The higher the stock market goes, the more I like to focus on quality stocks.

If a storm approaches, you want to make sure you’ve got great businesses in your portfolio.

It’s all about having a strong foundation.

Because if the foundation is weak, volatility could cause a toppling.

But if great businesses comprise your portfolio’s foundation, it should hold up against any tempest.

When I think of great businesses, high-quality dividend growth stocks immediately come to mind.

These stocks represent equity in world-class enterprises that pay reliable, rising dividends to shareholders.

They’re able to pay those reliable, rising dividends because they’re producing reliable, rising profits.

Perusing the Dividend Champions, Contenders, and Challengers list will show you what I mean.

Jason Fieber's Dividend Growth PortfolioThat 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.

I’ve relied on these stocks as I’ve gone about building my own portfolio, which I refer to as the FIRE Fund.

That real-money portfolio now produces enough five-figure passive dividend income for me to live off of.

Indeed, I was actually able to retire in my early 30s by living below my means and putting my capital to work with high-quality dividend growth stocks.

My Early Retirement Blueprint lays out exactly how I did that.

Having my own portfolio built upon a sturdy foundation of high-quality dividend growth stocks has been a blessing.

The businesses you invest in will determine much of your long-term success.

However, valuation at the time of investment will also dictate some of that success.

Price is only what you pay. But 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.

Making sure your portfolio’s foundation is comprised of high-quality dividend growth stocks that are acquired when undervalued should set you up for excellent long-term results and great protection against economic volatility.

As complex as valuation might seem, it’s actually not.

Fellow contributor Dave Van Knapp has greatly simplified the valuation process with Lesson 11: Valuation.

Part of his series of “lessons” on dividend growth investing, it provides a valuation guide that can help you to estimate the intrinsic value of just about 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…

Air Products & Chemicals, Inc. (APD)

Air Products & Chemicals, Inc. (APD) is a major global producer and supplier of industrial gases. They’re the largest supplier of hydrogen and helium in the world.

Founded in 1940, Air Products & Chemicals is now a $64 billion (by market cap) industrial gases giant that employs more than 19,000 people.

The company’s FY 2020 sales were reported through four Industrial Gases business segments organized by geography: Americas, 41%; Asia, 31%; EMEA, 22%; and Global, 4%. Corporate and other accounted for the remaining 2%.

Industrial gases are often critical input for the manufacturing process. This applies to a large range of end products.

Because of the critical nature, manufacturers set up a long-term contract with a reliable gas provider.

These long-term contracts are often combined with complex on-site infrastructure to provide a constant source of gasses. This makes it difficult to switch providers later.

In addition, Air Products & Chemicals operates as part of a global oligopoly. Most of the global market share is basically shared by three major companies that have the necessary scale to operate and compete.

Layering this oligopoly on top of the low-cost but critical nature of their products is a very powerful one-two punch which puts Air Products & Chemicals in an excellent position to prosper.

That should mean higher profits and higher dividends for many years to come.

Dividend Growth, Growth Rate, Payout Ratio and Yield

As things stand, this is a Dividend Aristocrat with 39 consecutive years of dividend increases.

The 10-year dividend growth rate is 10.3%.

That double-digit dividend growth comes on top of the stock’s market-beating yield of 2.06%.

And with the payout ratio at 66.4%, based on midpoint adjusted EPS guidance for this fiscal year, the dividend remains easily covered.

Revenue and Earnings Growth

There really is a lot to like about these dividend metrics.

As great as they are, though, they’re looking at what’s already transpired.

However, investors risk today’s capital for tomorrow’s rewards.

It’s future growth and dividend raises that matter most.

As such, I’ll now build out a forward-looking growth trajectory for the business, which will later help with the valuation process.

This will be partially based on what the company has done over the last ten years in terms of top-line and bottom-line growth.

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

Blending the proven past with a future forecast should give us a pretty good idea as to where the business is likely headed from here.

The company’s revenue actually decreased slightly from $10.082 billion in FY 2011 to $8.856 billion in FY 2020.

Any business shrinkage, especially over a long period of time, would initially seem disappointing.

However, this reduction in revenue can largely be attributed to the fact that the company purposely decided to make the business smaller and more focused.

They put together their “Five-Point Plan”, with focused them on industrial gases by jettisoning non-core businesses.

The execution of this plan led to spinning off the electronics material division in 2016, as well as selling the performance materials division in 2017 for $3.8 billion in cash.

Meanwhile, the company increased earnings per share from $5.63 to $8.49 over this time period, which is a CAGR of 4.67%.

