Experience.

It’s one of those things you wish you had to prevent mistakes before you make them.

Frustratingly, it’s often gained only after you make the mistakes, learn from them, and gain the ability to view the past from a detached distance and become wiser for it.

A great example of this is investing – or the lack thereof.

Almost everyone who invests wishes they would have started investing even earlier than they did.

Experiencing the power of compounding firsthand shows us the error of not getting it on our side even earlier in life.

The best day to start investing was yesterday; the second-best day is today.

And the best way to invest might just be dividend growth investing.

This is a long-term investment strategy that prioritizes buying and holding shares in world-class businesses paying out safe, growing dividends to shareholders.

You can find hundreds of such businesses by pulling up the Dividend Champions, Contenders, and Challengers list – a rich source of data on US-listed stocks that have raised dividends each year for at least the last five consecutive years.

Experience has taught me that nobody is coming to save me in life; if I want to live life on my terms and do what I want to do, I need passive income for that.

Well, there’s no source of income that’s more passive than dividends from terrific companies.

Once you own stock in a company paying out growing dividends, you then need to do nothing else from there on out in order to continue getting paid ever-more money.

While I’m one of the many who wish I would have started investing earlier in life – I didn’t start until I was in my late 20s – tapping into the power of compounding via dividend growth investing still allowed me to retire in my early 30s after reaching financial independence.

My Early Retirement Blueprint lays out how that was made possible.

Suffice it to say, a lot of it came down to old-fashioned hard work, saving, and investing – all of which added up to my ability to build the FIRE Fund over time.

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

Now, the dividend growth investing strategy involves more than just selecting the right businesses to invest in.

One also has to select the right valuations.

And that’s because price only tells you what you pay, but 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.

While everyone wishes they would have started investing earlier, taking advantage of the opportunities in the here and now by using your savings to buy undervalued high-quality dividend growth stocks can totally change your life by slowly opening up financial freedom.

Of course, finding undervalued stocks means one already knows what to look for.

Well, that’s where Lesson 11: Valuation comes in.

Written by fellow contributor Dave Van Knapp, it’s a guide to valuation that breaks things down using simple terminology and even provides a valuation template you can use on your own to value almost any dividend growth stock you’ll run across.

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…

UnitedHealth Group Inc. (UNH)

UnitedHealth Group Inc. (UNH) is a managed healthcare firm that provides health insurance, pharmacy benefit management, and care delivery to millions of clients.

Founded in 1974, UnitedHealth is now a $297 billion (by market cap) healthcare behemoth that employs 400,000 people.

The company reports results across two primary business segments: UnitedHealthcare, 54% of FY 2024 revenue; and Optum, 46%.

The largest business, UnitedHealthcare, primarily provides risk-based, fee-based health insurance (via UnitedHealth) to more than 50 million people globally.

This health insurance provides its members with immense comfort and value, as forgoing health insurance in the US can lead to financial ruin in the event that a major health event occurs.

This service gives a client access to cost-effective health services within a specified network of care.

One might look at health insurance in the US as the “key” to a labyrinth.

In addition, UnitedHealthcare provides supplemental Medicare insurance to seniors, as well as Medicaid management services for state governments.

The second business, Optum, is largely comprised of the conglomerate’s pharmacy benefit manager, OptumRx.

The PBM engages in drug price negotiation, the establishing of drug formularies, pharmacy network creation, and drug claim processing.

Optum, via the OptumHealth arm, also provides healthcare services to patients through networks of outpatient facilities.

What all of the preceding background tells us is, UnitedHealth Group essentially owns a piece of the entire US healthcare value chain.

This company has been able to achieve vertical integration by managing upstream clients on the insurance side and downstream clients on the healthcare side, all while leveraging its PBM in the middle.

This is a very powerful and effective flywheel, where every facet of the business complements and reinforces the other.

