“Someone is sitting in the shade today because someone planted a tree a long time ago.”

A sage adage from the Oracle of Omaha.

It’s all about diligently putting capital to work and patiently letting the compounding snowball exponentially expand.

However, I’d argue that planting the right seeds can supercharge this idea.

I’m talking about high-quality dividend growth stocks.

These stocks are some of the best stocks in the market.

That’s because they represent equity in some of the best businesses in the world.

You can see what I mean by perusing the Dividend Champions, Contenders, and Challengers list.

That list contains invaluable information on more than 700 US-listed stocks that have raised dividends each year for at least the last five consecutive years.

Jason Fieber's Dividend Growth PortfolioConsistently rising dividends are, of course, funded by consistently rising profits.

And only truly great businesses can consistently increase both for years on end.

That makes these some of the best “seeds” you’ll find.

I’ve been planting these seeds for years, building my FIRE Fund in the process.

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

Planting these seeds and building the Fund allowed me to retire in my early 30s.

I share in my Early Retirement Blueprint exactly how I was able to retire so early in life.

While I believe that high-quality dividend growth stocks are the right seeds, planting them at the right time is also very important.

And that mostly comes down to valuation at the time of investment.

See, price only tells you what you pay. Value tells you what you 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.

Planting the right seed (a high-quality dividend growth stock) at the right time (when it’s undervalued) can allow you to supercharge Warren Buffett’s advice and end up having it made in the shade.

Spotting undervaluation does require one to have an understanding of the valuation process in the first place.

Fortunately, it’s a lot less difficult than you might think.

Fellow contributor Dave Van Knapp’s Lesson 11: Valuation, which is part of an overarching series of “lessons” on dividend growth investing, provides a valuation template that you can apply to 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…

Cummins Inc. (CMI)

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 $30 billion (by market cap) manufacturing giant that employs nearly 60,000 people.

The company reports results across five business segments: Engine, 32% of FY 2021 sales; Distribution, 32%; Components, 25%; Power, 11%; 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.

Many different types of vehicles use these engines. This includes heavy-duty trucks, medium-duty trucks, buses, recreational vehicles, construction machinery, agricultural machinery, and watercraft.

But that’s not all.

Cummins is also preparing for the future of mobility by investing in fully electric and hybrid powertrain systems, as well as hydrogen fuel cell technology.

It might be easy to assume that Cummins is just an engine company.

However, I think that’s greatly oversimplifying it.

This story is really more about mobility and power generation.

And that’s a bigger and more impactful story than you might think.

For instance, everyday goods are often produced and moved around using the power generation products that Cummins manufactures and distributes.

In a way, Cummins is part of the industrial backbone of the American economy.

I think that’s why Cummins has been such a successful story for more than 100 years. And with their ongoing preparations for exciting new chapters in mobility, the company is positioning itself for more success over the next 100 years.

That augurs well for higher profits and higher dividends for years to come.

Dividend Growth, Growth Rate, Payout Ratio and Yield

Cummins has already increased its dividend for 16 consecutive years.

The 10-year dividend growth rate is an impressive 15.5%.

While impressive, it is important to keep in mind that more recent dividend increases have been in the 8% range.

Still, that’s plenty of dividend growth to go along with the stock’s yield of 2.7%.

That yield easily beats the broader market’s yield.

And it’s right in line with its own five-year average.

With the 39.7% payout ratio, it’s a well-covered dividend positioned for continued growth.

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.

This stock is right in the sweet spot.

Revenue and Earnings Growth

These are good dividend metrics, but they’re also largely 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 in the valuation process.

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 uncover a near-term professional prognostication for profit growth.

Lining up the proven past against a future forecast in this manner should give us a reasonable degree of clarity on where the company might be going from here.

Cummins increased its revenue from $17.3 billion in FY 2012 to $24.0 billion in FY 2021.

That’s a compound annual growth rate of 3.7%.

Solid. Not amazing. But solid.

Meanwhile, earnings per share moved up from $8.67 to $14.61 over this period, which is a CAGR of 6.0%.

Again, solid.

Now, I will say that Cummins operates a cyclical business model.

Therefore, results can be amazing or only so-so depending on the starting point and ending point of a comparison.

For instance, Cummins was knocking it out of the park during the two-year period leading up to the pandemic. The two-year period since the pandemic hit has been more lackluster.

