At any given time, investors have so many choices.

There are literally thousands of stocks that constitute the US stock market.

So how does one intelligently narrow down the choices?

Well, I’d argue there are two huge factors to consider.

The first factor is quality.

And when I think of quality, my mind immediately goes to high-quality dividend growth stocks.

These are stocks that represent equity in world-class businesses that pay reliable, rising dividends to shareholders.

Jason Fieber's Dividend Growth PortfolioBy their very nature, these are some of the best stocks in the market.

That’s because only truly great businesses can reliably produce the growing profit necessary to sustain ever-higher dividends for decades on end.

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

As you can see, we’ve already narrowed things down from thousands to hundreds of stocks.

I’ve personally invested in high-quality dividend growth stocks over the last decade.

Doing so allowed me to build out my FIRE Fund.

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

Indeed, I no longer need a day job to pay the bills.

Investing in these stocks helped me to retire in my early 30s.

I explain exactly how I achieved this feat in my Early Retirement Blueprint.

So if quality is the first factor, what’s the second?

That would be valuation.

While price is what you pay, value is 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.

Combining high-quality dividend growth stocks with undervaluation is a nearly unbeatable way to generate significant wealth and passive income over the long term.

Fortunately, identifying and taking properly applying these two factors isn’t as difficult as it might seem.

Fellow contributor Dave Van Knapp has greatly simplified one of them for you with Lesson 11: Valuation.

Part of an overarching series of “lessons” on dividend growth investing, it clearly spells out how to value just about 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…

Huntington Ingalls Industries Inc. (HII)

Huntington Ingalls Industries Inc. (HII) is a major American defense company, operating as the largest independent military shipbuilder.

Founded in 1886, Huntington Ingalls is now a $7 billion (by market cap) military mammoth that employs over 14,000 people.

Huntington Ingalls primarily designs, constructs, maintains, and repairs a range of nuclear and non-nuclear ships. These ships include aircraft carriers, submarines, and amphibious assault ships.

The United States Navy is by far their largest customer, comprising almost 90% of the company’s total annual revenue.

The company operates across three segments: Newport News, 60% of FY 2020 revenue; Ingalls, 29%; and Technical Solutions, 14%.

Huntington Ingalls has three advantageous and powerful characteristics working in its favor.

First, there is an endless runway as it pertains to demand for their products.

Sovereign defense is likely to be necessary for as long as sovereign entities exist, as human conflict is part of the human condition. This is just reality.

Second, they’re the only company that manufactures certain products for the US military.

A great example? Nuclear-powered aircraft carriers. If the US military orders a nuclear-powered aircraft carrier, Huntington Ingalls will be the company to get that order and build that product.

Third, defense products continue to become more complex and expensive as time goes on.

This consistent evolution in defense provides a built-in escalator in terms of growth. And it further entrenches the entrenched companies that have the scale and know-how to complete projects.

All of this bodes very well for the company to grow its revenue, profit, and dividend for years to come.

Dividend Growth, Growth Rate, Payout Ratio and Yield

Huntington Ingalls has already increased its dividend for 10 consecutive years.

And I think they’re just getting warmed up with that.

The five-year dividend growth rate of 20.0% is a very nice start, however.

And that big double-digit growth is paired with a starting yield of 2.5%.

That yield is twice as high as what the broader market offers.

It’s also a full 100 basis points higher than the stock’s own five-year average yield.

The one thing I’ll note is that there’s been a recent deceleration in dividend growth.

Of course, investors cannot expect 20% dividend growth to persist forever.

On the other hand, the low payout ratio of 28.3% gives them plenty of cushion to hand out sizable dividend increases in the years ahead.

I like dividend growth stocks in what I refer to as the “sweet spot” – a yield of between 2.5% and 3.5%, paired with a high-single-digit (or better) dividend growth rate.

While this yield is on the low end of that range, the dividend growth has mostly been outstanding.

Revenue and Earnings Growth

Outstanding it might be, but these dividend metrics are mostly looking at the past.

However, investors are putting up today’s capital in order to reap tomorrow’s rewards.

And so I’ll now build out a forward-looking growth trajectory for the business, which will help us to estimate the stock’s intrinsic value and what those future rewards may be.

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

Then I’ll reveal a near-term professional prognostication for profit growth.

Amalgamating the proven past with a future forecast in this manner should give us a reasonable idea of where the business might be going from here.

Huntington Ingalls grew its revenue from $6.6 billion in FY 2011 to $9.4 billion in FY 2020.

That’s a compound annual growth rate of 4.0%.

This is very respectable.

I tend to look for a mid-single-digit top-line growth rate from a large, mature business.

Huntington Ingalls performed to my expectations here.

Meantime, earnings per share increased from $2.91 in FY 2012 to $17.14 in FY 2020, which is a CAGR of 24.8%.

