What do investors and surfers have in common?

At first glance, not much.

However, I think it’s clear that they’re both always looking for advantageous entry points.

Surfers want to catch a wave at its trough and ride it to its crest.

Well, investors try to do the same thing… except with stocks.

Investors are always on the hunt for those deals, where high-quality stocks have dropped from recent highs, troughed, and are ready to explode higher.

This is true even for long-term investors like myself, as I’d certainly rather pay less than more for the same stock.

And I’ve “surfed” my way through the markets over the years to great effect.

In fact, I surfed right into retiring in my early 30s.

I share exactly how I did that in my Early Retirement Blueprint.

A major aspect of the Blueprint is the long-term strategy with which I’ve surfed.

It’s dividend growth investing.

This is a long-term investment strategy whereby you buy and hold shares in world-class enterprises that pay reliable, rising dividends.

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

I’ve been using this strategy for more than a decade.

It allowed me to build out my FIRE Fund.

That’s my real-money stock portfolio, which produces the five-figure passive dividend income I live off of.

Jason Fieber's Dividend Growth PortfolioLike I mentioned earlier, investors are always seeking those troughs.

That’s because of the importance of valuation.

While it’s price that you pay, it’s value that you actually end up getting 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.

Buying high-quality dividend growth stocks at troughs, when they’re undervalued, is a great way to get more shares for your money and experience excellent long-term investment results.

And I have great news for you.

Valuation isn’t an extremely difficult concept.

Fellow contributor Dave Van Knapp has made it a lot easier, with Lesson 11: Valuation.

As part of a comprehensive and overarching series of “lessons” on dividend growth investing, it provides an easy-to-follow model that can be used to value almost any dividend growth stock out there.

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…

Philip Morris International Inc. (PM)

Philip Morris International Inc. (PM) is the world’s largest publicly traded tobacco company, engaged in the manufacture and marketing of tobacco and related products.

Originally founded in 1847, Philip Morris International is now a $147 billion (by market cap) global tobacco giant.

FY 2020 revenue can be broken down geographically as follows: European Union, 37%; East Asia & Australia, 19%; South & Southeast Asia, 15%; Eastern Europe, 12%; Middle East & Africa, 11%; and Latin America & Canada, 6%.

They do not directly sell any products in the United States.

The company’s global market share is an estimated 28%, excluding China and the US.

Their incredible market share is due largely to the strength and ubiquity of their Marlboro brand, the #1 cigarette brand in the world.

This one brand alone made up 37% of their total cigarette sales volume for last year.

To say that it’s a dominant brand is greatly understating it.

What’s especially captivating about the investment thesis here is that Philip Morris is combining brand power with the addictive nature of their products.

Most companies do well purely with brand loyalty.

But Philip Morris kicks that up a notch by layering addictive properties on top of it.

This creates an end product that is highly price inelastic – i.e., an increase in price doesn’t significantly reduce demand.

This kind of pricing power is very uncommon.

And that bodes well for the company’s ability to increase its profit and its dividend for many years to come.

Dividend Growth, Growth Rate, Payout Ratio and Yield

Already, Philip Morris has increased its dividend for 14 consecutive years.

That streak is as long as it could possibly be, as it dates back to the company’s initial spin off from former parent company Altria Group Inc. (MO) in 2008.

The five-year dividend growth rate of 3.2% isn’t lighting the world on fire.

However, the stock yields 5.3%.

That’s four times higher than the broader market’s yield, making this a great income play.

This yield is also right in line with its own five-year average.

And with a payout ratio of 82.9%, based on midpoint guidance for this fiscal year’s adjusted EPS, the dividend remains covered and positioned to continue growing at a low-single-digit rate.

In my view, these dividend metrics are clearly desirable for income-oriented investors.

Revenue and Earnings Growth

As desirable as these metrics might be, though, they’re mostly looking at the past.

But investors are risking today’s capital for tomorrow’s rewards.

As a result, I’m now going to build out a forward-looking growth trajectory for the business, which will later aid in the valuation process.

I’ll first show you what the company has done over the last decade in terms of its top-line and bottom-line growth.

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

Comparing the proven past to a future forecast in this manner should give us a reasonable idea as to where the business might be going from here.

Philip Morris’s revenue decreased from $31.1 billion in FY 2011 to $28.7 billion in FY 2020.

Revenue is down mostly because of a secular decline in smoking, which has caused consistent drops in volume year after year.

At first glance, this looks bad.

But I think it’s a lot better than it looks.

The company has experienced steep declines in volumes. For example, FY 2020 showed an 11.1% YOY drop in cigarette volumes.

But even with this backdrop, Philip Morris is able to keep things fairly steady. That’s impressive, in my view.

Moreover, and more importantly, the company actually grew its bottom line on a per-share basis over the last decade.

Earnings per share increased from $4.85 to $5.16 over this 10-year period, which is a CAGR 0.7%.

It’s important to note at this juncture that Philip Morris features an idiosyncratic accounting structure. Their headquarters is in the US. But they don’t sell products in the US. This sets them up for somewhat volatile GAAP EPS when they convert foreign profits back into US dollars.