One thing that Cummins has been fairly consistent with, no matter where the cycle might be, is buybacks.

The outstanding share count is down by 23% over the last decade, which helped to drive a lot of that excess bottom-line growth.

Looking forward, CFRA believes that Cummins will compound its EPS at an annual rate of 11% over the next three years.

This looks somewhat aggressive against the 10-year result.

For additional perspective, Cummins itself is guiding for 6% YOY revenue growth for FY 2022. It wouldn’t be difficult for Cummins to get to high-single-digit YOY EPS growth with this kind of revenue support.

An 11% CAGR for EPS would be outstanding, but I don’t think that it’s necessary to make sense of an investment in Cummins.

In my view, an investment in Cummins is a long-term bet on mobility.

What I think is particularly compelling about Cummins in this regard is the one-two punch that it 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 states that its enthusiasm “reflects our outlook for acceleration in truck production volumes in 2022-2023, as well as long-term growth driven by CMI’s investments in electrification of trucks and power generation. We see electrification investments supported by developed economy governments pushing to reduce emissions and accelerate the shift to electric vehicles and electrified machinery.”

If you want the best of today’s propulsion, you’re probably going to Cummins.

If you want the best of tomorrow’s propulsion, you’re probably going to Cummins.

With high-single-digit near-term EPS growth being the base case here, and with the payout ratio being as low as it is, Cummins should be able to produce dividend growth at least in the high-single-digit range for the foreseeable future.

And when you’re already starting with a 2.7% yield, I see plenty to like about that.

Financial Position

Moving over to the balance sheet, Cummins has a terrific financial position.

The long-term debt/equity ratio is 0.4, while the interest coverage ratio is over 25.

Profitability is both robust and consistent, despite some mild cyclical bumps along the way.

Over the last five years, the firm has averaged annual net margin of 8.3% and annual return on equity of 24.2%.

Cummins strikes me as a great long-term investment idea in the industrial space.

And the company does benefit from durable competitive advantages that include economies of scale, high switching costs, tall barriers to entry, IP, R&D, technological know-how, and brand power.

Of course, there are risks to consider.

Competition, regulation, and litigation are omnipresent risks in every industry.

The company has a unique competitive landscape, as they’re often competing against some of their biggest customers (such as truck manufacturers).

There’s a high degree of exposure to economic cycles here.

Cummins has customer concentration risk, with the top four customers accounting for for approximately 30% of annual sales.

There’s technological risk. Propulsion technology could change faster than Cummins can adapt to, or in a way that’s unforeseen.

Any major changes to trucking and/or commercial transportation in general would impact Cummins.

It’s important to take these risks seriously, but I still view Cummins as a great business with qualities that more than offset the risks.

And with the stock more than 20% off of its recent high, the valuation makes it that much more compelling…

Stock Price Valuation

The stock is trading hands for a P/E ratio of 14.4.

That is well below 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 17.0.

And the yield, as noted earlier, is right in line with 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 10% discount rate and a long-term dividend growth rate of 7.5%.

That might look cautious at first glance.

It’s less than half that of the demonstrated 10-year dividend growth rate. The payout ratio is low. And CFRA believes that EPS will grow at a low-double-digit rate for Cummins over the next few years, opening up a path for like dividend growth.

However, the 10-year EPS growth rate is lower than this mark. The company is very cyclical. And dividend growth has been decelerating of late.

Speaking on that last point, it just so happens that the most recent dividend increase was 7.4% – almost exactly where I’m at.

Balancing things out, I think I’m modeling in a reasonable long-term expectation.

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.

I don’t think I was being aggressive at all with my valuation, yet the stock still comes out looking 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 4-star stock, with a fair value estimate of $242.00.

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 $275.00.

We’re all roughly in agreement here. Averaging the three numbers out gives us a final valuation of $255.47, which would indicate the stock is possibly 22% undervalued.

Bottom line: Cummins Inc. (CMI) is a high-quality industrial company with an excellent legacy business that’s allowing them to invest in and prepare for the future of mobility. With a market-beating yield, double-digit long-term dividend growth, a low payout ratio, more than 15 consecutive years of dividend increases, and the potential that shares are 22% undervalued, this clearly looks like a great long-term opportunity for 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 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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Source: DividendsAndIncome.com