Some people think the pandemic has changed people’s habits forever.

In my view, that’s a case of recency bias.

However, I do think that the pandemic has changed some businesses forever.

It seems to me that certain businesses have permanently stolen market share at the expense of competitors.

And that’s a long-term tailwind for the “pandemic winners”.

The crazy thing is, some of these businesses were already winning before the pandemic.

The ones I’m talking are high-quality businesses regularly growing their profits, which allows them to regularly grow the dividends they were sending back to shareholders.

Jason Fieber's Dividend Growth PortfolioI’m talking about high-quality dividend growth stocks.

My personal six-figure stock portfolio, which I refer to as the FIRE Fund, is chock-full of these stocks.

This portfolio, by the way, produces enough five-figure passive dividend income for me to live off of.

In fact, I was able to retire in my early 30s by buying and holding these stocks.

I share how I accomplished that feat in my Early Retirement Blueprint.

Simply put, high-quality dividend growth stocks are some of the best stocks in the world.

You can see what I mean by checking out the Dividend Champions, Contenders, and Challengers list.

That list contains invaluable data on more than 700 US-listed stocks that have increased their dividends for at least the last five consecutive years.

As great as these stocks can be, and as much winning as some businesses might be doing, valuation at the time of investment is always very important.

Price only tells you what you pay. It’s value that tells you what 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.

Buying a “winner” at an attractive valuation could lead to outsized long-term passive dividend income production and total return, all while taking on less risk.

Fortunately, discerning what kind of valuation is attractive isn’t all that difficult.

Fellow contributor Dave Van Knapp’s Lesson 11: Valuation has greatly demystified valuation.

Part of a comprehensive series of “lessons” on dividend growth investing, it provides a valuation mold that can be applied to just about 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…

Clorox Co. (CLX)

Clorox Co. (CLX) is a global manufacturer and marketer of a variety of everyday consumer products.

Founded in 1913, Clorox is now a $22 billion (by market cap) consumer staples giant that employs more than 8,000 people.

The company has four sales segments: Health & Wellness, 41% of FY 2020 sales; Household, 27%; Lifestyle, 17%; and International, 15%.

Some of their major brands include Brita, Burt’s Bees, Clorox, Glad, and Kingsford.

The global pandemic will come to an end in the near future.

However, there’s an argument to be made that consumers will remain more cognizant about personal hygiene habits for many years.

While the company’s large bump in sales over the last year was largely temporary, certain habits and brand awareness don’t just disappear overnight.

And as a global leader in the cleaning space, with trusted brands, Clorox stands to gain permanent market share and mindshare as a result of the pandemic.

As such, the company could end up becoming a “pandemic winner”.

Even without this benefit, though, Clorox has already reliably increased its profit and dividend for decades.

But I think there’s a very good chance that Clorox ends up stronger from all of this, which bodes well for their ability to grow their profit and dividend at an even higher rate in the future.

Dividend Growth, Growth Rate, Payout Ratio and Yield

As it stands, Clorox has increased its dividend for 43 consecutive years.

The 10-year dividend growth rate is 7.5%.

This inflation-beating dividend growth rate is very nice, especially when paired with the stock’s market-beating yield of 2.6%.

This yield, by the way, is 20 basis points higher than the stock’s own five-year average yield.

The payout ratio is a very manageable 64.4%.

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.

Clorox is squarely in that sweet spot.

Revenue and Earnings Growth

As solid as these dividend metrics are, though, they’re looking backward.

Investors risk today’s capital for tomorrow’s rewards.

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

As such, I’ll now build out a forward-looking growth trajectory for the business, which can later help 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 compare that to a near-term professional prognostication for profit growth.

Combining the proven past with a future forecast in this way should tell us quite a bit about what the future growth path might look like.

Clorox grew its revenue from $5.231 billion in FY 2011 to $6.721 billion in FY 2020.

That’s a compound annual growth rate of 2.82%.

What Clorox might lack in huge sales growth, I think they make up for in consistency.

The top-line growth has been incredibly consistent over the last decade, just steadily moving up from year to year. It’s been almost secular in nature.

Meanwhile, earnings per share increased from $4.02 to $7.36 over this period, which is a CAGR of 6.95%.

Again, this growth has been very consistent.

Clorox won’t knock you dead with growth. But it’s steadily improving year after year.

