many years to come.

When factoring in the low payout ratio on top of the economic rebound, the dividend should easily be able to grow at a high-single-digit rate for the foreseeable future. It wouldn’t surprise me to see future dividend raises back in the double-digit range.

Financial Position

Moving over to the balance sheet, General Dynamics maintains a very solid financial position.

The long-term debt/equity ratio is 0.64, while the interest coverage ratio is over 8.

I view the interest coverage ratio as artificially low, due to EBIT that has been temporarily compressed by the pandemic.

The company’s balance sheet is deceptively strong, and their overall financial position will almost certainly be improving sharply in coming quarters.

Profitability is robust.

Over the last five years, the firm has averaged annual net margin of 9.16% and annual return on equity of 26.42%.

There is a lot to like about General Dynamics. You have a record-high backlog and what should be an intense recovery in Aerospace. Plus, there’s the heavy IT exposure.

And the company is protected by durable competitive advantages that include economies of scale, an industry oligopoly, lengthy contracts, established geopolitical relationships, technological know-how, switching costs, and barriers to entry.

Of course, there are risks to consider.

Regulation, litigation, and competition are omnipresent risks in every industry.

The industry’s oligopoly limits competition. However, close government relationships heighten regulatory oversight.

The company is acutely sensitive to any changes in the US DoD budget.

All defense companies face geopolitical risk.

Any unforeseen setbacks regarding the pandemic will likely negatively affect the company’s Aerospace business.

The Aerospace business is cyclical. Any downturn in the economy would reduce demand for business jets.

The CSRA acquisition is still unproven over the long term, and the company will have to continue to acquire large IT contracts in order to eventually fully rationalize that acquisition.

Overall, I view this as a wonderful business.

And with the valuation currently being so attractive, it’s a compelling long-term investment idea right now…

Stock Price Valuation

The stock’s P/E ratio is 15.90.

That compares extremely favorably to the broader market, and it’s also well below the stock’s own five-year average P/E ratio of 16.8.

I think this comparison is better than it looks, due to the fact that the pandemic has hit the company’s TTM EPS.

There’s also cash flow to look at.

The P/CF ratio of 13.1 is way off of its three-year average of 17.2.

And the yield, as noted earlier, is significantly 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 is not an overly enthusiastic DGR when compared to the stock’s 10-year DGR. It’s also below the most recent dividend increase, which came in during a pandemic.

With a low payout ratio and a EPS forecast in the low-double-digit range, I think General Dynamics can easily clear this hurdle.

The DDM analysis gives me a fair value of $204.68.

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 a pretty conservative valuation model, 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 GD as a 4-star stock, with a fair value estimate of $182.00.

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 GD as a 5-star “STRONG BUY”, with a 12-month target price of $203.00.

I came within pennies of where CFRA is at. Averaging the three numbers out gives us a final valuation of $196.56, which would indicate the stock is possibly 12% undervalued.

Bottom line: General Dynamics Corporation (GD) is a fantastic business operating within an industry that benefits from an oligopoly. Their record-high backlog, unique industry position, and post-pandemic recovery sets them up for plenty of growth moving forward. With a market-beating dividend, a low payout ratio, double-digit long-term dividend growth, 30 consecutive years of dividend raises, and the potential that shares are 12% undervalued, dividend growth investors are advised to take a close look at this stock right now.

-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 GD’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 97. 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, GD’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 & Income

We’re Putting $2,000 / Month into These Stocks
The goal? To build a reliable, growing income stream by making regular investments in high-quality dividend-paying companies. Click here to access our Income Builder Portfolio and see what we’re buying this month.