Volatility is a constant feature of the stock market.
Stock prices go up and down every single day in which the market is open for business.
But this volatility can be digested a lot easier by focusing on that which isn’t volatile.
I’m talking about dividends.
See, the dividend payments from high-quality companies tend to only move in one direction: up.
At least, that’s how it usually is when you’re dealing with dividend growth stocks.
You can see what I mean by perusing the Dividend Champions, Contenders, and Challengers list.
This list contains a treasure trove of data on hundreds of US-listed stocks that have raised dividends each year for at least the last five consecutive years.
Some dividend growth track records stretch over five decades long!
You’ll notice world-class businesses left and right on this list.
You’ll also notice that the dividend payments from these world-class businesses aren’t volatile at all and only tend to go up each year.
There’s a reason for this, and it comes down to the circular relationship between profit and quality.
A great business can routinely increase its profit by selling the products and/or services the world demands.
It’s about selling more products and/or services, to more people, at higher prices.
As profit increases, so follows the dividend payment to shareholders.
That all circles back around to the business needing to be great in the first place.
And so a lengthy track record of consistent dividend growth is often a very good initial litmus test for business quality.
This is why I’ve stuck to these dividend growth stocks myself over the years, stuffing my FIRE Fund full of them.
That’s my real-money portfolio, and it produces enough five-figure passive dividend income for me to live off of.
I’ve actually been living off of dividends for many years now.
In fact, I was able to retire in my early 30s.
If you’re wondering how I did that, check out my Early Retirement Blueprint for the details.
Suffice it to say, the dividend growth stocks I’ve been buying have been key to my success.
But valuation at the time of buying is also extremely important.
Whereas price 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.
Buying high-quality dividend growth stocks when they’re undervalued can help you to build tremendous wealth and passive income over time, all while greatly helping you to ignore the constant volatility of the stock market by focusing on the non-volatile nature of growing dividends.
Sounds well and good, but valuing a business seems difficult.
Well, it’s not as difficult as you might think.
Fellow contributor Dave Van Knapp has made it far easier with his Lesson 11: Valuation.
Part of a comprehensive series of “lessons” designed to teach the ins and outs of dividend growth investing, it lays out an easy-to-follow valuation guide that can be applied toward 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…
Medtronic PLC (MDT)
Medtronic PLC (MDT) is a global developer and manufacturer of medical devices for chronic diseases.
Founded in 1949, Medtronic is now a $106 billion (by market cap) healthcare titan that employs 95,000 people.
The company reports results across four segments: Cardiovascular, 36% of FY 2022 revenue; Medical Surgical, 29%; Neuroscience, 28%; and Diabetes, 7%.
Medtronic’s product portfolio is comprised of a variety of life-saving and life-improving medical devices that include implantable defibrillators, heart valves, insulin pumps, glucose monitoring systems, pacemakers, stents, and surgical tools.
Healthcare, in general, enjoys secular growth.
Healthcare demand does not correlate with economic cycles.
If one is in need of care, it doesn’t matter whether or not the economy is in a recession – the health issue is all that matters to that person at that point and must be rectified.
The human condition essentially builds in a constant base level of demand for care, as human bodies slowly deteriorate during the aging process.
On top of that, our global population is growing.
The world’s population recently hit eight billion people for the first time.
Simultaneously, people are, on average, living longer than ever before.
Also, the wealth of the average person continues to rise.
This results in more older and wealthier human beings walking around, and you can almost draw a straight line from that demographic shift to increased demand for quality healthcare.
That’s the general state of healthcare.
But Medtronic, specifically, is situated very favorably.
This is due to the inelastic demand for its products.
The spending on these products is usually non-discretionary in nature, especially if it’s a life-or-death situation.
In that kind of situation, pricing is a non-concern.
Let’s say, for example, you need emergency surgery – pricing of medical devices are not likely to be a high priority for you in the moment when you’re more concerned about not dying.
This means Medtronic benefits from constant demand, rising demand, and inelastic demand.
That’s a powerful triad.
If that wasn’t already good enough, Medtronic has also built up advantageous leadership in the areas in which it competes.
