A rising stock market is akin to a rising tide that can lift all boats.

However, not all boats rise at the same rate.

And it could be argued that some boats have not yet risen to the level they ought to be at.

For whatever reason, some are simply not as high as they should be.

This discrepancy could be a massive opportunity.

Finding, and taking advantage of, these opportunities has greatly aided me in my quest to become financially independent at a young age.

In fact, I was able to retire in my early 30s – as I lay out in my Early Retirement Blueprint.

A large part of my success has hinged upon buying the best stocks at the most opportune moments.

The best stocks, in my opinion, are high-quality dividend growth stocks.

These are stocks that pay reliable, rising dividends.

These are world-class enterprises.

After all, its only possible to pay out reliable, rising dividends if you’re producing reliable, rising profits.

And you’re only able to do that if you’re selling the products and/or services the world demands.

You can find hundreds of these stocks by checking out the Dividend Champions, Contenders, and Challengers list.

I believe in these stocks so much, I’ve invested my life savings into them.

My real-money portfolio, which I refer to as the FIRE Fund, produces enough five-figure passive dividend income for me to live off of.

Jason Fieber's Dividend Growth PortfolioThis portfolio is chock-full of high-quality dividend growth stocks.

But, as I noted earlier, I always aimed to buy them at the most opportune times.

What I mean by that is, I looked for undervaluation.

Price is only what a stock costs. Value is 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.

Repeatedly taking advantage of discrepancies between price and value on high-quality dividend growth stocks is almost guaranteed to be a huge boon to your long-term wealth, passive income, and overall success.

Fortunately, finding these discrepancies isn’t all that hard.

Fellow contributor Dave Van Knapp has made that process much easier with Lesson 11: Valuation.

As part of an extensive series of “lessons” on dividend growth investing, it provides a valuation guide that an investor can use to estimate intrinsic value on a 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…

Huntington Ingalls Industries Inc. (HII)

Huntington Ingalls Industries Inc. (HII) is a major American defense company, operating as the largest independent military shipbuilder.

Founded in 1886, Huntington Ingalls is now an $8 billion (by market cap) military giant that employs over 14,000 people.

Huntington Ingalls primarily designs, constructs, maintains, and repairs a range of nuclear and non-nuclear ships. These ships include aircraft carriers, submarines, and amphibious assault ships.

The United States Navy is their largest customer, generating almost 90% of the company’s revenue.

The company operates across three segments: Newport News, 60% of FY 2020 revenue; Ingalls, 29%; and Technical Solutions, 14%.

A business like this can make for an excellent long-term investment, primarily because of the necessity of the products and the scarcity of competition.

This speaks to why this stock has amazingly compounded at an annual rate of 21% over the last decade.

It’s very simple.

The US isn’t suddenly going to stop needing to protect itself via sovereign defense. If anything, sovereign defense only becomes more critical over time.

And Huntington Ingalls is often competing against nobody.

For instance, Huntington Ingalls is the only builder of nuclear-powered aircraft carriers for the United States. If the US military orders a nuclear-powered aircraft carrier, Huntington Ingalls is the company that will build it.

This is a powerful one-two punch that bodes well for Huntington’s ability to increase its profit and dividend over the long run.

Dividend Growth, Growth Rate, Payout Ratio and Yield

The company has already increased its dividend for nine consecutive years.

Their five-year dividend growth rate is 18.6%.

That astounding dividend growth comes along with the stock’s current market-beating yield of 2.25%.

This yield, by the way, doesn’t just beat the market; it’s also more than 70 basis points higher than the stock’s own five-year average yield.

And with a low payout ratio of 27.5%, this is a very safe dividend.

Revenue and Earnings Growth

These dividend metrics are fantastic.

But as fantastic as they are, it’s the future dividends and dividend raises we care most about.

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

Thus, I’ll now build out a forward-looking growth trajectory for the business, which will later be used to estimate the intrinsic value of the stock.

This trajectory will base itself upon what the company has done over the last decade in terms of top-line and bottom-line growth.

I’ll then compare that historical growth to a near-term professional prognostication for profit growth.

Combining the proven past with a future forecast in this way should give us a very good idea as to where the company might be going.

Huntington Ingalls increased its revenue from $6.575 billion in FY 2011 to $9.361 billion in FY 2020.

That’s a compound annual growth rate of 4.0%.

