Investors are spooked.

The pandemic isn’t totally behind us.

Rising rates are on the horizon.

And now war is raging in Ukraine.

While the war is more of a humanitarian concern than anything else, investors always have to be mindful of geopolitical concerns.

Geopolitical concerns are always present.

It’s just that investors aren’t always aware of them.

The situation in Ukraine has reminded us of how fragile global peace is.

But what do investors do about this now?

Well, I’d argue that what investors should be doing now is what they should always be doing.

They should be building a broadly diversified portfolio of world-class businesses for the long term.

Jason Fieber's Dividend Growth PortfolioThat’s exactly what I’ve been doing for more than a decade.

The result of this behavior is my FIRE Fund.

That is my real-money portfolio, and it produces enough five-figure passive dividend income for me to live off of.

Indeed, receiving enough passive dividend income to live off of allowed me to retire in my early 30s.

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

A major pillar of that Blueprint is the investment strategy I’ve used to get here.

That strategy is dividend growth investing.

The FIRE Fund is chock-full of high-quality dividend growth stocks.

I’m talking about stocks like those you’ll find on the Dividend Champions, Contenders, and Challengers list.

These stocks represent equity in some of the best businesses on the planet.

That’s because only world-class businesses can reliably and consistently increase their profits and their dividends for decades on end.

As great as these stocks are, valuation at the time of investment remains crucial.

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.

Buying high-quality dividend growth stocks when they’re undervalued, and building out a broadly diversified portfolio in the process, should set you up for incredible success over the long term.

The valuation process might seem complicated, but it’s really not.

Fellow contributor Dave Van Knapp has made that process easier than ever through Lesson 11: Valuation.

Part of a rigorous series of “lessons” on dividend growth investing, it distills the valuation process into the essential and provides an easy-to-follow template that can be used to estimate the fair value of 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…

Merck & Co., Inc. (MRK)

Merck & Co., Inc. (MRK) is a leading global pharmaceutical company that produces a range of medicines, vaccines, and animal healthcare products.

Founded in 1891, Merck is now a $198 billion (by market cap) healthcare giant that employs nearly 68,000 people.

The company operates across two reportable segments: Pharmaceutical, 88% of FY 2021 sales; and Animal Health, 11%. Insignificant sales occur as Other Revenue.

Their core areas of focus are: diabetes, infectious diseases, oncology, vaccines, and animal health.

The US is the company’s largest market, accounting for over 40% of worldwide sales.

Some of the company’s key drugs include Keytruda, Januvia, Gardasil, and ProQuad.

Keytruda, their triumphant cancer drug, is the company’s most important product. It’s by far the top-selling drug in their portfolio.

This single drug comprised 35% of the company’s worldwide sales for FY 2021. That compares to nearly 30% of company revenues for FY 2020.

What’s exciting about Keytruda is that it’s becoming a larger piece of a growing pie. The company’s top-selling product is also one of its fastest-growing products.

With over $17 billion in sales for FY 2021, Keytruda is one of the top drugs on the planet – second only to Humira. It’s expected to be the best-selling drug in the world within a few years.

Based on recent growth, that seems highly plausible: Keytruda sales were up 20% YOY for FY 2021.

Notably, this drug is on patent through 2028 in the US and EU.

There are two appealing aspects about investing in Merck at this time.

First, Merck has almost no exposure at all to the crisis occurring in Ukraine.

If this were, say, a European energy company highly intertwined with Russian-based O&G enterprises, I’d be concerned. But this is a US-based pharmaceutical company. It’s hard to be more insulated than that.

Second, and far more importantly, there’s the secular growth story.

With a global population that is growing larger, older, and wealthier – simultaneously – the world’s demand for quality healthcare will surely continue to increase.

Indeed, it’s quality healthcare that’s helped to get us here in the first place by improving life expectancy.

It’s a virtuous circle at play.

And that bodes extremely well for Merck’s ability to routinely increase its revenue, profit, and dividend over the long run.

Dividend Growth, Growth Rate, Payout Ratio and Yield

As it sits, Merck has increased its dividend for 11 consecutive years.

Not the longest track record around, but they are off to a really good start.

Actually, it’s shifting from really good to great.

Their ten-year dividend growth rate is 5.5%.

That’s solid, but then you have the five-year dividend growth rate at 7.2% and the three-year dividend growth rate at 10.6%.

Their dividend growth rate has been accelerating.

In a normal environment (i.e., not now), this kind of growth easily beats inflation.

And the stock offers a yield of 3.5%.

That’s more than twice as high as the broader market’s yield.

It’s also 50 basis points higher than its own five-year average.

The payout ratio is only 47.3%, based on midpoint guidance for FY 2022 EPS.

That shows a healthy dividend that’s likely headed a lot higher.

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.

Merck is obviously right there.

Revenue and Earnings Growth

As great as these dividend metrics are, though, they’re mostly looking backward.

However, investors are risking today’s capital for tomorrow’s rewards.

