There’s really only way to live your life: your own way.
That’s it.
We can’t live anyone else’s life.
We have to live our life, and we have to do it our way.
That authenticity is priceless.
And when I think about living life my way, there’s one word that comes to mind: freedom.
That’s because we can’t live a life that’s true to ourselves without freedom.
This is why achieving financial freedom is of paramount importance.
Once we’re financially free, we’re truly free to go about our lives as we please.
Toward that end, this is where dividend growth investing comes in.
This is a long-term investment strategy whereby one buys and holds shares in high-quality businesses that pay safe, growing dividends out to shareholders.
By pulling up the Dividend Champions, Contenders, and Challengers list, you’ll immediately find hundreds of stocks that qualify for the strategy, as this list has compiled invaluable information on US-listed stocks that have raised dividends each year for at least the last five consecutive years.
This strategy is so effective at helping investors to achieve financial freedom because it narrows investment choices down to businesses that are so good and so consistently profitable that they’re able to reliably pay out ever-larger cash dividends to shareholders.
And it’s those ever-larger cash dividends that can form the bedrock of one’s financial freedom.
Once one is collecting enough passive dividend income to live off of, they’re free.
I used the simple logic behind this strategy for myself, using it to help me build the FIRE Fund.
That’s my real-money portfolio, and it generates enough five-figure passive dividend income for me to live off of.
I’ve been able to live off of passive dividend income since I quit my job and retired in my early 30s.
If you’re wondering how such a thing is possible, be sure to give my Early Retirement Blueprint a read.
Without even reading it, I can tell you that a big part of my success came down to living below my means and using my savings to buy high-quality dividend growth stocks (many of which are on the CCC list).
But that’s not all.
Paying close attention to valuation at the time of investment is also critical.
Whereas price is what you pay, it’s value that 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.
Achieving financial freedom by living below your means and routinely investing our savings into high-quality dividend growth stocks puts in place the foundation upon which you can then live your life your way.
Being able to spot undervaluation does, of course, require one to first understand the ins and outs of the whole concept of valuation.
This is why I recommend giving Lesson 11: Valuation a read.
Written by fellow contributor Dave Van Knapp as part of a comprehensive series of “lessons” designed to teach the dividend growth investing strategy, it deftly explains valuation using simple terminology and also provides a set of tools you can use on your own to go about valuing 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…
Automatic Data Processing Inc. (ADP)
Automatic Data Processing Inc. (ADP)Automatic Data Processing Inc. (ADP) is a US-based global technology company providing cloud-based enterprise human resources management software and services.
Founded in 1949, ADP is now a $103 billion (by market cap) HR giant that employs nearly 70,000 people.
ADP does business in more than 180 countries worldwide.
The company reports results across two segments: Employer Services, 67% of FY 2025 revenue; and Professional Employer Organization Services, 33%.
Employer Services, the largest segment by far, is where ADP does its bread and butter by providing a comprehensive range of cloud-based HR solutions such as payroll, human resource, benefits administration, attendance, tax filing, and reporting services.
Payroll is where ADP really shines, and it’s where the company has its key edge.
First of all, payroll processing requires specialized software that, once installed, becomes fully integrated and extremely “sticky”.
If this software is working, why make a change?
Especially when it’d be so difficult to make this change.
This service stickiness creates a high degree of recurring revenue for ADP (with client retention near 100%).
Payroll is a small portion of an enterprise’s overall operating expenses, but it’s vital to functionality, further cementing ADP’s role within any company’s ERP.
Plus, ADP is the biggest company in its industry, using its clout to gain and retain business.
This is all well and good, but payroll processing also has a hidden power.
During payroll processing, ADP holds onto client deposits until such time that employees are actually paid.
This time delay between ADP collecting deposits and employees taking their money gives the company a short-term, cost-effective “float”.
This is a source of capital that ADP can earn a return from – on top of what it earns from the core business model, which is in and of itself a powerful cash machine.
ADP has used this one-two payroll punch to grow into the world’s foremost HR company, and it’s also what explains how and why the company is so incredibly consistent when it comes to revenue, profit, and dividend growth.
