In this yield-starved world, stocks that offer yield are often priced for perfection.
That can make it difficult to put new capital to work and still get investment income.
Especially if you want some quality and growth to go with it.
But not all is lost.
There are still some high-quality stocks out there that are lowly valued and offer a high yield.
As a dividend growth investor, I’m always on the hunt for such stocks.
And when I find them, I tend to buy them and then hold on for the long term.
I’ve done that repeatedly as I went about building my FIRE Fund.
That’s my real-money stock portfolio, which produces the five-figure passive dividend income I live off of.
In fact, this portfolio helped me to retire in my early 30s.
I lay out in my Early Retirement Blueprint precisely how I used the dividend growth investing strategy to accomplish that feat.
This strategy is fantastic for so many reasons, and it’s perfectly suited for anyone aiming to accumulate the wealth and passive income necessary to achieve financial independence.
What better businesses to invest in than wonderful businesses?
What better way to prove how wonderful your business is than to pay reliable, rising dividends to your shareholders?
And what better source of passive income than those reliable, rising dividends?
The Dividend Champions, Contenders, and Challengers list contains invaluable data on more than 700 US-listed stocks that have increased their dividends each year for at least the last five consecutive years.
As great as many of those stocks are, though, buying the right stock at the right valuation is imperative.
Price tells you only what you pay. Value tells you what you actually 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.
While there are thousands of stocks you could buy at any given time, choosing to buy a high-quality dividend growth stock when it’s undervalued could result in exceptional long-term investment results.
Fortunately, discerning value isn’t that difficult.
Fellow contributor Dave Van Knapp has made that easier than ever, via introduction of Lesson 11: Valuation.
Part of a larger and more comprehensive series of “lessons” on dividend growth investing, it provides an easy-to-follow valuation process 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…
Philip Morris International Inc. (PM)
Philip Morris International Inc. (PM) is the world’s largest publicly traded tobacco company, engaged in the manufacture and marketing of tobacco and related products.
Originally founded in 1847, Philip Morris International is now a $141 billion (by market cap) global tobacco colossus.
FY 2020 revenue can be broken down geographically as follows: European Union, 37%; East Asia & Australia, 19%; South & Southeast Asia, 15%; Eastern Europe, 12%; Middle East & Africa, 11%; and Latin America & Canada, 6%.
The company’s global market share is an estimated 28%, excluding China and the US.
That impressive market share is based mostly on the strength and ubiquity of their Marlboro brand, the #1 cigarette brand in the world.
This one brand alone made up 37% of their total cigarette sales volume for last year.
That brand loyalty is formidable.
But it’s especially formidable when you combine it with the addictive nature of the products.
This combination of brand loyalty and addictive properties makes the product incredibly price inelastic – an increase in price doesn’t significantly reduce demand.
This level of pricing power is very rare.
It’s a unique tailwind that has blown the company’s way for years and helped them weather all storms.
This tailwind sets the company up to continue growing its profit and dividends for many years to come, despite the secular decline in the use of its main line of products.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Philip Morris has increased its dividend for 13 consecutive years.
That track record is as long as it could possibly be, as it dates back to the company’s initial spin-off from former parent company Altria Group Inc. (MO) in 2008.
The five-year dividend growth rate of 3.2% won’t knock you dead.
But it beats inflation.
What might get closer to knocking you dead is the stock’s 5.29% market-smashing yield.
That’s a very high yield in this low-rate environment. It’s more than three times higher than the broader market’s yield.
The payout ratio, at 93.0%, is admittedly high.
However, the company has an idiosyncratic accounting structure. Philip Morris’s headquarters is in the US. But they don’t sell products in the US. This sets them up for somewhat volatile GAAP EPS when they convert foreign profits into USD.
Nonetheless, the company has always operated with a high payout ratio. And their FCF even more comfortably covers the dividend.
This stock offers you a big dividend that’s growing in the low-single-digit range, which is well suited for older investors and/or investors seeking income.
Revenue and Earnings Growth
As attractive as the dividend is, though, these numbers are looking backward.
It’s those future dividends we care most about.
Investors are risking today’s capital for tomorrow’s rewards.
As such, 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.
I’ll then compare that to a near-term professional prognostication for profit growth.
Combining the proven past with a future forecast like this should allow us to extrapolate out a future growth path for the business with a reasonable amount of confidence.
Philip Morris’s revenue dropped slightly from $31.097 billion in FY 2011 to $28.694 billion in FY 2020.
Revenue is down because of a secular decline in smoking, which has caused consistent drops in volume year after year.
But this is actually better than it looks.
Volumes have been declining at precipitous rates. For example, FY 2020 showed an 11.1% YOY drop in cigarette volumes.
Even with these massive drops in volumes, Philip Morris is able to keep things fairly steady. I think that’s impressive.
Furthermore, the company actually grew its bottom line over the last decade.
Earnings per share increased from $4.85 to $5.16 over this 10-year period, which is a CAGR 0.69%.
Share buybacks aided bottom-line growth. The outstanding share count is down by approximately 12% over this 10-year stretch.
