There are only so many ways to become wealthy in life.
Finding a million different ways to the goal isn’t as important as finding the right one and sticking to it.
For many of us, living below our means and intelligently investing our savings is a simple but powerful and effective path toward achieving wealth and financial freedom.
And when it comes to intelligent investing, there’s one strategy that immediately comes to mind.
It’s dividend growth investing.
This is a long-term investment strategy all about buying and holding shares in high-quality businesses paying out reliable, rising cash dividends to shareholders.
You can find hundreds of examples of what I mean by looking over the Dividend Champions, Contenders, and Challengers list.
This list has compiled invaluable information on US-listed stocks that have raised dividends each year for at least the last five consecutive years.
These stocks tend to be fabulous long-term investments because it takes a special kind of business to be able to generate the steadily rising profit necessary to afford steadily rising cash dividend payments.
And those steadily rising cash dividend payments can be the solid foundation underpinning financial freedom.
I say that as someone who lives off of dividend income myself after becoming financially independent and retiring in my early 30s.
The FIRE Fund, which is my real-money portfolio, generates enough five-figure passive dividend income for me to live off of.
By the way, if you’re interested in finding out how I was able to retire at such a young age, be sure to read my Early Retirement Blueprint.
Now, intelligent investing isn’t only about the strategy one uses.
There’s also the matter of valuation.
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.
Success is often more about precision than endless variety, and concentrating on using one’s savings to buy undervalued high-quality dividend growth stocks for the long term can be a very effective way to achieve financial freedom over time.
But that concentration is only useful when there’s already an understanding in place regarding what valuation is all about.
That’s why Lesson 11: Valuation can be so helpful.
Written by fellow contributor Dave Van Knapp as part of a series of “lessons” designed to teach the dividend growth investing strategy, it explains valuation using simple terminology and even provides a simple-to-use template which can be used to estimate the fair value of 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…
PepsiCo Inc. (PEP)
PepsiCo Inc. (PEP) is an American multinational food, snack, and beverage corporation.
Founded in 1898, PepsiCo is now a $191 billion (by market cap) snack and beverage giant that employs nearly 320,000 people.
The company reports results across seven segments: PepsiCo Beverages North America, 30% of FY 2024 revenue; Frito-Lay North America, 27%; Europe, 15%; Latin America, 13%; Africa, Middle East, and South Asia, 7%; APAC (Asia Pacific), 5%; and Quaker Foods North America, 3%.
The company generates approximately 56% of revenue from the US; the remainder is generated internationally.
PepsiCo runs a simple but very effective business model: It sells cherished beverages and snack foods to billions of people across the world.
This simplicity and effectiveness has allowed PepsiCo to thrive for more than 125 years and build itself a beverage and snack empire.
While taste is subjective, there’s clearly some common ground among billions of people.
I say that because PepsiCo has 23 different billion-dollar brands (i.e., brands that do more than $1 billion per year in sales), including the likes of Aquafina, Doritos, Lay’s, Mountain Dew, and the eponymous Pepsi.
By providing consistent and desirable taste profiles across these branded products, PepsiCo has built up a loyal global customer base seeking the familiar – which allows the company to leverage pricing power and reinforce its resilience.
And since beverages and snacks must be repurchased once consumed, the company has an incredible amount of recurring and enduring revenue, which has translated into decades of profit and dividend growth.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Indeed, PepsiCo has increased its dividend for a whopping 53 consecutive years.
That qualifies it for its status as a vaunted Dividend Aristocrat more than twice over.
It’s a Dividend King – and a quintessential one, at that.
Its 10-year dividend growth rate is 7.4%, which is very solid for a large, mature company multiple decades into its dividend growth story, although more recent dividend raises have trended closer to the mid-single-digit area.
And you get to layer that dividend growth on top of the stock’s yield of 3.9%.
To see a stock of this stature offer a yield this high is honestly kind of shocking.
We’re in REIT and utility territory here.
To put things in perspective, this yield is 100 basis points higher than its own five-year average.
The one issue here with the dividend is the high payout ratio.
Based on TTM Core EPS, that number is 72.5%.
Making matters worse, the dividend is sucking up pretty much all of the company’s free cash flow.
While I don’t see the dividend as being in immediate danger, and while I’d really like to see a larger margin of safety here, the bigger issue for now is that dividend growth will be limited to, at best, whatever the business itself can generate (although dividend growth should actually be lower than business growth in order to get the payout ratio down).
Despite that quick warning, this remains a Dividend King with the utmost commitment to its outsized dividend.
For income-oriented investors, it’s awfully appealing to be able to capture a near-4% yield from a world-class consumer products company.
Revenue and Earnings Growth
As appealing as it may be, though, that largely draws on past data.
However, investors must always be thinking about the future, as the capital of today gets risked for the rewards of tomorrow.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will be useful for 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 a base of information upon which we can start to draw conclusions about where the business could be going from here.
PepsiCo moved its revenue from $63.1 billion in FY 2015 to $91.9 billion in FY 2024.
That’s a compound annual growth rate of 4.3%.
For a mature company that was already more than 100 years old and starting off with a sales base north of $60 billion, compounding the top line at a 4%+ clip annually is actually quite solid.
Meanwhile, earnings per share increased from $3.67 to $6.95 over this period, which is a CAGR of 7.4%.
We can see that dividend growth and EPS growth over the last decade have mirrored each other precisely, showing deft control from management.
