There’s a common misperception among investors.
This misperception is that you have to look far and wide for great long-term investment ideas.
It’s as if blue-chip companies that are household names can’t continue do well over the long run.
But that’s silly on its face.
The reason a blue-chip company becomes a household name is because it’s a wonderful business.
It should be obvious that wonderful businesses make for excellent long-term investments.
After all, what’s the alternative?
One of the best things about truly wonderful businesses is how often they directly reward their shareholders with growing dividends.
See what I mean by perusing the Dividend Champions, Contenders, and Challengers list.
And growing profit is the result of running a wonderful business.
This straightforward logic is a key tenet of the dividend growth investing strategy, which is a strategy I’ve been following for more than 10 years.
It’s treated me well.
As I lay out in my Early Retirement Blueprint, it allowed me to retire in my early 30s.
I now live off of the five-figure passive dividend income my real-money FIRE Fund produces for me.
But as great as this strategy is, an investor must always be on the lookout for particularly great opportunities.
These special opportunities come with the added benefit of an attractive valuation.
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.
Investing in a wonderful business at a wonderful valuation isn’t just an obvious thing to do but an intelligent thing to do.
While finding wonderful businesses might seem easy, valuation might seem more difficult.
Well, that’s not necessarily the case.
Fellow contributor Dave Van Knapp’s Lesson 11: Valuation, which is part of an overarching educational series, provides an easy-to-follow valuation template that you can apply to almost any dividend growth stock.
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…
Amgen, Inc. (AMGN) is a global biotechnology company that develops and manufactures a range of human therapeutics.
Founded in 1980, Amgen is now a $137 billion (by market cap) healthcare colossus that employs more than 24,000 people.
Amgen offers treatments for a range of ailments, including anemia, rheumatoid arthritis, psoriasis, cancer, and osteoporosis.
FY 2020 total product sales break down geographically as follows: US, 74%; Rest of World, 26%.
A world-class biotechnology business like this is an obvious business to invest in.
With the world growing bigger, older, and richer, demand for high-quality healthcare (including drugs) is sure to rise.
But it being obvious doesn’t make it a poor idea by any stretch of the imagination.
If anything, the opposite is true.
It was an obvious idea 10 years ago – yet it’s up more than 300% over the last decade.
Some of its major drugs include: Enbrel, 21% of FY 2020 sales; Prolia, 11%; Neulasta, 9%; Otezla, 9%; and XGEVA, 8%.
Their biggest blockbuster, Enbrel, generates over $5 billion in total annual sales.
Even with that, the company isn’t overly dependent on any one drug.
In addition to the product diversification, Amgen doesn’t face a near-term patent cliff on Enbrel. Patent protection runs until almost the end of the decade.
All of this augurs well for Amgen to continue performing at a high level for years to come.
That means growing profit and dividends for shareholders.
Dividend Growth, Growth Rate, Payout Ratio and Yield
As things stand, Amgen has increased its dividend for 11 consecutive years.
The five-year dividend growth rate of 15.2% is impressive.
And you’re pairing that double-digit dividend growth with the stock’s current yield of 2.94%.
This market-beating yield is more than 20 basis points higher than the stock’s own five-year average yield.
With a payout ratio of 58.3%, the dividend is also quite safe.
I like dividend growth stocks in what I refer to as the “sweet spot” – that’s a yield of between 2.5% and 3.5%, paired with a high-single-digit (or better) dividend growth rate.
Amgen is clearly in the sweet spot.
Revenue and Earnings Growth
These dividend metrics are great.
However, as great as they are, they’re looking at what’s already transpired.
Investors are risking today’s capital for tomorrow’s returns.
It’s future dividend raises and business growth we care most about.
As such, I’ll now build out a possible future 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 top-line and bottom-line growth.
Then I’ll provide a professional prognostication for near-term profit growth.
Amalgamating the proven past with a future forecast in this way should give us a reasonable degree of clarity regarding where the business is likely to go.
Amgen grew its revenue from $15.582 billion in FY 2011 to $25.424 billion in FY 2020.
That’s a compound annual growth rate of 5.59%.
I usually look for mid-single-digit top-line growth from a fairly mature business like Amgen.
They did slightly better than I’d expect.