Morningstar touches on this: “UnitedHealth Group operates a top-tier health insurer (UnitedHealthcare), pharmacy benefit manager (Optum Rx), provider (Optum Health), and health analytics franchise (Optum Insight). Historically, this integrated strategy resulted in some of the best returns in the managed care industry that other MCOs have attempted to copy…”

Morningstar adds: “By providing those diverse yet connected services, UnitedHealth has historically aimed to grow in nearly any regulatory environment, including a long-term annual earnings growth goal of 13%-16%.”

Because of how complex (and unaffordable without insurance) the US healthcare system is, having health insurance and access to an associated care network is practically a necessity for Americans.

This creates something along the lines of a “toll road” for UnitedHealth Group, as it provides a required point of travel and collects fees for doing so.

Not only that, but once a person has health insurance and is established in an associated network, that service is very “sticky”.

This stickiness is reinforced by the fact that a lot of the company’s customers acquire their insurance through a benefits package at work (meaning a wholesale change will likely only occur if one leaves that job).

This locks clients into both the insurance and the care.

Moreover, due to prevailing demographic trends, that client pool is growing larger, older, and wealthier (on average), naturally creating more demand for quality healthcare (and the insurance to affordably access it).

If all of that weren’t already compelling enough, UnitedHealth Group taps into one of the most lucrative and potent aspects of the insurance business model.

Because of the time delay between receiving money for premiums and paying out on claims, an insurance company builds up what’s known as a “float” – the capital that accrues over time because of this delay.

UnitedHealth Group ended last fiscal year with more than $75 billion in cash, cash equivalent, available-for-sale debt securities, and equity securities balances.

This massive pile of low-cost capital earns a low-risk return on top of everything else.

And while the core part of the business helps to continually and naturally generate more float capital, the float capital also grows all by itself through prudent allocation.

UnitedHealth Group simply has so many levers to pull and ways to win on the offensive side, and its vertical integration across the healthcare value chain has created an extremely defensible business model on the other side.

This explains why this juggernaut is able to consistently rack up higher revenue and profit over time, leading to larger dividends to shareholders.

Dividend Growth, Growth Rate, Payout Ratio and Yield

To that point, UnitedHealth Group has increased its dividend for 16 consecutive years.

A 10-year dividend growth rate of 19.3% shows just how prolific this company has been in terms of rewarding its shareholders with dividend raises.

Very recent dividend growth has slumped as a result of some challenges (which I’ll delve into), but these challenges are more transient than structural.

Before the challenges, dividend growth had settled into a low-teens rate (since a chunk of that huge 10-year dividend growth rate was earlier fueled by payout ratio expansion).

Along with that double-digit dividend growth, this stock yields 2.7%.

You don’t often see double-digit dividend growth paired with a near-3% yield.

That’s a rare combination – not only in terms of the market, in general, but also this stock, in particular.

That current yield is 130 basis points higher than its own five-year average.

This illustrates how much the stock has been beaten up of late.

It also illustrates how much of an opportunity that might be for long-term investors to capitalize on short-term panic.

With a payout ratio of 45.8%, which is low even during a temporary tough stretch for the business, the dividend remains highly secure, meaning those capitalizing are getting paid handsomely to wait for the recovery to play out.

Again, it’s hard to overstate just how compelling a mixture of a 3%ish yield and double-digit dividend growth is.

Revenue and Earnings Growth

As compelling as it may be, though, it’s largely based on what’s happened previously.

However, investors must always be thinking about what might happen, as today’s capital is risked for tomorrow’s rewards.

As such, I’ll now build out a forward-looking growth trajectory for the business, which will come in handy 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.

Amalgamating the proven past with a future forecast in this way should provide us with a baseline upon which we can evaluate where the business could be going from here.

UnitedHealth Group advanced its revenue from $157.1 billion in FY 2015 to $400.3 billion in FY 2024.

That’s a compound annual growth rate of 11%.

In the pure, absolute sense, just looking at the raw rate of compounding revenue, this is pretty impressive.

But what makes this especially impressive is the fact that UnitedHealth Group compounded at this rate off of a starting sales base of $150 billion.

To compound at more than 10% per year off of $150 billion to start with is incredible.

