The US stock market.

It’s been a compounding machine unlike the world has ever seen.

As such, it’s one of the biggest and best long-term wealth creators known to man.

But it can’t work for you if you don’t take advantage of it.

You have to be in it to win it. 

I’ve been in it for more than a decade now.

And it’s worked magic for me.

I went from below broke at age 27 to financially free at 33.

I retired in my early 30s, as I share in my Early Retirement Blueprint.

Regularly putting my day job savings to work in the market is what allowed for this.

But I didn’t buy stocks blindly.

I’ve always focused on high-quality dividend growth stocks.

These are stocks that pay reliable, rising dividends to their shareholders.

Reliable, rising dividends are funded by reliable, rising profits.

And reliable, rising profits are only possible when you’re running a world-class business.

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

I built a real-money portfolio that’s chock-full of these stocks.

I call it the FIRE Fund.

And it produces enough five-figure passive dividend income for me to live off of.

Jason Fieber's Dividend Growth PortfolioWhile buying and holding high-quality dividend growth stocks could be the best way to approach the market, valuation is always important.

Price only tells you what you pay. But value tells you what you actually 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.

Buying high-quality dividend growth stocks when they’re undervalued, and holding for the long term, could be the best possible way to take advantage of the US stock market.

Fortunately, the process of valuation isn’t as difficult or complex as it might seem.

Fellow contributor Dave Van Knapp’s Lesson 11: Valuation, which is part of an overarching series on dividend growth investing, lays out a valuation system that can be easily 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…

Gilead Sciences, Inc. (GILD)

Gilead Sciences, Inc. (GILD) is a biopharmaceutical company that develops and markets therapies to treat a variety of life-threatening diseases.

Founded in 1987, Gilead is now an $84 billion (by market cap) drug colossus that employs more than 13,000 people.

The company’s three primary disease areas are viral diseases, inflammatory diseases, and oncology.

Gilead focuses heavily on HIV and hepatitis B and C.

Their HIV franchise accounted for approximately 70% of FY 2020 sales. Biktarvy, which treats HIV, is their most important drug, making up about 29% of total FY 2020 sales.

Geographically, the US is by far their biggest market. The US accounted for approximately 74% of FY 2020 sales.

Gilead has been, in some ways, a victim of its own success.

That’s in part because they developed Sovaldi, a cure for hepatitis c.

When you cure people rather than simply treat them, that naturally leads to less product sales down the line as those cured people stop needing medicine.

In addition, their somewhat narrow focus on diseases like HIV that impact a relatively small percentage of the population also limits their possible customer pool.

So while Gilead should be applauded for providing life-saving treatments to people that desperately need them, investors have had to be a bit more patient with Gilead than the average pharma company.

Making it easier to remain patient has been the large and growing dividend they pay to shareholders.

Dividend Growth, Growth Rate, Payout Ratio and Yield

Gilead has increased their dividend for seven consecutive years.

The three-year dividend growth rate of 9.4% shows the level of growth they’re capable of delivering.

And that’s paired with a market-beating yield of 4.2%.

That’s in the range of what many utilities and REITs are yielding right now, which is unusual for a stock like this.

I think that underscores its income appeal.

This yield, by the way, is 70 basis points higher than the stock’s own five-year average yield.

And the dividend is protected by a low payout ratio of 40.1%, based on midpoint guidance for this fiscal year’s adjusted EPS.

These dividend metrics are very nice, with the yield, growth, and payout ratio checking all the right boxes.

Revenue and Earnings Growth

As good as these numbers are, though, they’re looking at what’s already transpired.

But investors risk today’s capital for tomorrow’s rewards.

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

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 show you a professional prognostication for profit growth.

Putting the proven past up against a future forecast in this way should allow us to have a good idea about where the business might be going from here.

Gilead increased its revenue from $8.4 billion in FY 2011 to $24.7 billion in FY 2020.

That’s a compound annual growth rate of 12.8%.

Great top-line growth.

However, it’s important to keep in mind that revenue most recently peaked in FY 2015 at over $32 billion for that year. Sovaldi was approved by the FDA in late 2013, which led to a burst in sales for Gilead over the following few years.

Earnings per share increased from $1.77 to $7.09 (adjusted) over this period, which is a CAGR of 16.7%.

It’s a fantastic 10-year growth picture that has to be viewed within the context of mid-decade explosive growth which has recently cooled.

A lot of excess bottom-line growth was driven by share repurchases. The outstanding share count is down by 20% over the last decade.