That’s extraordinary.

I’d expect this kind of growth from a high-flying tech company. But it’s shocking to see a rather staid shipbuilder put this up.

Now, some of it stems from a poor starting point – the company reported a relatively low EPS number for FY 2012.

That said, a combination of significant margin expansion and steady share buybacks greatly helped to drive a lot of excess bottom-line growth.

The outstanding share count is down by roughly 15% over the last decade. And net margin is about triple where it was in FY 2012.

I’ll quickly note that I started from FY 2012 and only took a nine-year look at EPS growth here. That’s because the company registered a GAAP loss for FY 2011.

Looking forward, CFRA forecasts that Huntington Ingalls will compound its EPS at an annual rate of 9% over the next three years.

While that would be a marked drop from what the company has produced over the last nine years, it’s not an unreasonable expectation.

The company is starting off in a much better position as it relates to EPS and net margin, so there’s less potential there to really crush those future numbers on a relative basis. They can only expand margins so much.

However, I find it hard to believe that shareholders would be upset to see the company grow its EPS at 9% annually over the next few years. That would be a very solid result.

Helping the company to meet – or even exceed – that kind of expectation would be their massive backlog.

At $50.1 billion, the backlog is more than six times the company’s entire market cap.

An alternative way to look at this backlog would be that it represents more than five times the company’s annual revenue, providing a revenue floor – no matter what’s going on with politics or the economy.

A 9% bottom-line growth rate would allow the company to deliver like or better dividend growth, as the low payout ratio gives them flexibility in that regard.

And when you combine that kind of dividend growth with a 2.5% yield, I see a lot to like about that setup.

Financial Position

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

The long-term debt/equity ratio is 0.9, while the interest coverage ratio is over 8.

Profitability is robust. As I alluded to earlier, the company has expanded margins at a very impressive rate.

Over the last five years, the firm has averaged annual net margin of 7.6% and annual return on equity of 37.1%.

I think there’s much to like about this company and little to dislike.

And the company is protected by durable competitive advantages that include high barriers to entry, large economies of scale, technological know-how, R&D, IP, long-term contracts, switching costs, and a unique government relationship.

Of course, there are risks to consider.

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

Whereas competition is limited, or sometimes non-existent, regulation is amplified by way of direct regulatory oversight.

The very business model has geopolitical risk.

The current Democratic regime in the US government could aim to limit defense spending, which would impact defense companies. The company’s backlog mitigates this risk, though.

Customer concentration is a risk. Huntington Ingalls is almost completely reliant on the US Navy.

Speaking on this risk, CFRA states this: “This concentration on Navy contracting subjects HII to the risk of government funding cuts for major ship programs. The Navy has proven a reliable long-term growth customer, though, and we see increasing
bipartisan support for Navy superiority over non-Democratic nations mitigating funding risk.”

The large backlog introduces execution risk. The company must complete projects in a timely and cost-effective manner in order to avoid backlash, scrutiny, and a possible reduction in order flow.

I see these risks as very acceptable when looking at the big picture.

That’s particularly true when also considering the attractive valuation…

Stock Price Valuation

The stock’s P/E ratio is 11.2.

That’s extremely low in this market. It’s less than half that of the S&P 500’s P/E ratio.

For a company expected to grow at 9%, that implies a PEG ratio of about 1.2.

Even for a company that typically commands a low multiple, it’s almost insulting.

After all, the five-year average P/E ratio for the stock is 15.0.

There’s also a big disconnect when looking at cash flow.

The current P/CF ratio of 6.9 is well off of its own five-year average of 10.6.

And the yield, as noted earlier, is substantially 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 8%.

Admittedly, this dividend growth rate is as high as I’ll go. But I think Huntington Ingalls is positioned to deliver.

The five-year dividend growth rate is well above this level.

And the near-term expectation for EPS growth is also higher than this.

Then you have the low payout ratio, which gives them the ability to increase the dividend even faster than the level at which EPS rises.

In my view, it seems unlikely that the company will fail to grow its dividend at this level over the long term.

The DDM analysis gives me a fair value of $254.88.

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 thought my valuation was fair, yet the stock’s pricing makes it look downright cheap right now.

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 HII 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 HII as a 4-star “BUY”, with a 12-month target price of $240.00.

I came out on the high end, but Morningstar’s number looks awfully low to me. Averaging the three numbers out gives us a final valuation of $229.96, which would indicate the stock is possibly 23% undervalued.

Bottom line: Huntington Ingalls Industries Inc. (HII) is a high-quality company from every angle. And a massive backlog gives them a sales floor moving forward, no matter what’s going on in the world. With 10 consecutive years of dividend raises, a market-beating yield, double-digit dividend growth, a very low payout ratio, and the potential that shares are 23% undervalued, this looks like a clear and present opportunity for 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 HII’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 68. 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, HII’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.