Morningstar puts it like this: “Medtronic has historically held roughly 50% share in its core heart devices. It’s also the market leader in spinal products, insulin pumps, and neuromodulators for chronic pain.”
As you can see, Medtronic almost can’t lose over the long run.
That’s why it’s set up so well for continued growth across its revenue, profit, and dividend for years and years to come.
Dividend Growth, Growth Rate, Payout Ratio and Yield
To date, the company has increased its dividend for 45 consecutive years.
That’s one of the longest dividend growth track records in all of healthcare, easily qualifying Medtronic for its status as a respected Dividend Aristocrat.
The 10-year dividend growth rate is 10.3%.
To go along with that strong, double-digit rate of dividend growth, the stock currently yields a market-beating 3.5%.
This yield is 130 basis points higher than its own five-year average, which is a remarkable spread.
And with the payout ratio at 51.6%, based on midpoint guidance for this fiscal year’s adjusted EPS, this is a healthy dividend poised for more growth.
I favor dividend growth stocks in what I call the “sweet spot” – a yield of between 2.5% and 3.5%, paired with a high-single-digit (or higher) dividend growth rate.
This stock is at the higher ends of both yield and dividend growth, making it very, very sweet.
Revenue and Earnings Growth
As sweet as these dividend metrics may be, they are largely looking backward.
However, investors are risking today’s capital for tomorrow’s rewards.
As such, I’ll now build out a forward-looking growth trajectory for the business, which will later be of great use when it comes time to estimate intrinsic value.
I’ll first show you what this company has done in terms of top-line and bottom-line growth over the last decade.
I’ll then reveal a professional prognostication for near-term profit growth.
Amalgamating the proven past with a future forecast should give us the ability to reasonably judge what the future path of this business might look like.
Medtronic moved its revenue from $16.6 billion in FY 2013 to $31.7 billion in FY 2022.
That’s a compound annual growth rate of 7.5%.
Nice.
I usually look for a mid-single-digit top-line growth rate from a mature business like this.
Medtronic exceeded my expectations.
However, a large chunk of this revenue growth was a result of the acquisition of Covidien PLC in 2015 for almost $50 billion.
This complementary addition to the company (with Covidien focusing on endomechanical instruments, adding to Medtronic’s cardiovascular and orthopedic offerings) gave a large boost to the top line in absolute terms.
Looking at relative growth on a per-share basis should give us a better idea as to what’s really happening here.
Earnings per share grew from $3.37 to $5.55 (adjusted) over this period, which is a CAGR of 5.7%.
To be fair, I did use adjusted EPS for FY 2022, and that’s because of certain issues that impact GAAP EPS and make comparisons difficult.
The bottom-line growth here isn’t bad.
But I think it could have – and should have – been better, if not for two serious headwinds (one of which is not the company’s fault).
First, Medtronic’s outstanding share count has been increased significantly as a result of the company using equity to help finance the Covidien acquisition.
This has made growth on a per-share basis more difficult.
Second, the pandemic has greatly affected Medtronic.
The global focus on the pandemic meant that anything that could be delayed, such as elective surgeries, have been delayed.
Making matters worse, key product launches coincided with the pandemic, and it’s been hard to bring supply to market.
What this means is that Medtronic has been facing both supply and demand challenges over the last three years.
There is a flip side to this, though.
Surgeries that could not be performed previously are almost certainly demand deferral, not demand destruction.
Delayed healthcare is likely causing pent-up demand, which could prove to be a strong growth driver for the business over the next few years.
And the addition of new products to the market precisely at the same time as rising demand could be a potent mix for the business, turning a former headwind into a new tailwind.
Looking forward, CFRA is projecting that Medtronic will compound its EPS at an annual rate of 8% over the next three years.
Notably, this forecast was at 7% as recently as this summer.
So we’ve had a decent bump here.
CFRA reinforces what I just stated: “We see potential for strong appreciation in [Medtronic] shares over the next year, driven by its broad lineup of new products and high exposure to recovering global medical procedure volumes.”