Meanwhile, earnings per share increased from $4.04 to $12.31 over this time period, which is a CAGR of 13.18%.
This is fantastic.
We can now see where the double-digit dividend growth came from – it came from similar EPS growth.
Much of this excess bottom-line growth came about as a result of meaningful share buybacks.
The company reduced its float by 35% over the last decade. That’s one of the largest buyback programs I’ve ever come across.
Looking forward, CFRA forecasts that Amgen will compound its EPS at an annual rate of 9% over the next three years.
This would be a slight drop compared to Amgen’s performance over the prior decade.
CFRA cites Amgen’s promising pipeline, auspicious biosimilars business, diverse product portfolio, robust cash flow, large buybacks, and acquisition flexibility as advantageous areas for the company.
Regarding the acquisition flexibility, Amgen acquired the worldwide rights to inflammatory disease drug Otezla for $13.4 billion in November 2019. CFRA expects this drug to surpass $4 billion in annual sales before the expiration of certain patents in 2028.
A key headwind for Amgen is the slowing of growth among major legacy drugs, particularly Enbrel. Enbrel showed a 4% YOY decline in sales for FY 2020.
Overall, I see CFRA’s near-term EPS growth projection as fair.
And that would present Amgen with the capability to produce dividend growth in that same range.
Combined with the ~3% yield, that’s a compelling combination of yield and growth.
Moving over to the balance sheet, the company has a rock-solid financial position.
The long-term debt/equity ratio is 3.50.
That’s actually quite high; however, it’s high because of low common equity, not because of a high debt load.
The interest coverage ratio of over 7 tells the true story, which is one of no problems with servicing debt.
Profitability is extremely robust.
Over the last five years, the firm has averaged annual net margin of 28.15% and annual return on equity of 42.89%.
There really is a lot to like about Amgen.
It’s a high-quality biotechnology company that naturally benefits from massive, long-term demographic tailwinds. These tailwinds should allow for a very prosperous future.
And the company is protected by durable competitive advantages that include patents, R&D, IP, established healthcare relationships, and global scale.
Of course, there are risks to consider.
Litigation, regulation, and competition are omnipresent risks in every industry.
Some of Amgen’s smaller products, including Neulasta and Epogen, are starting to see biosimilar competition.
Any major changes to the US healthcare system, especially as it relates to drug pricing, would impact Amgen.
Amgen’s Otezla acquisition had a high price tag. This drug has to perform well in order to rationalize the acquisition.
And the company’s balance sheet, while still very solid, has weakened in recent years.
Even after careful consideration of these risks, I still believe Amgen should make for an excellent long-term investment.
That’s particularly true with the valuation being appealing right now…
Stock Price Valuation
The stock is trading hands for a P/E ratio of 19.86.
That’s way below the broader market’s earnings multiple.
It’s also well off of the stock’s own five-year average P/E ratio of 24.0.
And the yield, as noted earlier, is above 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 is on the high end of what I typically will allow for.
But I think this business warrants the benefit of the doubt.
It’s one of the strongest biotech companies in the world. And while they are facing increasing biosimilar competition, they’re fighting fire with fire with their own biosimilars.
This DGR is below what Amgen has produced over the last decade in terms of EPS growth. It’s also below the demonstrated five-year DGR. And it’s below CFRA’s near-term EPS growth forecast.
With the payout ratio being moderate, I see Amgen as being likely to exceed this level.
Still, I’d rather err on the side of caution.
The DDM analysis gives me a fair value of $302.72.
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 what was arguably a conservative valuation, the stock 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 AMGN as a 2-star stock, with a fair value estimate of $215.00.
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 AMGN as a 4-star “BUY”, with a 12-month target price of $270.00.
I came out high, surprisingly. But I also think Morningstar is awfully conservative here. Averaging the three numbers out gives us a final valuation of $262.57, which would indicate the stock is possibly 10% undervalued.
Bottom line: Amgen, Inc. (AMGN) is a world-class biotechnology company that should naturally benefit from large, long-term demographic tailwinds. With a market-beating dividend, double-digit dividend growth, a moderate payout ratio, more than a decade straight of dividend raises, and the potential that shares are 10% undervalued, this stock should be on every dividend growth investor’s radar right now.
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 AMGN’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 74. 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, AMGN’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
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