And so I’ll now build out a forward-looking growth trajectory for the business, which will later help when it comes time to estimate intrinsic value.

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

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

Lining up the proven past against a future forecast in this way should give us a great backdrop from which to draw conclusions about where the company might be going from here.

Merck increased its revenue from $47.3 billion in FY 2012 to $48.7 billion in FY 2021.

Basically flat.

Not really what you want to see, but there’s a big caveat here.

Keytruda didn’t come on the scene until 2015. Merck’s revenue is up nearly 25% since FY 2015.

Moreover, revenue growth has been blunted by the spinning off of Organon & Co. (OGN) in 2021 – an $8 billion company in its own right.

Meanwhile, earnings per share expanded from $2.00 to $4.86 over this period.

That’s a CAGR of 10.4%.

A combination of margin expansion and share buybacks helped to propel a lot of this relatively impressive bottom-line growth.

For perspective on the buybacks, the outstanding share count has been reduced by 17% over the last 10 years.

Looking forward, CFRA believes that Merck will compound its EPS at an annual rate of 10% over the next three years.

This would be right in line with what Merck produced over the last decade.

I think that’s a fair assessment of the situation, but it could prove to be conservative.

I say that because the last decade was partially marred by an era that predated Keytruda.

With Keytruda putting up some great numbers and still under the patent umbrella until almost the end of this decade, Merck’s near-term prospects are brighter than ever before.

In addition, the company has a robust pipeline in preparation for a future in which Keytruda no longer has its patent protection.

They have 75 programs in Phase 2 and 28 programs in Phase 3. The company has a favorable timeline to develop programs because of the multiyear runway for Keytruda.

But even if they do only ring up 10% annual EPS growth over the next few years, which would still be great, the company would be free to hand out dividend raises that are at least on this level.

Better yet, the low payout ratio could allow them to be even more generous.

And when you’re already starting off with a 3.5% yield, that’s a great combination of yield and dividend growth.

Financial Position

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

The long-term debt/equity ratio is 0.8, while the interest coverage ratio is over 18.

Profitability is extremely healthy.

Over the last five years, the firm has averaged annual net margin of 14.9% and annual return on equity of 22.7%.

Merck is arguably in the best position it’s ever been in.

Their blockbuster drug Keytruda is growing quickly and under patent protection for years to come, adding support to the recent growth acceleration.

And the company is protected by durable competitive advantages that include economies of scale, a global distribution network, patents, IP, and R&D.

Of course, there are risks to consider.

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

I think all three of these risks are elevated in the pharmaceutical industry specifically.

Patent cliffs are always a concern for Big Pharma, but Merck’s biggest drug is still in a golden period right now.

Keytruda could actually be both the company’s biggest advantage and biggest disadvantage. It’s starting to become an overwhelming portion of the company’s sales. This linchpin drug could weigh on the business and stock in the future after patent protection comes off.

Any changes to the complex US healthcare system would almost certainly directly affect Merck.

There’s also pipeline risk here. The pipeline is pressured to produce successful drugs in order to support sales, rationalize R&D, and mitigate patent cliffs. Fortunately, Merck’s pipeline is strong.

The risks should be thoughtfully considered, but I think Merck is still a great long-term investment candidate.

That’s especially true with the valuation looking so appealing after a 15% drop from its 52-week high…

Stock Price Valuation

The stock is now trading hands for a P/E ratio of 16.1.

Well below the broader market’s earnings multiple, this is highly undemanding.

We can also see a P/CF ratio of 14.1 that is way off of its own five-year average of 19.2.

And the yield, as noted earlier, is significantly 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%.

That dividend growth rate can look aggressive or conservative depending on where you stand.

Compared to the 10-year dividend growth rate, it looks aggressive.

But compared to more recent dividend increases, which are being propelled by Keytruda’s growth, it looks conservative.

I think the truth lies somewhere in the middle, which is where I land.

Keep in mind, the payout ratio is still low. And CFRA’s near-term EPS growth forecast is well over this mark.

I believe Merck has the capability to surprise to the upside, but I also like to err on the side of caution.

The DDM analysis gives me a fair value of $98.44.

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 believe my valuation was fair, if not cautious, yet the stock still looks very 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 MRK as a 4-star stock, with a fair value estimate of $94.00.

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 MRK as a 5-star “STRONG BUY”, with a 12-month target price of $101.00.

We have a pretty tight consensus here. Averaging the three numbers out gives us a final valuation of $97.81, which would indicate the stock is possibly 25% undervalued.

Bottom line: Merck & Co., Inc. (MRK) is a high-quality enterprise that is taking advantage of powerful demographic tailwinds. The business has arguably never looked better than it does right now. With a market-beating yield, accelerating dividend growth, a low payout ratio, more than 10 consecutive years of dividend increases, and the potential that shares are 25% undervalued, long-term dividend growth investors should strongly consider adding shares to their portfolios.

— 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 MRK’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 99. 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, MRK’s dividend appears Very Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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