This further highlights how great and necessary this business truly is.

It’s that necessity that is the linchpin of the entire investment thesis.

Since there’s no foreseeable future in which Americans will no longer require health insurance in order to protect themselves and viably interact with the US healthcare system, this business has a very strong floor underneath it.

Meanwhile, earnings per share grew from $6.01 to $27.66 (adjusted) over this period, which is a CAGR of 18.5%.

What an extraordinary result.

Margin expansion and modest buybacks combined to drive excess bottom-line growth.

We can see how that near-20% dividend growth was responsibly covered by similar bottom-line growth.

Looking forward, CFRA does not have a three-year EPS growth projection for UnitedHealth Group.

This is unfortunate, as I do like to compare the proven past to a future forecast.

However, I can say that this number was 10% when I last looked at CFRA’s report a few months ago (before they pulled the projection).

While that would represent a material slowdown relative to what this business had done over the prior decade, I think it’s fair to assume a lower growth profile over the near term.

As I foreshadowed earlier, UnitedHealth Group has been dealing with a slate of headwinds recently.

There are three primary challenges to be aware of: higher medical costs, a change in leadership, and investigations by the DOJ into billing practices and possible fraud.

First, rising medical costs are weighing on the firm’s profitability and medical care ratio.

A higher cost framework is bad news over the short term; however, insurers actually benefit from higher costs over the long run because of higher costs feeding through into higher premiums (although the delay between action and reaction is where the near-term problem is).

It’s important not to miss the premium forest for the cost trees.

Second, UnitedHealth Group has brought back prior CEO Stephen Hemsley (who previously led the company for more than 10 years) after former CEO Andrew Witty stepped down.

Again, I see short-term pain for long-term gain.

Witty was unable to properly articulate the value proposition of UnitedHealth Group, deal with reputational fallout after a mad gunman gunned down one of the company’s leaders, and get the firm straightened out with firm leadership.

Hemsley, on the other hand, is a proven and capable manager who oversaw one of the most prolific periods of expansion for the company, and he’s put his money where his mouth is by buying millions of dollars of company stock on the open market in order to soothe investors and create more alignment between management and shareholders.

Regarding the DOJ investigations, these have to play out and let time tell the story.

In addition to the above, there was also a cyberattack thrown in for good measure.

Although these challenges will weigh on near-term results, none of this is really structural in nature.

It comes down to a simple question: Do you see any future in which US healthcare is nationalized?

If the answer to that question is no, then there’s zero chance of Americans suddenly forgoing health insurance en masse.

Being the largest provider of such insurance, with almost all healthcare roads leading to it, UnitedHealth Group basically can’t lose over time in that scenario.

I’m anchoring to that 10% number CFRA was using before, which I think is a pretty fair assessment of where UnitedHealth Group’s earnings power is at for the time being.

That said, if 10% is kind of a trough EPS growth profile, that speaks volumes on just how incredible this business is.

Now, dividend growth over the next year or two will likely be muted as UnitedHealth Group works through its temporary challenges.

However, as solutions meet problems, dividend growth will likely return to a low-teens rate.

And that is coming on top of a near-3% yield, which is way higher than this stock has typically offered.

Financial Position

Moving over to the balance sheet, UnitedHealth Group has a very good financial position.

The long-term debt/equity ratio is 0.6, while the interest coverage ratio is just under 8.

While these ratios are not bad at all, they don’t do the balance sheet full justice.

The company’s total long-term debt load of approximately $72 billion is more than offset by the cash and investments noted earlier.

Balancing things out, the balance sheet is actually fairly strong.

This is unsurprising.

Being an insurance company in the business of assuming risk, the balance sheet must be conservative and strong.

I’ve never seen any insurance company manage its balance sheet aggressively; UnitedHealth Group is no different.

Profitability for the firm is robust.

Return on equity has averaged 24% over the last five years, while net margin has averaged 5.6%.

Even without excessive leverage, UnitedHealth Group is generating high returns on capital – speaking to the power of its flywheel and business model.

