Life is hard, isn’t it?

The expectations, responsibilities, and temptations add up.

We should make it a bit easier on ourselves.

But how do we do that?

By living below our means and investing our spare cash.

I grew up on welfare in Detroit, lost my parents, and never graduated college.

Yet I still lived below my means and invest as much as possible.

But I don’t invest blindly.

I invest in high-quality dividend growth stocks.

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

You can find hundreds of examples on the Dividend Champions, Contenders, and Challengers list, which has complied invaluable data on US-listed stocks that have raised dividends each year for at least the last five consecutive years.

Living modestly and intelligently investing capital helped to create this snowball effect, where wealth and passive income started to compound.

This has resulted in the building of my FIRE Fund.

That’s my real-money portfolio.

It produces enough five-figure passive dividend income for me to live off of.

And I’m super fortunate to be in such a position at a young age.

In fact, I achieved financial independence and was able to retire in my early 30s.

My Early Retirement Blueprint recounts how all of that happened.

Suffice it to say, buying the best stocks I could find at any given time made a huge difference.

That’s not all.

Valuation at the time of investment also made a huge difference.

See, price is what you pay, but it’s value that you end up getting.

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.

Living below your means and investing your spare cash into high-quality dividend growth stocks when they’re undervalued can make a difficult life a lot easier.

Of course, recognizing undervaluation requires one to first understand the concept of valuation.

But it’s not that hard.

Lesson 11: Valuation, put together by my colleague Dave Van Knapp, is super helpful in this regard.

Part and parcel of a comprehensive series of “lessons” on dividend growth investing, it deftly explains valuation and provides a template that can be easily applied toward 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…

Lockheed Martin Corp. (LMT)

Lockheed Martin Corp. (LMT) is the world’s largest defense contractor.

Founded in 1912, Lockheed Martin is now a $114 billion (by market cap) global defense juggernaut that employs 116,000 people.

The company reports results across four segments: Aeronautics, 41% of FY 2022 revenue; Rotary and Mission Systems, 24%; Space, 18%; and Missiles & Fire Control, 17%.

The US Department of Defense accounts for approximately 64% of revenue; the remainder is sourced from foreign government militaries and various US government agencies.

Locked Martin manufactures a range of major military aircraft platforms, including the F-35 Lightning II, the F-22 Raptor, the F-16 Fighting Falcon, and the SH-60 Seahawk.

The F-35, a fifth-generation combat aircraft, is the largest and most expensive military weapons system in the world.

In addition, the company’s various missile programs are critical for both offensive and defensive capabilities.

Conflict is, unfortunately, part of the human condition.

We’ve advanced from slinging rocks at each other thousands of years ago to launching explosive missiles today, but the core issue of human conflict remains the same.

I wish the world were different, but we must exist and invest in the reality we have.

To that point, Lockheed Martin is an obvious beneficiary of human conflict.

The company provides the sovereign defense tools necessary for nations to protect themselves against possible outside threats.

Since conflict is an endless source of demand, defense contractors are practically guaranteed ongoing sales for a time period that stretches beyond my lifetime.

Furthermore, because defense tools continue to become more complex and more expensive, sales from Lockheed Martin to its customers become incrementally larger in price terms.

Rocks may be cheap, but missiles are most certainly not.

What we have here is inherent progression layered onto built-in demand.

What’s especially powerful about Lockheed Martin is that it is the world’s largest defense contractor, headquartered in the world’s largest spender on defense products and services.

It’s a symbiotic relationship between the best supplier and the best customer.

Put simply, Lockheed Martin has a unique combination of scale and positioning within an industry that will likely co-exist alongside human beings until the end of time.

That’s why Lockheed Martin should continue to deliver revenue, profit, and dividend growth indefinitely.

Dividend Growth, Growth Rate, Payout Ratio and Yield

To date, Lockheed Martin has increased its dividend for 19 consecutive years.

The 10-year dividend growth rate is 10.6%.

Very nice.

Not surprising to see a double-digit long-term dividend growth rate here, as Lockheed Martin is a world-class business that leads its industry.

While you wait for those sizable dividend raises to pile up, the stock kicks things off with a market-beating 2.7% yield.

This yield, by the way, is 10 basis points higher than its own five-year average.

Seeing as how the payout ratio is only 44%, this appears to be a very safe dividend with lots of leeway for more growth ahead.

We have balanced dividend metrics here.

I don’t see where any major sacrifices have to be made.

Investors get a very nice mix of yield and growth.

Revenue and Earnings Growth

As balanced as these metrics may be, though, some of the numbers are looking into the past.

However, investors must look toward the future, as today’s capital is being risked for tomorrow’s rewards.

That’s why I’ll now build out a forward-looking growth trajectory for the business, which will be put to use when the time comes later to estimate intrinsic value.

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

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

Blending the proven past with a future forecast like this should allow us to develop an idea as to where the business could be going from here.

Lockheed Martin moved its revenue from $45.4 billion in FY 2013 to $66 billion in FY 2022.

That’s a compound annual growth rate of 4.2%.

Meanwhile, earnings per share grew from $9.13 to $21.66, which is a CAGR of 10.1%.