Share repurchases aided bottom-line growth. The outstanding share count is down by ~12% over this stretch.

We can see that the company is growing its profit and dividend, despite a secular decline in smoking. That sheds light on the pricing power I already noted earlier.

All that said, what’s so compelling about a business that’s basically treading water?

Well, if the company can manage some EPS growth with steep declines in volumes and a strong dollar that reduces its reported GAAP EPS, could it not do a lot better with growth in volumes and a weaker dollar?

I believe so.

And I’m not alone.

Looking forward, CFRA is forecasting that Philip Morris will compound its EPS at an annual rate of 8% over the next three years.

This leads us to the crux of the matter.

The company’s strong pricing power can allow the business to advance at a slow rate, even if volumes are contracting and the dollar is strong.

But a weaker dollar of late works to their favor.

The bigger story, however, is IQOS.

IQOS is their revolutionary heat-not-burn tobacco product.

Whereas traditional cigarette volumes contracted by 11.1% in FY 2020, heated tobacco shipments increased by 27.6%.

Philip Morris is embracing technology and the future of their industry. And it’s helping the company to offset the secular decline in smoking with a product that offers growth potential.

The IQOS is relatively new, but results thus far have been encouraging.

If we look at a more recent bottom-line growth picture, Philip Morris compounded its EPS at an annual rate of 3.6% over the last five years.

There’s a company-wide growth acceleration occurring here. It’s not massive. It takes time to turn a big ship. But it is real.

The worst-case scenario, in my view, is that the dividend continues to grow at a low-single-digit rate. But since the yield is so high, the status quo should be acceptable.

Meanwhile, I see a lot of possible upside as it relates to future dividend growth.

Financial Position

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

The long-term debt/equity ratio is N/A because of negative common equity. But their interest coverage ratio of over 16 indicates no issues whatsoever with their debt load or interest expenses.

Profitability is quite robust, as you’d expect.

They command nearly unrivaled pricing power on high-margin, addictive products.

Over the last five years, the firm has averaged annual net margin of 25.5%. ROE is N/A because of negative common equity.

I view this as a slow-growth, high-yield stock ideally suited for income-oriented investors.

And with a growth acceleration playing out, this stock is arguably more compelling as a long-term investment than it’s ever been.

The company also benefits from durable competitive advantages, including strong pricing power, brand loyalty, global economies of scale, and high barriers to entry.

Of course, there are risks to consider.

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

The very business model introduces regulation and litigation risks that exceed what the average business would typically be exposed to.

There’s also a flip side to that coin. The entrenched players, while competitive with one another, are unlikely to see any major new competition ever. It’s virtually impossible for a new cigarette company to start up today. This has created a global oligopoly.

It’s also important to keep in mind that Philip Morris doesn’t really fall under the regulatory jurisdiction of the US FDA. I view the general US regulatory environment as particularly unfavorable for a company like this. Since Philip Morris doesn’t directly sell products in the US, this reduces some regulatory risk.

The US dollar is a somewhat unique risk because of the aforementioned accounting idiosyncrasy.

A slowing of the worldwide adoption of IQOS would reduce the company’s ability to offset traditional cigarette volume declines. A recent legal setback regarding the company’s ability to market IQOS in the US through Altria Group is evidence of this risk.

Lastly, a further rise in traditional cigarette volumes declines would hurt overall growth.

I believe these risks are tolerable when looking at the whole picture.

And with an appealing valuation, this name looks enticing right now…

Stock Price Valuation

The stock has a P/E ratio of 16.3.

This is well below the broader market’s earnings multiple.

It’s also well off of the stocks own five-year average P/E ratio of 19.2.

Then there’s the P/CF ratio of 13.2, which is significantly lower than its own five-year average of 15.2.

And the yield, as noted earlier, is right in line with 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 an 8% discount rate (to account for the high yield) and a long-term dividend growth rate of 3%.

I’m being conservative with my dividend growth rate.

It’s lower than the company’s demonstrated long-term dividend growth, including the 4.2% dividend increase that was announced in September.

It’s also much lower than CFRA’s near-term EPS growth expectation.

As I stated, there’s a case to be made that future dividend growth can surprise to the upside.

However, I’d rather err on the side of caution, as the long-term EPS growth is below 1% and the payout ratio is somewhat elevated.

The DDM analysis gives me a fair value of $103.00.

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 was fair, if not downright cautious, with my valuation, yet the stock still 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 PM as a 4-star stock, with a fair value estimate of $108.00.

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 PM as a 4-star “BUY”, with a 12-month target price of $110.00.

I’m on the low end this time around. Averaging the three numbers out gives us a final valuation of $107.00, which would indicate the stock is possibly 14% undervalued.

Bottom line: Philip Morris International Inc. (PM) operates a high-margin business that benefits from nearly unrivaled pricing power. Recent growth acceleration portends a bright future. With a market-smashing 5.3% yield, inflation-beating dividend growth, more than a decade straight of dividend increases, and the potential that shares are 14% undervalued, this high-yield stock is ideal for income-oriented long-term dividend growth investors.

-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 PM’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 64. 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, PM’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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Source: DividendsAndIncome.com