We can also see where the dividend growth came from – it matches up almost exactly with EPS growth over the last 10 years.

Clorox has expanded its margins considerably, which explains the excess bottom-line growth.

And this margin expansion wasn’t a one-time pandemic benefit, either. There’s evidence of steady expansion over the last decade.

Looking forward, CFRA is anticipating that Clorox will compound its EPS at an annual rate of 10% over the next three years.

This would be a lot of bottom-line growth acceleration.

In relation to earlier points I made on permanent tailwinds for the business, CFRA states: “…certain consumer habits (e.g., health, hygiene, personal care) are likely to be forever changed due to Covid-19.”

Now, this could be a rising tide that lifts all boats in this industry, but I happen to believe that Clorox’s brands stand out.

CFRA seems to agree, with one of their notes stating: “Compared to peers, we think CLX will have a longer sales tailwind from the pandemic.”

Even if Clorox doesn’t have a permanent tailwind in place, we’re looking at a market-beating yield and high-single-digit long-term dividend growth. If that’s a base case, color me pleased.

However, there’s room for optimism here. With that, the odds are good for bigger dividend raises and/or a shrinking payout ratio when we look ahead.

Financial Position

Moving over to the balance sheet, the company has a rock-solid financial position.

The long-term debt/equity ratio is 3.06.

This is high because of low common equity, not because of debt.

With the the interest coverage ratio near 13, Clorox has no issues with debt whatsoever.

Profitability is robust, and it’s been improving of late.

Over the last five years, the firm has averaged annual net margin of 12.97% and annual return on equity of 161.67%.

Low common equity inflated the ROE. Nonetheless, the numbers are very good.

I see a lot to like about Clorox.

It’s a business that’s been around for more than a century, sells basic consumer products that everyone knows and uses, owns trusted brands, and could benefit from sustained changes in consumer behavior.

Of course, there are risks to consider.

Litigation, regulation, and competition are omnipresent risks in every industry.

The competition isn’t blind to the change in behavior and increased demand for hygiene products, which translates to even more competition.

Rising input and labor costs will likely weigh on near-term results.

The company’s international exposure is somewhat low relative to major competitors in the consumer space. This concentrates Clorox domestically.

Clorox has some customer concentration, with major retailers accounting for significant portions of annual sales.

Despite brand value, there are no switching costs with consumer products.

Even with these risks, Clorox still strikes me as a very appealing long-term investment idea.

With the stock down 10% YTD and back to where it was when the pandemic began, the valuation makes the stock that much more appealing…

Stock Price Valuation

The stock is trading hands for a P/E ratio of 25.05.

That’s lower than the broader market, and it’s basically right in line with the stock’s own five-year average.

Indeed, the valuation in general doesn’t seem to price in any kind of long-term tailwind from behavioral change. The stock has dramatically fallen from pandemic-induced mania that drove the stock up to well over $200/share. It’s now where it was in March 2020, which counts the sales over the last 15 months for nothing.

The P/CF ratio of 14.1 is lower than its own five-year average of 19.5.

And the yield, as noted earlier, is slightly 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 assumes the status quo.

It’s right in line with the 10-year demonstrated DGR, which itself is not far off from the demonstrated 10-year EPS CAGR.

So I’m not modeling in any market share or mindshare gains at all, which I think is really erring on the side of caution here.

In my view, Clorox could stand to do quite a bit better than this. But with so much near-term uncertainty, I’m relying more on Clorox’s long-term, consistent track record.

The DDM analysis gives me a fair value of $199.52.

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 was abundantly cautious, yet 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 CLX as a 3-star stock, with a fair value estimate of $171.00.

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 CLX as a 4-star “BUY”, with a 12-month target price of $210.00.

I came out somewhere in the middle. Averaging the three numbers out gives us a final valuation of $193.51, which would indicate the stock is possibly 8% undervalued.

Bottom line: Clorox Co. (CLX) is a high-quality company with great brands and incredible consistency, and they’re positioned to actually benefit from all that’s occurred over the last year or so. With a market-beating 2.6% yield, high-single-digit dividend growth, more than 40 consecutive years of dividend raises, and the potential that shares are 8% undervalued, this looks like a rare deal in the consumer staples sector for dividend growth investors.

-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 CLX’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 75. 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, CLX’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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