We’re coming up on two years from the onset of the global pandemic.
And the world is starting to emerge from this extremely unfortunate event.
Yet a lot of stocks are still priced below where they were before the pandemic.
That’s despite admirable business performance in the interim.
These disconnects could be your opportunity.
The constant search for mispriced assets is part of what makes investing so fun.
It’s also part of what makes it so rewarding.
I describe exactly how I was able to accomplish that in my Early Retirement Blueprint.
As I explain in the Blueprint, the investment strategy of dividend growth investing was a key facet of my success.
This strategy advocates buying and holding shares in world-class enterprises that pay reliable, rising dividends.
You can find hundreds of these stocks on the Dividend Champions, Contenders, and Challengers list.
By implementing this strategy, I built up my FIRE Fund.
That’s my real-money dividend growth stock portfolio, which produces enough five-figure passive dividend income for me to live off of.
A favorable disconnect between price and value can greatly improve long-term investment results.
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.
Finding advantageous disconnects between price and value in the market can make long-term investing much more rewarding by potentially supercharging the amount of wealth and passive dividend income you can accumulate.
Fortunately, finding these disconnects through a process of valuation isn’t as difficult as it might seem.
Fellow contributor Dave Van Knapp’s Lesson 11: Valuation, which is part of a comprehensive series on dividend growth investing, provides an easy-to-follow valuation template that can be applied 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…
Merck & Co., Inc. (MRK) is a leading global pharmaceutical company that produces a range of medicines, vaccines, and animal healthcare products.
Founded in 1891, Merck is now a $193 billion (by market cap) healthcare behemoth that employs nearly 75,000 people.
The company operates across two reportable segments: Pharmaceutical, 90% of FY 2020 sales; and Animal Health, 10%. Insignificant sales occur in unreported segments.
Their core areas of focus are: diabetes, infectious diseases, oncology, vaccines, and animal health.
The US is the company’s largest market, accounting for over 40% of worldwide sales.
Some of the company’s key drugs include Keytruda, Januvia, Gardasil, and ProQuad.
Keytruda, their marvel cancer drug, is the company’s most important product. It’s by far the top-selling drug in their portfolio.
This single drug made up almost 30% of the company’s worldwide sales for FY 2020. That compares to nearly 25% of company revenues for FY 2019.
What’s exciting about Keytruda is that it’s becoming a larger piece of a growing pie. The company’s top-selling product is also one of its fastest-growing products.
Also, Keytruda isn’t only Merck’s best-selling drug. With almost $15 billion in sales for FY 2020, it’s one of the top drugs on the planet – second only to Humira. The anticipation is for it to be the best-selling drug in the world within a few years.
Based on recent growth, that seems highly plausible: Keytruda sales were up 30% YOY for FY 2020.
Notably, this drug is on patent through 2028 in the US and EU.
Now, the Merck of 2021 does look slightly different than the Merck of 2020.
That’s chiefly because, in June 2021, they completed the spin-off of certain non-core assets into a new company called Organon & Co. (OGN).
However, this will have an immaterial impact on Merck. Organon has a market cap below $10 billion, which is less than 5% of Merck’s market cap.
Merck’s business model is highly lucrative and highly appealing.
After all, global demand for, and access to, quality healthcare is sure to increase over time. The world’s population is becoming larger, older, and wealthier.
Merck has powerful demographic tailwinds blowing its way.
That should translate into more profits and bigger dividends.
Dividend Growth, Growth Rate, Payout Ratio and Yield
The company has already increased its dividend for 10 consecutive years.
With a five-year dividend growth rate of 6.3%, which comes on top of the stock’s yield of 3.4%, the stock offers an appealing combination of growth and yield.
This market-beating yield, by the way, is 50 basis points higher than the stock’s five-year average yield.
And the payout ratio is a low 47.1%, based on this year’s guidance for adjusted EPS at the midpoint.
It’s a well-covered dividend.
I like dividend growth stocks in what I refer to as the “sweet spot” – that’s a yield between 2.5% and 3.5%, paired with a high-single-digit (or better) dividend growth rate.
The dividend growth rate is on the bubble, but the yield is at the high end of that range.
Revenue and Earnings Growth
These dividend metrics are great.
As great as they are, though, they’re looking backward.
However, investors risk today’s capital for tomorrow’s reward.
It’s future business growth and dividend raises we care most about.
As such, I’ll now build out a forward-looking 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 compare that to a near-term professional prognostication for profit growth.
Amalgamating the proven past with a future forecast like this should allow for a reasonable appraisal of their future growth path.
Merck’s revenue is essentially flat between FY 2011 and FY 2020, moving from $48.047 billion to $47.994 billion.
