Great businesses tend to command premium valuations.
After all, you get what you pay for.
And the higher the quality of something, the more it should be worth.
That’s why being able to buy a great business at a less-than-premium valuation is the holy grail for long-term investors.
Great businesses can be easy to find.
I think it’s even easier when one is sticking to high-quality dividend growth stocks like those found on the Dividend Champions, Contenders, and Challengers list.
High-quality dividend growth stocks pay reliable, rising dividends to shareholders.
The reason they’re able to do that is because they are often great businesses producing reliable, rising profits.
This is also intuitive.
It’s very difficult to run a bad business and pay out reliable rising dividends for years on end.
My Early Retirement Blueprint explains exactly how I achieved that.
I now control a six-figure dividend growth stock portfolio, which I refer to as the FIRE Fund.
This portfolio produces enough five-figure passive dividend income for me to live off of.
High-quality dividend growth stocks often represent equity in great businesses.
But even with great businesses, valuation is still important.
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.
Investing in a great business at a less-than-premium valuation can lead to truly spectacular results over the long run.
The good news is, estimating intrinsic value isn’t difficult.
Fellow contributor Dave Van Knapp’s Lesson 11: Valuation, which is part of an overarching series of “lessons” on dividend growth investing, provides a template that greatly simplifies the valuation process.
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…
Cummins Inc. (CMI) is a multinational company that designs, manufactures, and distributes engines, filtration, and power generation products.
Founded in 1919, Cummins is now a $33 billion (by market cap) manufacturing giant that employs nearly 58,000 people.
The company reports results across five business segments: Engine, 32% of FY 2020 sales; Distribution, 29%; Components, 24%; Power, 15%; New Power, less than 1%.
Cummins makes most of its money by manufacturing, distributing, and supplying components for a range of diesel and natural gas engines.
A variety of vehicles use these engines. This includes heavy-duty trucks, medium-duty trucks, buses, recreational vehicles, construction machinery, agricultural machinery, and watercraft.
In addition, Cummins is preparing for the future of mobility by investing in fully electric and hybrid powertrain systems, as well as hydrogen fuel cell technology.
This company, in a roundabout way, forms part of the backbone of our industrialized economy. Goods are often produced and moved around using the power generation products that Cummins manufactures.
That’s why it’s been around for more than 100 years, and it’s highly likely it’ll be around for another 100 years (and beyond).
This should translate to continued growth in their profit and dividend.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Already, Cummins has increased its dividend for 16 consecutive years.
Neither the Great Recession nor the pandemic stopped them.
The five-year dividend growth rate is 8.5%.
The stock offers a current yield of 2.5%.
I see that combination of yield and growth – which is in the low double digits – as quite compelling.
This yield is within 20 basis points of its five-year average.
And the payout ratio is a low 39.0%.
These dividend metrics are very, very solid.
Revenue and Earnings Growth
As good as the dividend metrics are, though, they’re looking backward.
However, 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 help in the process of estimating 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.
Lining up the proven past against a future forecast in this way should give us some idea as to where the company might be going from here.
Cummins has increased its revenue from $18.048 billion in FY 2011 to $19.811 billion in FY 2020.
That’s a compound annual growth rate of 1.04%.
Meanwhile, earnings per share grew from $9.55 to $12.01 over this period, which is a CAGR of 2.58%.
These are middling results, at best.
However, as we all know, FY 2020 was extremely unkind to most businesses. Ending this 10-year period on FY 2020 artificially and negatively skews the company’s long-term growth profile.
Cummins has already started to bounce back, though, with TTM EPS at nearly $15.00 – up almost 24% compared to EPS for FY 2020.
Looking forward, CFRA is forecasting that Cummins will grow its EPS at a compound annual rate of 15% over the next three years.
This can look awfully aggressive against the ~2.6% EPS CAGR that Cummins actually produced over the preceding 10 years.
Then again, it doesn’t look aggressive at all when you look at the recovery that’s already taking place for Cummins.
CFRA points out – rightly so – the one-two punch that Cummins offers: Cummins has a strong legacy business that’s also being positioned for the future of mobility. It’s a past-future combination that’s exciting.
CFRA says this: “We expect CMI’s market share for medium-duty trucks to remain strong around 80%. We expect increasing adoption of battery electric powertrains, especially for buses and tractors, in coming years.”
Then they point this out: “CMI benefits from leading-edge technology in truck engines and fuel cell development, aiding market share.”
If you want today’s best propulsion, you’re probably going to Cummins.
If you want tomorrow’s best propulsion, you also probably going to Cummins.
I see CFRA’s near-term EPS growth forecast as reasonable, considering more recent results. That easily sets the company up for continued high-single-digit dividend growth for the foreseeable future.
Moving over to the balance sheet, Cummins has a fantastic financial position.
Their long-term debt/equity ratio is 0.45, while the interest coverage ratio is over 24.
Profitability is consistent and robust.
Over the last five years, the firm has averaged annual net margin of 8.12% and annual return on equity of 23.29%.
I see Cummins as a high-quality company that’s aggressively bouncing back as they position the business for the next century of energy and mobility.
And with economies of scale, switching costs, barriers to entry, IP, R&D, technological know-how, and brand power, the company does have durable competitive advantages.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
Cummins is in a unique situation where they’re often competing with some of their biggest customers (such as truck manufacturers).
The company is directly exposed to economic cycles by catering to heavy industry.
There’s customer concentration risk, with sales to the top four customers accounting for approximately 32% of FY 2020 sales.
If engine technology changes faster than Cummins can adapt, this leaves the company at risk of falling behind.
Any major changes to trucking in general would impact Cummins.
Even with these risks known, I still happen to believe that this company can be a great long-term investment for dividend growth investors.
And after a 15%+ correction from its 52-week high, the stock looks attractively valued…
Stock Price Valuation
The P/E ratio is 15.6.
That’s much lower than the broader market’s earnings multiple.
It’s also quite a bit lower than the stock’s own five-year average P/E ratio of 17.5.
We see a similar disconnect in the cash flow multiple, with the P/CF ratio of 10.4 well off of its own five-year average of 11.5.
And the yield, as noted earlier, is very close to 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 is slightly lower than the demonstrated long-term DGR. It’s also right in line with the company’s most recent dividend increase of 7.4%, which was announced in July.
While it looks high when you see the 10-year EPS growth rate, I see this result as inaccurate.
CFRA is forecasting double-digit EPS growth for the next three years, and the payout ratio is very low. Also, the balance sheet is extremely healthy.
I think this is a fair expectation for future dividend growth.
The DDM analysis gives me a fair value of $249.40.
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 practical valuation model, 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 CMI as a 3-star stock, with a fair value estimate of $230.00.
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 CMI as a 4-star “BUY”, with a 12-month target price of $270.00.
I came out almost exactly in the middle. Averaging the three numbers out gives us a final valuation of $249.80, which would indicate the stock is possibly 8% undervalued.
Bottom line: Cummins Inc. (CMI) is a high-quality company with great fundamentals that’s smartly positioning itself for the future of its industry. With a market-beating yield, inflation-beating dividend growth, a low payout ratio, 16 consecutive years of dividend increases, and the potential that shares are 8% undervalued, dividend growth investors ought to take a good look at this stock right now.
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 CMI’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 98. 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, CMI’s dividend appears Very Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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