Dividend Growth, Growth Rate, Payout Ratio and Yield
That consistency is exemplified by the company’s track record of 49 consecutive years of dividend increases.
This easily qualifies ADP for its status as an acclaimed Dividend Aristocrat.
In fact, it’s nearly a Dividend Aristocrat twice over and about to become a Dividend King.
The consistency also shows up in the rate, not just the length, of dividend growth.
Its 10-year dividend growth rate is 12.8%, nearly matching its five-year dividend growth rate of 12.1%.
ADP is almost a lock for double-digit dividend growth – year in and year out.
It’s clockwork.
And you layer that double-digit dividend growth on top of the stock’s current starting yield of 2.7%.
That’s a pretty remarkable combination of yield and growth, as one usually has to accept a much lower starting yield in order to a access a higher growth rate like this.
Not only that, but this yield is 80 basis points higher than its own five-year average, only adding to the unusualness of the situation.
The one knock against the dividend profile might be the payout ratio; at 67%, it’s elevated (although certainly not worrisome).
That said, as a mature company returning most of its free cash flow back to shareholders, this higher payout ratio is nothing new for ADP, and the company has never expressed any kind of inability to properly manage it.
Despite its maturity, ADP remains a Dividend Aristocrat growing its dividend at an aggressive rate.
This is one of the best overall dividend pictures out there, in my view.
Revenue and Earnings Growth
As much as that may be the case, though, this viewpoint is based mostly on what’s already happened.
However, investors must always be thinking about what is likely yet to happen, as the capital of today ultimately gets risked for the rewards of tomorrow.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will be highly useful when later going through the valuation process.
I’ll first show you what the business has done over the last decade in terms of its top-line and bottom-line growth.
And I’ll then reveal a professional prognostication for near-term profit growth.
Lining up the proven past with a future forecast in this manner should give us enough information to roughly gauge where the business could be going from here.
ADP moved its revenue from $11.7 billion in FY 2016 to $20.6 billion in FY 2025.
That’s a compound annual growth rate of 6.5%.
This is pretty strong.
I usually look for a mid-single-digit top-line growth rate out of a mature company like this, and ADP is more than delivering.
Meantime, earnings per share grew from $3.25 to $9.98 over this period, which is a CAGR of 13.3%.
Excellent.
What’s especially impressive about this is that ADP has been unusually consistent.
I don’t see a single fiscal year with a YOY drop in EPS – not even during the pandemic.
The growth is relentless and secular in nature.
For those who value extreme consistency, ADP is about as good as it gets.
I can’t overstate just how blown away I am by ADP’s dependable ability to move up and to the right like clockwork.
Looking forward, CFRA believes that ADP will compound its EPS at an annual rate of 9% over the next three years.
CFRA sums it up well here: “ADP delivers steady operational performance with strong retention, but hiring remains cautious with pays per control flattening to 0%”
Regarding that latter point, AI and its evolution will have a lot to say about overall employment trends and ADP’s success (or lack thereof).
On one hand, AI quite possibly threatens the very existence of a large swath of jobs, which would result in less payroll requirements and demand.
AI could also result in making it easier to develop in-house software.
On the other hand, AI can also help ADP internally (through cost controls).
There’s also something to be said about almost all technological advances across history being used to enhance productivity and increase the number of overall opportunities across the economy.
To this point, ADP is using AI as an enhancement through continued expansion of its ADP Assist (a generative AI-powered assistant) platform.
We’re still in early days here, and the jury is obviously still out on all of this.
However, I’d be keen to give ADP the benefit of the doubt.
The company has simply been too good for too long.
Circling back around to CFRA’s near-term forecast, I think it’s quite reasonable – if not a tad conservative (which I’m fine with).
ADP’s own medium-term guidance calls for 9% to 11% adjusted EPS growth.
Taking the low end of that puts us at that 9% mark.
Combining that with the 2.5%+ starting yield can put the stock on track for a low-double-digit type of annualized total return (in line with management’s medium-term guidance for 11% to 13% total shareholder return).