Looking forward, CFRA is forecasting that Gilead will compound its EPS at an annual rate of 2% over the next three years.

I last looked at CFRA’s three-year EPS growth forecast for Gilead in May, at which time it was 6%.

It’s odd to see the forecast change so dramatically in such a short period of time, despite Gilead printing a very solid Q2 report in July that saw 21% YOY revenue growth, general improvement across the board, and upped FY 2021 sales and adjusted EPS guidance.

In addition, while the three-year growth forecast has been lowered, CFRA has simultaneously increased their 12-month target price on the stock. I’m not sure how you rationalize that.

The pipeline is strong, with 51 clinical stage programs.

Gilead has also broadened itself out into oncology, most notably and most recently with the $21 billion acquisition of Immunomedics. Key cancer drug Trodelvy received FDA approval in April 2020. This drug is expected to do $3.5 billion in annual sales by 2026.

Now, I will say that Gilead has temporarily benefited from increased sales of Veklury (branded remdesivir) to treat COVID-19.

Still, taking a longer view of the business, I think they’re capable of much more than low-single-digit bottom-line growth.

This is a company that’s doing triple the revenue and double the free cash flow they were doing a decade ago, on 80% of the share float.

I don’t have super high expectations for Gilead, simply due to their narrow focus.

But I don’t see mid-single-digit EPS and dividend growth as a difficult hurdle for them to clear. And with a 4%+ starting yield, that’s nothing to shake your fist at.

Financial Position

Moving over to the balance sheet, the financial position is good.

The balance sheet has deteriorated in recent years, with Gilead seeking out growth through acquisitions. But their financial position is not weak.

The long-term debt/equity ratio of 1.7 looks high at first glance. But it’s more a function of low common equity than high debt.

The interest coverage ratio is N/A for FY 2020. This is due to unusually volatile GAAP earnings.

The interest coverage ratio for FY 2019 was over 6, indicating no issues with servicing debt. Their interest expense has not substantially increased YOY.

Unsurprisingly, profitability is vigorous.

Over the last five years, the firm has averaged annual net margin of 21.5% and annual return on equity of 29.3%.

The company is fundamentally sound, bordering on excellent.

But a sales collapse from curing HCV caused the stock to start collapsing around the summer of 2015. The stock is actually down over the last five years.

Expectations are low. Revenue is on the upswing. And the portfolio is broadened.

I think there’s a lot to like about that setup.

And with economies of scale, IP, patents, R&D, inelastic demand for products, and an established relationship with partners, the company does benefit from durable competitive advantages.

Of course, there are risks to consider.

Regulation, litigation, and competition are omnipresent risks in every industry.

I view all three of these risks as elevated within the pharma space.

The slowing HCV market and incoming generics for HIV threaten the company’s sales base.

There’s integration risk with Immunomedics, with pressure on Trodelvy to perform.

And there’s pipeline risk. New blockbuster drugs must overcome slowing sales from older drugs.

With these risks stated, I still think there’s a long-term investment case that can be made.

That’s especially true with the valuation being as low as it is…

Stock Price Valuation

The P/E ratio is 16.6.

That’s quite low in this market.

Moreover, the forward P/E ratio, using midpoint guidance for this fiscal year’s adjusted EPS, is only 9.6.

And the yield, as noted earlier, is significantly higher than its own five-year 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 9% discount rate (to account for the high yield) and a long-term dividend growth rate of 5%.

This is the mid-single-digit long-term growth I discussed earlier.

I’m not putting undue expectations on the business here. There’s nothing to indicate that Gilead can’t perform at this, admittedly middling, level over the coming years.

If anything, Gilead should be able to do quite a bit better than this.

But I’d rather err on the side of caution, as Gilead has had issues over the last few years with managing its portfolio.

The DDM analysis gives me a fair value of $74.55.

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 cautious 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 GILD as a 4-star stock, with a fair value estimate of $81.00.

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 GILD as a 3-star “HOLD”, with a 12-month target price of $70.00.

I came out somewhere in the middle this time around. Averaging the three numbers out gives us a final valuation of $75.18, which would indicate the stock is possibly 11% undervalued.

Bottom line: Gilead Sciences, Inc. (GILD) is a high-quality pharmaceutical company that is set up to do well, despite low expectations. With a market-beating 4%+ yield, inflation-beating dividend growth, a low payout ratio, and the potential that shares are 11% undervalued, dividend growth investors should consider loving this unloved stock.

-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 GILD’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 70. 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, GILD’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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