Margin expansion is also worth noting, as net margin was lower than 4% a decade ago.

While there are some chinks in the armor now, the core business model remains unassailable, supported largely by sheer necessity in a complex and extremely expensive US healthcare system.

And with economies of scale, “sticky” memberships, vertical integration, an established float, and network effects, 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.

I believe the first two of those three risks are elevated in this case relative to the average business model, although competition is somewhat limited to only a few major players with the scale and finances necessary to effectively compete in the marketplace.

A recent cyberattack temporarily affected claims management – evidence that the company’s size and deep pockets invites this kind of behavior from bad actors.

It’s possible (albeit extremely unlikely) that that US healthcare system undergoes some kind of fundamental change in the future (such as partial or full nationalization), and any changes along these lines would directly and majorly impact this company.

The advent of GLP-1s may cause a spike in spending for UnitedHealth Group (due to the cost of covering these drugs), but a healthier populace would likely result in lower overall utilization rates on the back end.

Although the company’s size is an advantage, it could start to introduce the law of large numbers.

Recent management turmoil adds to the uncertainty.

And while the expensive and complex US healthcare system leads right to UnitedHealth Group’s raison d’être, sky-high healthcare costs weigh on the company’s profitability.

There are a number of moving parts and risks here, which isn’t surprising given the complexity of the US healthcare system, and the business is dealing with transient problems.

However, the current valuation seems to be pricing in a lot of permanent harm and weakness that I just don’t see…

Valuation

The P/E ratio on the stock is 17.1.

For a stock that has usually commanded a premium to the market (and deserved, in my view), seeing this kind of discount is as unusual as it is shocking.

This is well below its own five-year average of 23.4.

Relative to both the market and itself, this is low.

Also, relative to the growth rate, it’s low.

The sales multiple of 0.7 is also quite a bit lower than its own five-year average of 1.2.

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 two-stage dividend discount model analysis.

I factored in a 10% discount rate, a 10-year dividend growth rate of 10%, and a long-term dividend growth rate of 7.5%.

I’m assuming dividend growth in line with where EPS growth should come in at over the near term (lining up with CFRA’s prior projection).

But I would caution that the next year or two specifically is likely to have muted dividend growth (roughly similar to the most recent dividend raise), with an acceleration to play out thereafter once the business start to fully recover from its temporary issues.

I’m averaging out that short-term weakness against longer-term strength.

Structurally, nothing is wrong with UnitedHealth Group; to the contrary, it remains one of the best healthcare companies in the US.

Its long-term growth profile remains more limited by its size and maturity than any of the current headlines, and that’s why the model does build in a sizable drop in dividend growth beyond the next decade (to reflect a natural slowing of growth over time for a large, mature company).

The DDM analysis gives me a fair value of $468.52.

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.

This stock looks materially undervalued to me.

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 UNH as a 4-star stock, with a fair value estimate of $427.00.

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 UNH as a 3-star “HOLD”, with a 12-month target price of $410.00.

I came out a bit high, but we all agree that the current pricing looks quite favorable. Averaging the three numbers out gives us a final valuation of $435.17, which would indicate the stock is possibly 25% undervalued.

Bottom line: UnitedHealth Group Inc. (UNH) is a high-quality healthcare company with numerous levers to pull and ways to win. What it offers its clients is necessary for both financial protection and access to the extremely complex US healthcare system. In exchange for providing this “on-ramp”, the company collects recurring “tolls”. And it’s parlayed these “tolls” into a massive float and unmatched scale. While headlines are negative, the core business model remains unassailable. With a market-beating yield, double-digit dividend growth, a moderate payout ratio, more than 15 consecutive years of dividend increases, and the potential that shares are 25% undervalued, long-term dividend growth investors should seriously consider buying this blue-chip name while it’s down.

-Jason Fieber

Note from D&I: How safe is UNH‘s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 80. 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, UNH‘s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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.

Source: Dividends & Income

Disclosure: I have no position in UNH.