However, it’s important to keep in mind that Keytruda didn’t come on the scene until 2015. Merck’s revenue is up more than 20% since FY 2015.
Meanwhile, earnings per share increased from $2.02 to $5.94 over this 10-year period.
That’s a CAGR of 12.73%.
I will note that I used adjusted EPS for FY 2020. That’s because FY 2020 GAAP EPS included acquisition costs and intangible asset impairments that aren’t reflective of the company’s true earnings power.
Excess bottom-line growth was largely propelled by significant share buybacks – the outstanding share count is down by almost 18% over the last decade.
Looking forward, CFRA forecasts that Merck will compound its EPS at an annual rate of 10% over the next three years.
This is a reasonable assumption, in my view. It’s also highly compelling in terms of the investment thesis.
Merck’s pipeline is robust, with 53 programs in Phase 2 and 25 programs in Phase 3. The company has time to develop programs because of the multiyear runway for Keytruda.
Speaking of that runway, CFRA notes this: “We see a favorable patent setup for MRK with no key brands losing marketing exclusivity until 2022, and MRK’s growth engine, Keytruda, on patent until 2028. We also expect Keytruda to grow on further uptake in existing cancer indications as well as potential for longer-term approvals in major indications such as breast and colon cancers.”
I don’t see CFRA’s forecast as a high expectation for Merck, based on recent results.
And this would support like dividend growth. So that’s high-single-digit dividend growth potential on top of a 3.4% yield. I like that.
Moving over to the balance sheet, the company’s financial position is solid.
The long-term debt/equity ratio is 1.0, while the interest coverage ratio is over 11.
Shareholders’ equity has been artificially lowered by treasury stock. That’s due to the aforementioned buybacks. This pushes up the debt/equity ratio, but the balance sheet is highly satisfactory.
Profitability is quite robust. Since Keytruda’s arrival, there’s been a pronounced margin expansion.
Over the last five years, the firm has averaged annual net margin of 14.0% and annual return on equity of 20.6%.
Merck is, perhaps, in the best position it’s ever been.
And the company does benefit from durable competitive advantages, including economies of scale, a global distribution network, patents, IP, and R&D.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
Patent cliffs are always a risk with pharmaceutical companies, although Merck is in the midst of a favorable patent period.
Keytruda might simultaneously be the company’s biggest advantage and disadvantage. I say that because it’s starting to become an overwhelming portion of the company’s sales. This linchpin drug could weigh on the business and stock in the future after patent protection comes off.
Any changes to the complex US healthcare system would likely affect Merck.
All pharmaceutical companies have pipeline risk. The pipeline is pressured to produce successful drugs in order to support sales, rationalize R&D, and mitigate patent cliffs.
With these risks out in the open, I still think Merck could be a great long-term investment for dividend growth investors.
That’s particularly true with the stock flat on the year, below its pre-pandemic pricing, and looking attractively valued right now…
Stock Price Valuation
The stock is trading hands for a forward P/E ratio of 13.8, based on the midpoint guidance for this fiscal year’s EPS.
That’s a very low P/E ratio in this market.
Also, the stock’s P/CF ratio of 18.5 is lower than its own five-year average of 19.1.
And the yield, as I showed 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.
I factored in a 10% discount rate and a long-term dividend growth rate of 7%.
This DGR is basically right in line with the company’s demonstrated DGR over the last five years, including the most recent dividend increase of 6.6%.
I’m modeling in a minor acceleration off of those recent numbers, as the payout ratio is low, the 10-year EPS growth rate is in the double digits, and CFRA is expecting a near-term EPS growth rate of 10%.
I don’t see this 7% DGR as an unreasonable hurdle for the company to clear.
If anything, it’s on the conservative side.
The DDM analysis gives me a fair value of $92.73.
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 with what is arguably a cautious valuation, the stock still looks extremely 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 MRK as a 4-star stock, with a fair value estimate of $94.00.
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 MRK as a 4-star “BUY”, with a 12-month target price of $90.00.
I came out in the middle, but we’re all in general agreement here. Averaging the three numbers out gives us a final valuation of $92.24, which would indicate the stock is possibly 21% undervalued.
Bottom line: Merck & Co., Inc. (MRK) is a high-quality company across the board. It’s, perhaps, positioned as well as it’s ever been. With a market-beating yield, a low payout ratio, inflation-beating dividend growth, 10 consecutive years of dividend raises, and the potential that shares are 21% undervalued, this could be one of the best deals in this market for dividend growth investors.
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 MRK’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 99. 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, MRK’s dividend appears Very Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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