The market continues to ratchet higher.
And investors aiming to find undervalued stocks continue to be flustered.
But fear not.
One adage has long helped me, and I think it’ll also help you.
It’s a market of stocks, not a stock market.
The S&P 500 isn’t a monolith.
It’s a collection of ~500 individual businesses, each with unique dynamics (and valuations).
There are always opportunities. In any market.
And it helped me to build my FIRE Fund.
That’s my real-money stock portfolio.
It generates the five-figure passive dividend income I live off of in my 30s.
Indeed, I retired in my early 30s – thanks to this portfolio.
And I accomplished this without a college degree or a high-paying job.
My Early Retirement Blueprint exposes exactly how I did that.
Suffice it to say, the investing strategy I used was highly important.
That strategy was, and remains, dividend growth investing.
The Dividend Champions, Contenders, and Challengers list contains invaluable data on hundreds of these stocks.
But it’s more than just picking the right stock.
As I pointed out earlier, it’s also about finding the right valuation.
Price is only what you pay. Value is what you actually 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 the stock market as a market of stocks and selecting the highest-quality dividend growth stocks at the lowest possible valuations is a recipe for extraordinary success, wealth, and passive income.
Fortunately, the process of estimating intrinsic value isn’t all that difficult.
Fellow contributor Dave Van Knapp has made that process easier than ever, via Lesson 11: Valuation.
Part of a larger series of “lessons” on dividend growth investing, it lays out a valuation template that an investor 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…
Lockheed Martin Corporation (LMT) is the world’s largest defense contractor.
Founded in 1912, Lockheed Martin is now a $106 billion (by market cap) global defense juggernaut that employs more than 110,000 people.
Fiscal year 2020 revenue is broken out by segment: Aeronautics, 40%; Rotary and Mission Systems, 25%; Space Systems, 18%; Missiles & Fire Control, 17%.
The US Department of Defense accounts for approximately 65% of revenue. International sales account for nearly 25% of revenue. The remaining 10% comes from various US government agencies. Commercial sales are insignificant.
Lockheed Martin is truly in a league of their own.
Morningstar declares this: “We view Lockheed Martin as the highest-quality defense prime contractor, given its exposure as the prime contractor on the F-35 program and its missile business.”
One could quibble with whether or not it truly is the highest-quality defense contractor, but there’s no doubting its position as the biggest defense contractor. In terms of defense revenue, nobody is even close.
Lockheed Martin manufactures a range of major military aircraft, including the F-35 Lightning II, the F-22 Raptor, the F-16 Fighting Falcon, the SH-60 Seahawk.
The F-35, a fifth-generation combat aircraft, is the largest and most expensive military weapons system in the world.
In addition, their various missiles offerings are extremely important for both offensive and defensive capabilities.
The investment thesis here is quite simple.
You only have to believe that human conflict will persist.
Since we know that human conflict has existed as long as, well, humans, one doesn’t need to do mental gymnastics in order to rationalize a long-term investment in Lockheed Martin.
Moreover, that conflict has become more complex and expensive over time, and will continue to do so.
We used to use bows and arrows. It’s now jets and missiles. The future likely involves drones and tech we can’t yet imagine.
This kind of progression built onto natural demand bodes well for Lockheed Martin’s ability to increase its profit and dividends over the long run.
Dividend Growth, Growth Rate, Payout Ratio and Yield
The company has already increased its dividend for 18 consecutive years.
Their 10-year dividend growth rate is an impressive 14.0%.
That long-term double-digit dividend growth comes on top on the stock’s market-beating yield of 2.79%.
This yield, by the way, is almost 20 basis points higher than the stock’s own five-year average yield.
Whereas a lot of stocks are offering up yields lower than their recent historical averages, this stock is the opposite.
The dividend is also safe, protected by a payout ratio of 42.0%.
I view the “sweet spot” for a dividend growth stock to be a yield of between 2.5% and 3.5%, paired with a high-single-digit (or better) dividend growth rate.
You can clearly see that this stock is squarely in the sweet spot.
Revenue and Earnings Growth
As great as these dividend metrics are, though, they’re looking backward.
However, investors are risking today’s capital for tomorrow’s rewards.
As such, I’ll now build out a forward-looking growth course 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 of profit growth.
Combining the proven past with a future forecast like this should allow us to reasonably appraise a growth trajectory.
Lockheed Martin grew its revenue from $46.499 billion in FY 2011 to $65.398 billion in FY 2020.
That’s a compound annual growth rate of 3.86%.
I usually look for a mid-single-digit top-line growth rate from a mature business like this. Lockheed Martin is in the neighborhood.