Consistent buybacks helped to drive excess bottom-line growth, with the outstanding share count down by more than 7% over the last 10 years.
Again for such a large, mature company with what could be described as saturated markets, this is very respectable growth.
Looking forward, CFRA is projecting a 3% CAGR for PepsiCo’s EPS over the next three years.
This would represent a more than 50% deceleration in bottom-line growth, relative to what PepsiCo generated over the prior decade.
While CFRA lauds the company’s quality and earnings resiliency, as well as the power of its various brands, it’s hard to ignore recent organic volume trends.
PepsiCo’s growth of late has been driven by price taking, which stemmed from inflation hitting the company’s input costs hard during the pandemic, but this taking of price hurt volumes.
Consumers are simply scaling back on purchases as costs rise.
In addition, there’s the ongoing question of what GLP-1s will ultimately do demand for the types of beverages and snacks that PepsiCo offers, although the company has been shifting its portfolio toward healthier options through both in-house moves and acquisitions.
The company’s 2025 acquisition of fast-growing prebiotic soda brand Poppi for just under $1.7 billion is a perfect example of this.
I think CFRA’s caution is warranted, and it’s fair to assume modest growth out of PepsiCo over the next few years.
However, as prices settle, margins stabilize, and the healthier portfolio starts to shine, something closer to the company’s historical growth rate could certainly return.
Meanwhile, those getting in now are locking in that near-4% yield while awaiting the tide to turn.
Financial Position
Moving over to the balance sheet, PepsiCo has a good financial position.
The long-term debt/equity ratio is 2, while the interest coverage ratio is 14.
Because of low common equity, the former metric looks artificially high.
Further assuaging shareholders should be the fact that PepsiCo commands excellent, investment-grade credit ratings: A1, Moody’s; A+ S&P.
Profitability for the firm is outstanding.
Return on equity has averaged 51.8% over the last five years, while net margin has averaged 10.1%.
ROE has been boosted by the balance sheet, but ROIC is often in a high-teens range.
Despite slowing growth, PepsiCo is still one of the world’s foremost branded food and beverage companies.
And with economies of scale, a global distribution network, IP, R&D, brand power, and barriers to entry through established retail relationships with dedicated shelf space, 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.
Regulation, especially with the stance of the current HHS, could be an even larger hurdle for PepsiCo and its slate of processed foods.
Adding to the regulatory pressure, there are general and changing consumer trends toward healthier foods – a trend likely to be accelerated by GLP-1s – which may negatively impact sales across some of PepsiCo’s products that lean more into taste/enjoyment than outright health.
GLP-1s may reduce overall demand for food consumption, generally, which would be a negative for PepsiCo.
Technology and the rise of alternative forms of media make it easier for new entrants to come into the market, advertise, make themselves known to consumers, and compete with entrenched giants like PepsiCo.
PepsiCo must continue to navigate different tastes in different markets, as well as evolving consumer tastes and preferences globally.
The company’s international footprint exposes it to exchange rates and geopolitical risks (such as tariffs).
Input costs can be volatile.
Passing on higher costs by raising prices on products can lead to lower volumes and strained relationships with retailers.
The balance sheet isn’t as strong as it used to be, which somewhat constrains PepsiCo’s broadening through acquisitions.
Because of the law of large numbers, PepsiCo’s large size and thorough market saturation may be a serious headwind for future growth.
This isn’t a risk-free proposition, and no business is, but the stock’s 25% drop from recent all-time highs seems to compensate for plenty of risks…
Valuation
The stock is trading hands for a P/E ratio of 18.6, based on TTM Core EPS.
This is a stock that has usually commanded an earnings multiple of well over 25.
Its P/CF ratio of 14.7 is further evidence of how undemanding the valuation has become, comparing favorably to its own five-year average of 17.8.
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 5.5%.
With the payout ratio being as high as it is, along with the near-term expectation for fairly slow bottom-line growth, I don’t see room for dividend growth to come in much higher than this over the foreseeable future.
The company’s most recent dividend raise came in at 5%, and I think that’s a good baseline upon which to build realistic expectations from here.
It’s actually quite possible that dividend growth over the next year or two is even lower than what I’m modeling in, but I’d anticipate a slight bounce from there once business normalizes and its higher-growth, healthier portfolio starts to shine.
I’m leaning conservative here, but I do like to err on the side of caution.
The DDM analysis gives me a fair value of $133.40.
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.
My model shows a more appropriate level of valuation after the stock’s big 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 PEP as a 4-star stock, with a fair value estimate of $166.00.
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 PEP as a 4-star “BUY”, with a 12-month target price of $170.00.
Perhaps my model was too cautious? Averaging the three numbers out gives us a final valuation of $156.47, which would indicate the stock is possibly 7% undervalued.
Bottom line: PepsiCo Inc. (PEP) is an iconic snack food and beverage company with more than 125 years of successful operations. Although growth has slowed, this remains one of the premier businesses in its field. With a market-smashing yield, an acceptable payout ratio, high-single-digit dividend growth, more than 50 consecutive years of dividend increases, and the potential that shares are 7% undervalued, this blue-chip Dividend Aristocrat and Dividend King is ripe for long-term dividend growth investors to consider picking.
-Jason Fieber
Note from D&I: How safe is PEP‘s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 93. 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, PEP‘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 PEP.
