As the US stock market continues to lurch higher, investors have a dilemma.
On one hand, it’s nice to see the brokerage accounts sport higher numbers.
On the other hand, opportunities to put new capital to work are seemingly fewer and farther between.
But opportunities haven’t completely disappeared.
It’s just that deals may not be quite as good as they were a year ago.
However, we can’t go back in time; we must look at what’s available today.
Moreover, there are degrees of attractiveness.
This mantra has helped me to build out my FIRE Fund.
That’s my real-money stock portfolio.
It produces enough five-figure passive dividend income to live off of.
I built this portfolio using the tenets of dividend growth investing.
This is a long-term investment strategy that advocates buying and holding shares in high-quality businesses that pay reliable, rising dividends.
You can find hundreds of examples of these stocks by checking out the Dividend Champions, Contenders, and Challengers list.
This investment strategy is so powerful and amazing, it helped me to retire in my early 30s.
My Early Retirement Blueprint explains exactly how I used this strategy to retire so early in life.
Like I said, there are degrees of attractiveness.
After all, price is only what you pay. It’s value that 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.
There are undervalued high-quality dividend growth stocks to be found in any and every market, and finding them will bode well for your long-term success as an investor.
Fortunately, finding them isn’t as difficult as you might think.
Fellow contributor Dave Van Knapp has made that process a lot easier with his Lesson 11: Valuation.
Part of a comprehensive series of “lessons” on dividend growth investing, it provides you with a valuation system 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…
3M Company (MMM) is a diversified global manufacturing conglomerate.
Founded in 1902, they’re a $107 billion (by market cap) industrial behemoth that employs 95,000 people.
3M operates across four business segments: Safety and Industrial, 34% of FY 2020 sales; Transportation and Electronics, 26%; Healthcare, 25%; Consumer, 16%. Corporate and Unallocated accounted for the remainder.
The Americas accounted for 51% of FY 2020 revenue; 30%, Asia Pacific; 19%, Europe, Middle East, and Africa.
The company focuses on applying science across 12 areas of expertise: Automotive; Design & Construction; Manufacturing; Commercial Solutions; Electronics, Mining, Oil & Gas; Communications; Energy; Safety; Consumer; Healthcare; and Transportation.
Their products are used in various end applications, including appliances, packaging, aerospace, electronics, construction, surgical supplies, telecommunications networks, and renewable energy.
3M has numerous brands that convey quality and consistency both on the consumer and industrial sides.
Some of their brands are: Scotch, Scotchgard, Post-it, Scotch-Brite, ACE, and the eponymous 3M.
This is a very large and diversified global industrial company with incredible breadth, which touches almost every facet of life across the world.
As society prospers, so should 3M. There’s almost no future in which 3M isn’t prospering.
As long as society continues to advance, so should 3M.
This augurs well for their ability to increase their profit and their dividend over the long run.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Already, 3M is a legend in this respect.
They’ve increased their dividend for 63 consecutive years.
That’s one of the longest such track records in existence, spanning wars, recessions, and even the pandemic.
This easily qualifies them to be a Dividend Aristocrat.
It also crowns them a Dividend King. Dividend Kings are stocks that have increased their dividends for 50 or more consecutive years.
Their double-digit 10-year DGR of 10.8% is also impressive, although recent dividend increases have been rather modest.
While dividend growth of late has slowed, the current yield has risen to 3.2%.
So it’s a dynamic where you’re getting more yield in lieu of the growth.
That yield, by the way, is more than twice as high as what the broader market offers.
It’s also 40 basis points higher than the stock’s own five-year average yield.
And with the payout ratio at only 58.6%, this is a well-covered dividend.
Revenue and Earnings Growth
These are fantastic dividend metrics.
As great as these metrics are, though, they’re looking backward.
Investors are risking today’s capital for tomorrow’s rewards.
It’s future dividends and growth we care most about.
As such, I’ll now build out a forward-looking growth trajectory for the company, which will later aid in estimating the stock’s intrinsic value.
I’ll first show you what 3M’s top-line and bottom-line growth over the last decade.
Then I’ll show you a near-term professional prognostication for profit growth.
Taking a blended approach and and amalgamating this data should give us a reasonable idea as to where the company might be going from here.
3M increased its revenue from $29.611 billion in FY 2011 to $32.184 billion in FY 2020.
That’s a compound annual growth rate of 0.93%.
Meanwhile, earnings per share moved up from $5.96 to $9.25 over this period, which is a CAGR of 5.01%.