Meanwhile, earnings per share increased from $7.81 to $24.30 over this period, which is a CAGR of 13.44%.
We now see where that strong dividend growth came from – it came from strong EPS growth.
A combination of margin expansion and buybacks helped to propel the excess bottom-line growth; the outstanding share count is down by ~17% over the last decade.
Looking forward, CFRA is forecasting an 8% EPS CAGR for Lockheed Martin over the next three years.
One of the biggest concerns surrounding Lockheed Martin now, which is a concern that surrounds it at all times, is one of possible DoD spending cuts.
Regarding this, CFRA notes this: “However, we see this risk mitigated by LMT’s focus on DoD’s high priority, advanced technology programs, which are likely to avoid cuts even if total defense spending is reduced, in our view. Moreover, government defense spending has historically increased regardless of recessions, limiting LMT’s cyclical risk.”
That sums it up nicely.
Furthermore, President Biden has already requested a ~2% increase to US defense spending.
Underpinning that steady growth is the incredible backlog – it’s at $147.1 billion as of Q1 2021, which is more than twice the company’s annual revenue. It’s also greater than the entire market cap of the company.
And then there’s the $4.4 billion acquisition of Aerojet Rocketdyne Holdings Inc. (AJRD), which is supposed to close in the second half of 2021. This gives Lockheed Martin greater exposure to propulsion and space, which is a growth area for the business.
I see CFRA’s near-term EPS growth forecast as reasonable.
Lockheed Martin’s own midpoint guidance for this fiscal year’s GAAP EPS would show 7.6% YOY growth. That’s not far off from 8%.
With the payout ratio being as low as it is, that would portend similar or better dividend growth for the foreseeable future. Indeed, the most recent dividend increase, announced toward the end of 2020, came in at 8.3%.
Moving over to the balance sheet, the company maintains a rock-solid financial position.
The long-term debt/equity ratio, at 1.94, is high largely because of low common equity (rather than a large debt load).
Their interest coverage ratio of over 15 is great and shows no issues whatsoever with debt servicing.
Profitability is robust and improving. Margins have been expanding nicely, although low common equity has juiced ROE.
Over the last five years, the firm has averaged annual net margin of 8.93% and annual return on equity of 308.93%.
There really is very little to dislike about this business.
It’s fundamentally excellent, the backlog is huge, their industry is an oligopoly, and it provides a necessary suite of products and services to very willing buyers with near-unlimited checkbooks.
And global scale, significant barriers to entry, long-term contracts, technological know-how, and high costs provide the company with durable competitive advantages.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
While competition is naturally limited in this case, regulation is heightened as a result of working directly with government agencies.
The very business model presents unique geopolitical risks.
Production execution has been a recent risk. Cost overruns with the F-35 program are an example of that.
Any pressure on government spending, which would put pressure DoD spending, could reduce Lockheed Martin’s revenue and profits.
In my opinion, these risks as very manageable, especially when compared to the company’s overall quality.
And with the valuation being so appealing, this is a particularly compelling long-term investment right now…
Stock Price Valuation
The stock is trading hands for a P/E ratio of 15.06.
That’s well below the broader market’s earnings multiple.
It’s also way off of the stock’s own five-year average P/E ratio of 23.1.
There’s also the P/CF ratio. At 13.7, it’s materially lower than its five-year average of 17.1.
And the yield, as noted earlier, is 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 8%.
This DGR is on the high end of what I usually allow for.
But I think this business merits it.
That’s lower than both the demonstrated 10-year EPS and dividend growth rates, respectively. It’s in line with CFRA’s near-term EPS growth forecast. And it’s slightly lower than the most recent dividend increase.
With the underlying business growth further bolstered by a moderate payout ratio, I judge this as a sensible expectation for long-term dividend growth.
The DDM analysis gives me a fair value of $561.60.
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 analysis reveals a very attractive valuation.
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 LMT as a 4-star stock, with a fair value estimate of $436.00.
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 LMT as a 5-star “STRONG BUY”, with a 12-month target price of $504.00.
I came out on the high end, but we all think the stock is priced below its worth. Averaging the three numbers out gives us a final valuation of $500.53, which would indicate the stock is possibly 34% undervalued.
Bottom line: Lockheed Martin Corporation (LMT) is a high-quality company with a backlog of projects that exceeds the entire market cap of the company, ensuring plenty of revenue, profits, and dividends for years to come. With a market-beating dividend, double-digit dividend growth, a moderate payout ratio, almost two straight decades of dividend increases, and the potential that shares are 34% undervalued, this is a dividend growth dream stock.
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 LMT’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 84. 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, LMT’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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