This is a good result. I usually look for mid-single-digit top-line growth from a mature business like this. They delivered.

Meantime, earnings per share grew from $2.91 in FY 2012 to $17.14 in FY 2020, which is a CAGR of 24.81%.

Incredible bottom-line growth, which shows us where the dividend growth came from.

It’s important to note that I moved the starting year for the EPS growth rate one year forward. This is because the company registered a GAAP loss for FY 2011.

A combination of buybacks and margin expansion drove a lot of excess bottom-line growth.

The outstanding share count is down by ~15% over the last decade, while net margin has doubled compared to a decade ago.

Looking forward, CFRA projects that Huntington Ingalls will compound its EPS at an annual rate of 9% over the next three years.

This kind of EPS growth, while certainly strong, would represent a material drop from the kind of growth the company has enjoyed over the last nine years.

In my view, that really underestimates what this company is capable of.

But Huntington Ingalls is used to be underestimated.

For example, the company recently reported Q1 GAAP EPS of $3.68. That beat consensus expectations by a whopping $1.07!

And let’s keep in mind that their backlog just reached a record $48.8 billion – almost six times the company’s entire market cap.

That said, the timing of contracts and deliveries can impact growth over a short period of time.

However, even if Huntington Ingalls only produces a CAGR of 9% for its EPS over the next three years, that would still be more than enough to power low-double-digit dividend growth for years to come. Their low payout ratio gives them flexibility.

With the good possibility that they actually do better than CFRA’s expectation, and considering the 2.25% yield, there’s a spectacular combination of current income and dividend growth at work here.

Financial Position

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

The long-term debt/equity ratio is 0.89, while the interest coverage ratio is over 8.

Profitability is robust. As pointed out earlier, the expansion in net margin in recent years has been nothing short of extraordinary.

Over the last five years, the firm has averaged annual net margin of 7.44% and annual return on equity of 36.14%.

For perspective on the margin expansion, net margin for FY 2012 was below 2.5%.

No matter how you slice it, this is a high-quality business.

And they do benefit from durable competitive advantages, including massive barriers to entry, scale, technological know-how, R&D, IP, long-term contracts, high switching costs, and a unique government relationship.

Of course, there are risks to consider.

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

While competition is limited, or sometimes completely non-existent, regulation is amplified by way of direct regulatory oversight.

The very business model introduces geopolitical risk.

The current Democratic regime in the US government could aim to limit defense spending, which would impact this business.

Customer concentration is a risk.

There is also execution risk, especially with such a large backlog. The company must continue to complete projects in a timely and cost-effective manner in order to avoid backlash, scrutiny, and a possible reduction in order flow.

These risks are very acceptable, in my opinion.

That’s especially true if the stock is bought at an attractive valuation.

With the stock still well below its pre-pandemic pricing, I see the valuation as very attractive…

Stock Price Valuation

The P/E ratio is 12.23.

That’s substantially lower than the broader market’s earnings multiple.

It’s also well below the stock’s own five-year average P/E ratio of 15.6.

We can also look at cash flow.

The stock’s P/CF ratio of 7.7 is way off of its own five-year average of 10.7.

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.

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 at the high end of what I ordinarily allow for, but I believe this company deserves it.

The long-term EPS growth rate and long-term dividend growth rate are both more than double this number. And CFRA’s near-term EPS growth forecast, which is arguably conservative, is higher than this.

In addition, the payout ratio is very low.

I think Huntington Ingalls could exceed this expectation over the next few years, but I’d rather err on the side of caution when modeling something out over many years.

The DDM analysis gives me a fair value of $246.24.

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.

The stock looks cheap, even after a rather prudent 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 HII as a 3-star stock, with a fair value estimate of $201.00.

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 HII as a 4-star “BUY”, with a 12-month target price of $249.00.

I came in pretty close to where CFRA is at on this one. Averaging the three numbers out gives us a final valuation of $232.08, which would indicate the stock is possibly 15% undervalued.

Bottom line: Huntington Ingalls Industries Inc. (HII) is a high-quality defense firm that powerfully benefits from providing necessary products with limited competition. With a market-beating yield, an extremely low payout ratio, double-digit dividend growth, and the potential that shares are 15% undervalued, this is a compelling long-term investment opportunity 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 HII’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 68. 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, HII’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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