Now, 5% isn’t lighting the world on fire. However, I actually see this as rather solid – the ending year of this period (2020) involved a global pandemic and worldwide economic shutdowns.
A lot of excess bottom-line growth came about from buybacks, with 3M reducing its outstanding share count by 19% over the last decade.
Looking forward, CFRA believes that 3M will compound its EPS at an annual rate of 11% over the next three years.
That would represent a nice acceleration of bottom-line growth relative to what 3M has produced over the last 10 years.
Somewhat interesting is CFRA’s take on 3M’s asymmetric risk-reward profile.
They say this: “A diverse product and geographic base allows 3M to outperform the economy in periods of economic weakness, in our view – 2020 EPS was down just 2% vs. 2019, while the S&P 500’s fell 13%.”
And then there’s this: “We also see 3M outperforming the broader economy as vaccinations quell the pandemic and drive reopening, thanks to high exposure to the residential construction boom and rebounding end-markets like autos, manufacturing, and general medical supplies.”
Less downside and more upside. That’s the best of both worlds.
If 3M is able to perform as CFRA is forecasting, that would set them up for at least mid-single-digit dividend growth for the foreseeable future.
And that’s the base case I’m working with.
Moving over to the balance sheet, 3M’s rock-solid financial position is another reason to like the business.
They have a long-term debt/equity ratio of 1.40.
While that looks high at first glance, it’s largely because of treasury stock (relating to the buybacks) artificially weighing on shareholders’ equity.
The interest coverage ratio of over 13 tells the better story, which is one of no issues whatsoever with the debt load or the servicing of it.
Profitability is consistent and robust.
Over the last five years, the firm has averaged annual net margin of 15.89% and annual return on equity of 45.80%.
3M is a blue-chip Dividend King with one of the most reliable dividends you’ll find, and they could be on the cusp of a growth renaissance.
And the company is protected by durable competitive advantages like economies of scale, brands, patents, IP, and a large R&D platform for innovation.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
I see litigation as a bigger risk for 3M in particular, compared to regulation and competition.
As diversified as 3M is, a global recession would impact them due to exposure to cyclical end markets.
Their 2019 $6.7 billion acquisition of medical products maker Acelity, Inc., which is 3M’s largest acquisition ever, has integration and execution risks. This acquisition reduced the company’s flexibility and balance sheet strength. It’s still a question as to whether or not this will be an accretive acquisition.
The R&D spending is high and must be rationalized through new products.
With these risks known, I still believe that 3M could be a great long-term investment for dividend growth investors.
The current valuation only makes me more enthusiastic…
Stock Price Valuation
The P/E ratio is sitting at 18.3, which is quite a bit lower than the broader market’s earnings multiple.
It’s also significantly lower than the stock’s own five-year average P/E ratio of 22.5.
The P/CF ratio of 12.7 is also well off of its own five-year average of 16.7.
That’s despite the fact that there could be a near-term growth acceleration setting upon 3M.
The stock arguably deserves a higher-than-average multiple, yet it’s getting a lower-than-average multiple.
And the yield, as noted earlier, is materially 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 can look aggressive or conservative, depending on your perspective.
Against recent dividend increases and the 10-year EPS growth rate, it looks aggressive.
On the other hand, it looks conservative against the 10-year demonstrated DGR and CFRA’s near-term EPS growth forecast.
I’m basically splitting the difference here, assuming that dividend growth going forward will be better than it’s recently been (but not as high as the 10-year DGR).
The payout ratio is moderate, and EPS growth is expected to be strong over the next few years. I think 3M is fully capable of delivering mid-single-digit dividend growth from here.
The DDM analysis gives me a fair value of $211.15.
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.
After a down-the-middle pitch, the stock’s valuation looks like a home run.
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 MMM as a 3-star stock, with a fair value estimate of $195.00.
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 MMM as a 4-star “BUY”, with a 12-month target price of $224.00.
I came out roughly in the middle here. Averaging the three numbers out gives us a final valuation of $210.05, which would indicate the stock is possibly 13% undervalued.
Bottom line: 3M Company (MMM) is a blue-chip Dividend King with incredible scale, diversification, and breadth. And their future could look even better than their past, which is already legendary. With a market-beating yield, more than 60 consecutive years of dividend increases, double-digit long-term dividend growth, a moderate payout ratio, and the potential that shares are 13% undervalued, this classic dividend growth stock looks on sale.
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 MMM’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, MMM’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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