Legendary author and investor Benjamin Graham infamously personified the stock market as “Mr. Market”.
Mr. Market is a bipolar next-door neighbor intent on trading securities with you every single day.
Securities can be priced highly when Mr. Market’s mood is manic, whereas securities can be priced lowly when Mr. Market is depressed.
It should go without saying that it’s far better to buy from Mr. Market when he’s in a depressed mood.
Well, Mr. Market has been down in the dumps lately – and it would behoove you to consider taking advantage.
But don’t take advantage and buy blithely.
Consider doing so in a targeted, focused way.
I can tell you what I’m doing.
I’m buying high-quality dividend growth stocks from Mr. Market.
Well, these stocks represent equity in some of the best businesses on the planet.
Don’t believe me?
Check out the Dividend Champions, Contenders, and Challengers list.
This list contains invaluable information on hundreds of US-listed stocks that have raised dividends each year for at least the last five consecutive years.
You’ll notice many household names on that list.
That’s because it takes a special kind of business to be able to routinely increase its dividend, which requires that business to routinely increase its profit.
I’ve been buying these stocks for years.
I built my FIRE Fund by doing that.
This is my real-money portfolio, and it produces enough five-figure passive dividend income for me to live off of.
I’ve been fortunate enough to be able to live off of passive dividend income for a long time now.
In fact, I quit my job and retired in my early 30s.
I share in my Early Retirement Blueprint how I was able to accomplish this.
But that’s only because of how great these stocks tend to be.
However, as great as these stocks can be, valuation at the time of investment is critical.
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.
Taking advantage of Mr. Market’s depressive moods, and doing so in a focused way by buying high-quality dividend growth stocks when they’re undervalued, is a fantastic way to build serious wealth and passive income over the long term.
Now, this does require one to have a basic understanding of valuation in the first place.
But this isn’t all that difficult.
Dave Van Knapp, my colleague, put together Lesson 11: Valuation in order to help you form that understanding.
As part of a comprehensive series of “lessons” on dividend growth investing, it describes a valuation process that can be easily applied toward 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…
Prudential Financial, Inc. (PRU) is a global, diversified insurance company that offers life insurance, annuities, investment management, retirement plan services, and other financial products and services.
Founded in 1875, Prudential Financial is now a $34 billion (by market cap) major financial player that employs more than 40,000 people worldwide.
The company serves approximately 50 million customers across 40 different countries.
Prudential Financial reports operations across the following four segments: U.S. Businesses, 44% of FY 2021 pretax segment operating profit; International Businesses, 38%; and Investment Management, 18%.
Prudential Financial is one of the largest insurance companies in the world.
And what a great business model insurance is.
On its face, it seems like a pretty pedestrian way to make money.
You charge premiums to insure, and you pay out when claims are made.
If you can underwrite prudently, there’s a good opportunity to make some decent coin in that process.
However, this misses the point.
The point is that there’s often a significant lag in time between premiums collected and claims paid.
This time slippage allows for low-cost capital accrual, which is called the “float”.
The float can be massive, and it can generate a ton of profit – in many cases, even more profit than core underwriting.
It’s ingenious, and it’s why Warren Buffett started to build his fortune by way of insurance decades ago.
But Prudential Financial kicks things up a notch by combining insurance with asset management.
Via its PGIM business, with $1.4 trillion in assets under management, Prudential Financial is also one of the world’s largest asset managers.
This is yet another great business model, as asset managers are able to charge fees on global assets that should continue to benefit from the rising tide (global productive output) lifting all boats (global assets).
Prudential Financial has been doing well for many decades already, and it should continue to grow its revenue, profit, and dividend for many decades yet to come.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Already, the company has increased its dividend for 14 consecutive years.
The 10-year dividend growth rate is 12.5%, which is great, but more recent dividend increases have been in the mid-single-digits.
The last dividend increase, announced in February, was 4.3%.
The dividend growth rate has come down.
But the yield has come up.
Indeed, the stock currently yields 5.3%.
That is a rather high yield in both absolute and relative terms, and I think it appropriately compensates for the lower growth.
For the sake of comparison, it’s 80 basis points higher than the stock’s own five-year average yield.
And with a payout ratio of 40.4%, based on TTM adjusted EPS, the outsized dividend looks secure.
So we’ve had a shift from a lower yield and higher dividend growth rate in the past to a higher yield and lower dividend growth rate today.
This shift has made Prudential Financial particularly suitable for income-oriented dividend growth investors.
Yields, in general, have moved up, but I see the overall package here as pretty compelling.
Revenue and Earnings Growth
As compelling as these numbers might be, they’re largely looking at what’s already transpired.
However, investors risk today’s capital for the rewards of tomorrow.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will later be of great help when it comes time to estimate the stock’s 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.
And I’ll then unveil a near-term professional prognostication for profit growth.
Amalgamating the proven past with a future forecast in this way should give us the kind of data we need in order to formulate an idea about where the business might be going from here.
Prudential Financial’s revenue has decreased from $84.8 billion in FY 2012 to $70.9 billion in FY 2021.
While I never like to see a drop in revenue, this is easily explainable.