Material margin expansion, relating back to the aforementioned focusing, definitely helped to propel bottom-line growth in the face of revenue shrinkage.

It’s also worth noting that the company’s GAAP EPS can be lumpy. Their growth can look mediocre or truly outstanding, depending on what time frame you’re looking at.

The CAGR in GAAP EPS seemingly belies their earnings power. In my view, adjusted EPS gives a more accurate view into their overall growth profile.

Their guidance for this fiscal year calls for 7% to 9% growth in adjusted EPS for the full year.

Looking forward, CFRA forecasts that Air Products & Chemicals will compound its EPS at an annual rate of 10% over the next three years.

This anticipated growth acceleration might look aggressive when compared to the sub-5% EPS growth rate the business has produced over the last decade.

On the other hand, it’s not that far off from the top end of the company’s own recent guidance for adjusted EPS growth.

There’s one piece of supporting evidence here that I think is particularly salient. Per CFRA: “APD is well positioned to capitalize on gasification related to carbon capture and hydrogen mobility, which are long-term secular tailwinds.”

Air Products & Chemicals already benefits from the powerful one-two punch I highlighted earlier.

Adding on carbon capture and hydrogen mobility only serves to supercharge their potential, which gives weight to a growth acceleration thesis.

That said, even if the company comes in shy of CFRA’s near-term EPS growth forecast, they’d still be easily able to put together high-single-digit dividend raises for the foreseeable future.

And that adds up to a pretty picture when you’re starting out with a 2% yield.

Financial Position

Moving over to the balance sheet, the company has a spectacular financial position.

The long-term debt/equity ratio is 0.62. Their interest coverage ratio is over 23.

Moreover, they have a healthy amount of cash on the balance sheet.

Seeing as how this is a capital-intensive business model, the balance sheet is extremely impressive.

Their profitability is quite robust.

Over the last five years, the firm has averaged annual net margin of 20.08% and annual return on equity of 18.48%.

Fundamentally speaking, this is a high-quality business across the board.

And they also benefit from durable competitive advantages that include global scale, barriers to entry, high switching costs, a global oligopoly, and long-term contracts with fixed infrastructure.

Of course, there are risks to consider.

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

There is limited competition in this industry. The competition that is present, however, is fierce.

Demand for industrial gases is cyclical. Any reduction in economic output affects demand for the company’s products.

The company is heavily exposed to major energy projects around the world. Substantial changes in the global energy complex could diminish the company’s long-term growth story.

Overall, I view this as a high-quality dividend growth stock that should make for an excellent long-term investment.

After a recent correction from its 52-week high of $327.89/share, the current valuation only serves to make me more enthusiastic…

Stock Price Valuation

The stock is trading hands for a P/E ratio of 34.24.

That’s arguably high. But it’s also based off of TTM GAAP EPS, which can be problematic in this case.

The midpoint for this fiscal year’s adjusted EPS, which is $9.03, puts the forward P/E ratio at 32.19.

That’s not unreasonable for a Dividend Aristocrat that’s expected to accelerate bottom-line growth into a double-digit rate for the foreseeable future.

And the P/CF ratio of 17.9 isn’t totally disconnected from the five-year average of 17.1, despite the growth acceleration anticipation.

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 very high end of what I typically allow for.

But I think this is a business that warrants the benefit of the doubt.

Their long-term demonstrated dividend growth rate is well above this level. Furthermore, their most recent dividend increase, which was announced in January of this year, came in at 11.9% – during a pandemic.

With the expectation for a bottom-line growth acceleration being supported by a larger-than-average dividend raise this year, I think 8% is a rational number for the model.

The DDM analysis gives me a fair value of $324.00.

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.

I don’t see my valuation model as aggressive, yet 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 APD as a 3-star stock, with a fair value estimate of $323.00.

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 APD as a 5-star “STRONG BUY”, with a 12-month target price of $341.00.

I came in almost on the nose with Morningstar, but the overall consensus this time around is tight. Averaging the three numbers out gives us a final valuation of $329.33, which would indicate the stock is possibly 13% undervalued.

Bottom line: Air Products & Chemicals, Inc. (APD) is a high-quality company that benefits from the powerful one-two punch of providing low-cost but critical manufacturing input material within the framework of a global oligopoly. Carbon capture and hydrogen mobility only adds to the appeal. With a market-beating yield, double-digit dividend growth, 39 consecutive years of dividend raises, and the potential that shares are 13% undervalued, this Dividend Aristocrat should be on every dividend growth investor’s radar.

-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 APD’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 95. 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, APD’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 & Income

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