Delving into new products, CFRA adds the following: “Key [Medtronic] products to pay attention to, both launched and soon-to-be launched, include Micra AV pacemaker, the renal denervation program, and the Hugo robotic-assisted surgery platform.”
That last product is especially exciting, as robotic-assisted surgery platforms are likely going to be big growth drivers over the long run.
CFRA agrees: “One product line that has particularly immense potential is [Medtronic’s] robotic assisted surgery platform, which we see ultimately being adopted worldwide, up from just eight countries using the technology in FY 22.”
With all of this said, I think Medtronic is compelling for dividend growth investors over both the short term and the long term.
Pent-up demand could cause a substantial near-term bounce in business.
And the long term is bright because of the structural nature of global demographics and global healthcare.
Medtronic’s business is already situated to benefit from this structural nature, but new products only serve to strengthen the company’s competitive position.
If we take CFRA’s EPS growth prediction as the base case, that should set the dividend up to grow at a similar rate over the foreseeable future.
Pairing that with the 3.5% starting yield gives investors an extremely appealing combination of yield and growth.
Financial Position
Moving over to the balance sheet, Medtronic has a rock-solid financial position.
The long-term debt/equity ratio is 0.4, while the interest coverage ratio is 11.
Profitability is already fairly robust, but I think the coming years will show even better numbers.
Over the last five years, the firm has averaged annual net margin of 13.6% and annual return on equity of 8.1%.
To give perspective on what could be coming down the road, net margin came in at nearly 16% for FY 2022.
Medtronic is a great business that should become greater as supply and demand shocks abate.
And the company does have durable competitive advantages that include IP, R&D, switching costs, economies of scale, a global distribution network, high barriers to entry, and a diversified portfolio of entrenched products.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
I see all three of these risks as being elevated compared to other business models.
Any changes in the way healthcare spending is managed, especially in the United States, would almost certainly impact the company.
Medtronic occasionally recalls products, which involves cost and reputation risks.
Demand for medical devices is fairly disconnected from economic cycles, but a recession could cause people to delay or cancel elective surgeries.
Any major technological changes in medical devices can alter the competitive landscape, which pressures Medtronic to constantly innovate and stay ahead of the tech curve.
No business is without risks, and Medtronic is no different, but I still think this business looks captivating for long-term investment.
And with the stock down more than 30% from its 52-week high, the valuation makes it especially captivating right now…
Stock Price Valuation
The forward P/E ratio is only 14.6, based on midpoint adjusted EPS guidance for this fiscal year.
That’s a very low earnings multiple for a Dividend Aristocrat of this caliber.
The P/CF ratio of 16.4 is also favorably detached from its own five-year average of 21.4.
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 7.5%.
This dividend growth rate is below the demonstrated long-term dividend growth rate from the business, and it’s also quite a bit lower than the expectation for near-term EPS growth.
On the other hand, EPS growth over the last decade does trail this mark.
I’m assuming a rebound in this highly resilient business, and it wouldn’t take much for Medtronic to make good on this.
Unless Medtronic is permanently impaired from what’s transpired over the last three years, this kind of dividend growth rate shouldn’t be overly difficult to match or exceed.
The DDM analysis gives me a fair value of $116.96.
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 believe that my valuation model was aggressive, yet the undervaluation looks noticeable.
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 MDT as a 5-star stock, with a fair value estimate of $112.00.
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 MDT as a 4-star “BUY”, with a 12-month target price of $104.00.
I came out very close to where Morningstar is at on this one, but we all see severe undervaluation here. Averaging the three numbers out gives us a final valuation of $110.99, which would indicate the stock is possibly 44% undervalued.
Bottom line: Medtronic PLC (MDT) is a high-quality business that should explosively rebound higher as supply and demand shocks fade. Demographic trends are on its side, and new products are coming out at just the right time. With a market-beating yield, a double-digit long-term dividend growth rate, a balanced payout ratio, more than 40 consecutive years of dividend increases, and the potential that shares are 44% undervalued, this Dividend Aristocrat is screaming for long-term dividend growth investors to consider buying it.
-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 D&I: How safe is MDT’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, MDT’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: Dividends & Income