Getting that out of a Dividend Aristocrat with the utmost level of reliability is awfully attractive.
Financial Position
Moving over to the balance sheet, ADP has a terrific financial position.
The long-term debt/equity ratio is 0.6, while the interest coverage ratio is nearly 13.
Total cash exceeds long-term debt.
And ADP has credit ratings well into investment-grade territory: S&P, AA-; Moody’s Aa3.
ADP actually had a AAA rating once upon a time, but it lost this when it spun off its dealer services unit about a decade ago.
Although it’s not as impervious as it once was, ADP’s balance sheet remains a pillar of strength.
Profitability for the firm is outstanding.
Return on equity has averaged 76.4% over the last five years, while net margin has averaged 18.7%.
ROIC is often north of 30%.
Even without employing much leverage, ADP’s able to generate very high returns on capital due to its high-quality, capital-light operating model.
What I see here is a wonderful business firing on all cylinders.
And with economies of scale, “sticky” services with deep integration, high switching costs, IP, float usage, and brand reputation, the company does benefit from durable competitive advantages.
Of course, there are risks to consider.
Competition, regulation, and litigation are omnipresent risks in every industry.
Although ADP’s industry is fiercely competitive, its status as the clear industry leader with an impeccable reputation for reliability and capabilities does insulate it somewhat.
The company has exposure to the broader economy through overall employment levels, as employment feeds through into demand for its services.
There is now profound uncertainty regarding whether AI turns out to be a friend or foe.
Being an international company, it has exposure to geopolitics and currency exchange rates.
ADP has a very concentrated business model after spinning off various parts of the company over the years, resulting in a lot of dependence on its core payroll software.
This business has always struck me as having a fairly moderate risk profile, although the rise of AI does muddy the waters.
However, the stock’s recent 20%+ slide has priced in more risk than usual and created what appears to be an attractive valuation…
Valuation
The stock is now trading hands for a P/E ratio of 25.4.
While this isn’t all that low in absolute terms, it’s quite a bit lower than its own five-year average of 30.9.
This stock has long commanded a healthy premium (and deservedly so, in my opinion), but that premium has all but evaporated on the back of the recent drop.
The P/CF ratio of 16.3 is also well off of its own five-year average of 21.
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 8%.
This 8% growth rate is as high as I allow for in the model, but I think ADP’s remarkable consistency deserves this designation.
It’s coming up on Dividend King status with no signs of slowing down.
Based on ADP’s demonstrated EPS and dividend growth rates, respectively, over the last decade, and based on the near-term forecast for EPS growth (which is solidly rooted in medium-term guidance out of ADP itself), an 8% mark actually runs on the conservative side.
Because we’re still in the early innings of AI, which has all kinds of unknown implications, it makes sense to err on the side of caution.
Still, in almost any type of ordinary environment, ADP should be fully capable of exceeding this 8% number.
Building in a margin of safety to account for AI, though, does make the model more resilient.
The DDM analysis gives me a fair value of $367.20.
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 Dividend Aristocrat looks materially undervalued to me after its recent drop.
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 ADP as a 4-star stock, with a fair value estimate of $305.00.
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 ADP as a 3-star “HOLD”, with a 12-month target price of $300.00.
I came out surprisingly high, despite what wasn’t an overtly aggressive model. Averaging the three numbers out gives us a final valuation of $324.07, which would indicate the stock is possibly 21% undervalued.
Bottom line: Automatic Data Processing Inc. (ADP) is running a high-quality, capital-light business model that generates high returns on capital without employing a lot of leverage. It has consistently operated at a high level for decades. Although AI adds a new wrinkle, its software remains deeply integral and integrated within clients’ ERP. With a market-beating yield, a manageable payout ratio, double-digit dividend growth, nearly 50 consecutive years of dividend increases, and the potential that shares are 21% undervalued, this Dividend Aristocrat is one of my best long-term ideas right now for dividend growth investors.
-Jason Fieber
Note from D&I: How safe is ADP‘s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 97. 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, ADP‘s dividend appears Very 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’m long ADP.