Per the company’s FY 2013 annual report: “In 2012, we completed two significant non-participating group annuity pension risk transfer transactions for which the premiums associated with these transactions represented approximately 38% of Prudential Financial’s 2012 total consolidated revenue.”
Annual revenue on either side of FY 2012 had a 4-handle on it, so we can see that the company has meaningfully grown its revenue over the last decade.
Meanwhile, earnings per share increased from $1.05 to $19.51 over this period, which is a CAGR 38.4%.
The company’s growth over the last 10 years looks extremely strong at first glance.
However, the numbers are also quite messy – frequent sizable adjustments have to be taken into account.
I always like to use a decade’s worth of data as a proxy for the long term.
In this case, though, I think it’s insightful to zoom in on the last five years.
EPS came in at $17.86 for FY 2017, so we’re looking at a five-year CAGR of 2.2% for EPS.
In my view, the truth lies closer to the latter number than the former.
And that means the recent deceleration of the dividend growth rate makes a lot of sense.
It’s also why I would continue to expect the dividend to grow at a mid-single-digit rate per year.
Looking forward, CFRA has no three-year forecast for Prudential Financial’s EPS growth.
This is disappointing, as I do like to compare a historical result with a near-term professional prognostication.
That said, CFRA does provide this nugget: “We forecast segment operating revenues will rise by 4% to 6% in 2022 and by 3% to 5% in 2023.”
If we assume that bottom-line growth would track this top-line growth, which certainly isn’t crazy, we’re basically looking at a firm growing at a mid-single-digit rate across the board.
And that hearkens back to what I was just saying about dividend growth rate expectations.
For additional color around this subject, I last studied CFRA’s report on Prudential Financial in September 2020.
At that time, CFRA was projecting a 4% CAGR for Prudential Financial’s EPS over the coming three years.
I believe that’s fair.
So we’ve got an insurance and asset management business that could grow its revenue, EPS, and dividend at somewhere around 5% annually over the next few years.
Prudential Financial’s float should benefit from rising rates, but difficult market conditions work against their AUM fees.
In the end, I think a setup for ~5% growth is more than acceptable when you pair it with a 5%+ starting yield.
Moving over to the balance sheet, the company has a rock-solid financial position.
The long-term debt/equity ratio is 0.3.
The company’s long-term senior debt has the following investment-grade credit ratings: A, Standard & Poors; A3, Moody’s; A-, Fitch.
Profitability is solid for the industry, although the irregularity of GAAP results clouds the picture.
Over the last five years, the firm has averaged annual net margin of 6.9% and annual return on equity of 8.1%.
Prudential Financial isn’t exciting.
Instead, this is the kind of “boring” business that can slowly but steadily deliver wealth and growing income for its shareholders over the long run, which I think is actually quite exciting.
And with economies of scale, “sticky” assets, and established policies, 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.
The company’s exposure to global capital markets can negatively impact AUM and collectable fees during extremely volatile periods.
Further pressuring fees, the industry is facing a secular move toward passive instruments with lower fees.
Underwriting must remain prudent, but the long-term nature of life insurance makes this difficult to assess in real-time.
Rising rates are favorable, but any turn toward lower rates in the future could harm the power of the company’s float.
Broad geographic diversification is a strength, but it also adds geopolitical and currency risks.
The risks are worth weighing, but the quality and valuation of the business are also worth weighing.
With the stock down nearly 30% from its 52-week high, the valuation looks very appealing…
Stock Price Valuation
The stock’s P/E ratio is 7.6, based on TTM adjusted EPS.
Even for a company only growing at a mid-single-digit rate, that’s low.
It’s not even close to the broader market’s earnings multiple.
It’s also well off of the stock’s own five-year average P/E ratio of 8.5.
We can see the P/S ratio of 0.5 is lower than its own five-year average of 0.6.
Adjusted book value of $104.19 per share is measurably higher than the current share price.
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 5%.
It’s simple for me.
Everything we’ve gone over points to a company that has grown, can grow, and should grow at a mid-single-digit rate.
That applies to revenue, EPS, and the dividend.
There will likely be better years, and there will likely be worse years.
That’s how it goes in business.
But averaging things out, this is what I see for Prudential Financial.
The DDM analysis gives me a fair value of $100.80.
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 comes out looking undervalued, even after putting it through what I feel was a very rational valuation model.
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 PRU as a 4-star stock, with a fair value estimate of $105.00.
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 PRU as a 3-star “HOLD”, with a 12-month target price of $102.00.
We have a super tight consensus here. Averaging the three numbers out gives us a final valuation of $102.60, which would indicate the stock is possibly 14% undervalued.
Bottom line: Prudential Financial, Inc. (PRU) has put two terrific business models under one roof, and the company’s Rock of Gibraltar logo befits this rock-solid firm. With a market-smashing 5.3% yield, mid-single-digit dividend growth, a low payout ratio, nearly 15 consecutive years of dividend increases, and the potential that shares are 14% undervalued, income-oriented dividend growth investors ought to take a very close look at this name right now.
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 D&I: How safe is PRU’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 75. 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, PRU’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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Source: Dividends & Income