We can now see how EPS growth and dividend growth over the last decade line up almost exactly with each other, demonstrating great control and prudence from management.

Excess bottom-line growth was driven by a combination of margin expansion and extensive share buybacks.

For perspective on the latter, the outstanding share count is down by approximately 19% over the last 10 years.

Looking forward, CFRA is forecasting a 6% CAGR for Lockheed Martin’s EPS over the next three years.

This would represent a material drop in growth relative to what Lockheed Martin has enjoyed over the last 10 years.

I would differ on this one.

Geopolitical tensions are higher than they’ve been in years.

The US has sent a lot of aid (i.e., weaponry) to Ukraine, who is defending itself against Russia, and a drawn-down stockpile will have to be rebuilt.

Plus, many European countries are now ramping up defense spending for the first time in many years, adding incremental upward pressure on global demand for defense products and services.

All Lockheed Martin seems to do is land one huge defense contract after another.

And that’s not a surprise, seeing as how this industry has an oligopoly where only a few major companies are actually capable of fulfilling these contracts.

I’d also point out that Lockheed Martin’s own guidance for FY 2023 calls for $27.10, at the midpoint, which would represent 25.1% YOY growth.

FY 2022 was a mediocre year for EPS, so this comparison isn’t totally fair.

On the other hand, Lockheed Martin still generated a 10%+ CAGR in EPS over the last 10 years, even when using a subpar FY 2022 as the ending point.

I’d quibble with the conservative forecast, but a 6% CAGR in Lockheed Martin’s EPS over the next few years would allow for high-single-digit dividend growth.

And if the company surprises to the upside on bottom-line growth, that could very well translate to upsized dividend growth.

When starting off with a near-3% yield, a worst-case scenario of high-single-digit dividend growth is tough to dislike.

Financial Position

Moving over to the balance sheet, Lockheed Martin has a good financial position.

The long-term debt/equity ratio is 1.7, while the interest coverage ratio is slightly less than 12.

There has been some mild deterioration in the balance sheet over the last few years, but Lockheed Martin has no major issues yet.

Profitability is excellent.

Net margin has averaged 9.5% over the last five years, while return on equity is routinely coming in at around 60%.

Debt juices ROE, so we have to take that with a grain of salt.

However, the returns on capital, in general, are high for Lockheed Martin.

And the margin expansion story has been impressive, as net margin was in the 7% range 10 years ago.

Overall, what we have here is a business that’s practically printing money by selling defense products and services primarily to the world’s largest spender on such products and services.

Lockheed Martin almost can’t lose over the long run.

And the company does benefit from durable competitive advantages that include global scale, high barriers to entry, long-term contracts, unique government relationships, R&D, IP, and technological know-how.

Of course, there are risks to consider.

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

On one hand, the industry’s oligopoly does limit competition.

On the other hand, direct government relationships can lead to more regulatory risk.

The very business model introduces geopolitical risk.

Production execution is a risk, with cost overruns on the F-35 program being a prime example.

Any reduction in US government spending, which would put pressure on DoD spending, could weigh on the company’s ability to grow revenue, profit, and the dividend.

That said, CFRA notes that “government defense spending has historically increased regardless of recessions.”

Moreover, CFRA cites Lockheed Martin’s favorable focus on “advanced technology programs, which are likely to avoid cuts even if total defense spending is reduced.”

Being an international company, there’s exposure to currency exchange rates.

These risks aren’t to be brushed aside, but they do have to be weighed against the quality and growth of the business.

Also worth weighing is the valuation, which currently looks attractive…

Stock Price Valuation

The stock is trading hands for a P/E ratio of 16.5.

That’s quite a bit below where the broader market’s earnings multiple is at.

It’s also well off of the stock’s own five-year average P/E ratio of 19.1.

The P/CF ratio of 15.1 is lower than its own five-year average of 16.5.

And the yield, as noted earlier, is 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%.

That’s on the higher end of what I allow for, but it’s not as high as I can go.

This is arguably conservative, seeing as how Lockheed Martin has grown its EPS and dividend at double-digit rates, respectively, over the last 10 years.

However, the near-term forecast calls for constrained EPS growth.

And the last couple of dividend increases have been in the 7% range.

In my view, this strikes a reasonable balance between what’s been demonstrated and what seems likely over the coming years.

The DDM analysis gives me a fair value of $516.00.

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 I put together a fair and balanced valuation, yet the stock looks cheap anyway.

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 LMT as a 3-star stock, with a fair value estimate of $480.00.

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 LMT as a 3-star “HOLD”, with a 12-month target price of $475.00.

We’re all in the same neighborhood here. Averaging the three numbers out gives us a final valuation of $490.33, which would indicate the stock is possibly 8% undervalued.

Bottom line: Lockheed Martin Corp. (LMT) is a high-quality company benefiting from built-in demand from the human condition, an industry oligopoly, and a main customer that can literally print money. With a market-beating yield, a double-digit long-term dividend growth rate, a moderate payout ratio, nearly 20 consecutive years of dividend increases, and the potential that shares are 8% undervalued, long-term dividend growth investors looking for a defensive investment should have their eyes on this defense contractor.

-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 LMT’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 84. 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, LMT’s dividend appears Very Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.

Source: Dividends & Income