So the company is actually growing its profit and dividend, despite a consistent drop in volumes. That casts a bright light on the pricing power I mentioned earlier.
But what’s exciting about a company just treading water?
If the company can do this with a secular decline in its main products and a strong dollar that reduces its GAAP EPS potential, what could it do with volume growth and a weaker dollar?
I bet they could do much more than we’ve seen.
And I’m not alone with that viewpoint.
Looking forward, CFRA is forecasting that Philip Morris will compound its EPS at an annual rate of 6% over the next three years.
This leads me to the point I’m trying to make.
Philip Morris already has incredible pricing power that can keep the business growing at a slow rate, even if volumes are contracting and the dollar is strong.
But the recent weakening of the dollar is one advantage.
The bigger story, however, is their IQOS product.
This is their revolutionary heat-not-burn tobacco product.
Whereas traditional cigarette volumes contracted by 11.1% in FY 2020, heated tobacco shipments increased by 27.6%. This strategy of embracing the future is helping the company to offset the secular decline in smoking with a product that is actually growing.
The IQOS is new, but early results are promising.
If we look at a more recent bottom-line growth picture, Philip Morris compounded its EPS at an annual rate of 3.60% over the last five years.
There’s an acceleration occurring here. This leads me to believe that CFRA isn’t afoul with their EPS growth forecast.
The worst-case scenario, in my mind, is one where Philip Morris continues to only increase the dividend at a low-single-digit level. But that would be very acceptable dividend growth since the yield is so high.
Meantime, there’s the potential for a lot of upside surprise as it relates to future dividend growth.
Moving over to the balance sheet, the company maintains a pretty solid financial position.
The long-term debt/equity ratio is N/A because of negative common equity. But their interest coverage ratio of over 16 indicates no issues whatsoever with their debt load or interest expenses.
Profitability, as you might already expect, is extremely robust.
After all, they specialize in a high-margin, addictive product.
And the costs to manufacture the product don’t rapidly rise, even though the strong pricing power is there. Most of their operating cash flow drops straight down. It’s a cash cow.
Over the last five years, the firm has averaged annual net margin of 24.81%. ROE is N/A because of negative common equity.
This is a slow-growth, high-yield stock that’s great for income-seeking investors.
And with growth accelerating, there’s actually a lot to be excited about.
Plus, the company benefits from competitive advantages that include pricing power, brand loyalty, global economies of scale, and high barriers to entry.
Of course, there are risks to consider.
Litigation, regulation, and competition are omnipresent risks in every industry.
This business has long faced regulation and litigation risks that greatly exceed what the average business would be looking at.
On the other hand, the entrenched players, while competitive with one another, are given an advantage by way of it being virtually impossible for a new cigarette company to start up today. This has created a global oligopoly.
The US dollar is a risk because of the aforementioned accounting idiosyncrasy.
A slowing of the adoption of IQOS would reduce the company’s ability to offset traditional cigarette volume declines.
Lastly, any increase in traditional cigarette volume declines would hurt revenue, profit, and the sustainability of the dividend.
Overall, I view these risks as manageable.
And the stock’s low expectations have produced an attractive valuation that makes the investment that much more compelling…
Stock Price Valuation
The stock’s P/E ratio of 17.60 is well below where the broader market is at.
While I think the stock’s slower growth rate deserves a lower multiple, this is well off of even the stock’s own five-year average P/E ratio of 20.3.
The P/S ratio of 4.9 is slightly below its five-year average of 5.0.
And the yield is right in line with 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 an 8% discount rate (to account for the high yield) and a long-term dividend growth rate of 3%.
This DGR is on the conservative side, in my opinion.
It’s in line with the five-year dividend growth rate. And the most recent dividend increase, announced in September 2020, came in at about 2.6%.
So I’m right in that range here.
However, I really do believe that the business is on the cusp of a stronger tailwind gust than it’s had in years. And that could lead to much higher dividend growth than shareholders have become accustomed to.
On the flip side, I do like to err on the side of caution with these long-term forecasts and valuation models.
I think this is a very reasonable estimation of the forward-looking growth profile, which should lead to a very reasonable estimate of intrinsic value.
The DDM analysis gives me a fair value of $98.88.
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 with what I’d argue is a conservative valuation model, the stock still looks cheap 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 PM as a 4-star stock, with a fair value estimate of $108.00.
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 PM as a 5-star “STRONG BUY”, with a 12-month target price of $100.00.
I came out on the low end, but we’re all in a pretty tight range. Averaging the three numbers out gives us a final valuation of $102.29, which would indicate the stock is possibly 13% undervalued.
Bottom line: Philip Morris International Inc. (PM) is a high-margin business that benefits from extremely unique competitive advantages. After a period of languishment, growth is starting to accelerate. With a market-smashing 5.3% yield, more than a decade straight of dividend raises, inflation-beating dividend growth, and the potential that shares are 13% undervalued, this stock could be a perfect fit for dividend growth investors seeking safe income for their portfolios.
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 PM’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 64. 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, PM’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
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.