After the longest economic expansion in US history, a recession is finally upon us.
It’s a shame.
If not for the COVID-19 pandemic, I’m confident that the US economy would still be doing very well.
But we must invest in the world we have, not in the world we wish we had.
And in this world, it makes more sense than ever to invest in businesses with durable competitive advantages.
This quick and steep recession is going to shake out weak hands.
Only the strongest businesses are set up to survive the present – and then thrive after we emerge from the crisis.
Said another way, companies with durable competitive advantages are going to come out of this even stronger.
That’s why I’m supremely happy to be investing in high-quality dividend growth stocks.
These are businesses that have long-term track records of profit growth, often due to durable competitive advantages.
That profit growth is tangibly proven out with the rising dividends they’re paying out to shareholders.
You can find more than 800 US-listed dividend growth stocks by checking out the Dividend Champions, Contenders, and Challengers list.
Through my real-money FIRE Fund, I’m collecting enough five-figure passive dividend income to live off of.
As I lay out in my Early Retirement Blueprint, I used dividend growth investing to retire in my early 30s.
But not every dividend growth stock is a good investment at this time.
Fundamental analysis and valuation are vital to finding the truly great investments.
Valuation in particular is critical.
Price is only what you pay. Value is what you get for your money.
An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.
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.
Investing in a high-quality business with durable competitive advantages, and doing so when the business is undervalued, can set you up for massive long-term financial rewards.
Fellow contributor Dave Van Knapp’s Lesson 11: Valuation, which is part of a more comprehensive series on DGI, provides a valuation template that can be applied to 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…
Merck & Co., Inc. (MRK) is a leading global pharmaceutical company that produces a range of medicines, vaccines, and animal healthcare products.
Founded in 1891, Merck is now a $192 billion (by market cap) company that employs more than 70,000 people across the world.
The company operates across two reportable segments: Pharmaceutical, 89% of FY 2019 sales; and Animal Health, 9%. Insignificant sales occur in unreported segments.
There core areas of focus include: diabetes, infectious diseases, oncology, vaccines, and animal health.
The US is the company’s largest market, accounting for approximately 43% of FY 2019 revenue.
Some of the company’s key drugs are Keytruda, Januvia, Gardasil, and ProQuad.
Cancer drug Keytruda is the company’s top-selling drug by far, making up almost 25% of the company’s total revenue last fiscal year. This drug is on patent through 2028 in the US and EU.
The COVID-19 pandemic has been a tragedy in every sense of the word.
But it has brought to light the importance of modern medicine and vaccines.
As one of the global leaders in these areas, Merck is poised to ride the wave of humanity’s renewed sense of appreciation for healthcare.
And this wave includes plenty of growing dividends.
Dividend Growth, Growth Rate, Payout Ratio and Yield
In fact, Merck has increased its dividend for nine consecutive years.
The five-year dividend growth rate is 4.6%; however, there’s been an acceleration of dividend growth of late, with some of the more recent dividend increases landing in the double digits.
This current yield, by the way, is 20 basis points higher than the stock’s five-year average yield.
With a payout ratio of 61.8%, the dividend is in a good position to continue growing in line with EPS.
Revenue and Earnings Growth
Now, this is looking at the past.
But it’s ultimately those future dividend payments we care most about.
Investors put today’s capital at risk for tomorrow’s gains.
I’ll now build out a forward-looking growth trajectory for Merck, which will later help us estimate the stock’s fair value.
The first thing I’ll show you is what the company has done over the last decade in terms of top-line and bottom-line growth.
Then I’ll compare that to a near-term professional prognostication of earnings growth.
Combining the proven past with a future forecast like this should allow us to extrapolate out a future growth path.
Merck increased its revenue from $45.897 billion in FY 2010 to $46.840 billion in FY 2019.
That’s a compound annual growth rate of 0.23%.
Not exactly stellar.
But the top-line growth has been stellar since FY 2015, riding the success of Keytruda (approved for medical use in the US in 2014).
Meanwhile, earnings per share advanced from $0.28 to $3.81 over this 10-year period, which is a CAGR of 33.65%.
That’s obviously phenomenal; however, the anomalous result in FY 2010 doesn’t give us a very good starting point.
Again, looking at results since FY 2015, when blockbuster Keytruda came onto the scene, shows EPS more than doubling. So there’s reason to believe that Merck is growing its EPS in the high-single-digit range, or perhaps better.
An expansion of margins and share buybacks have both helped to propel excess bottom-line growth.
The outstanding share count is down by approximately 18% over the last decade.
Looking forward, CFRA is projecting that Merck will compound its EPS at an annual rate of 10% over the next three years.
I think this is a perfectly reasonable assumption, especially with Keytruda in full swing.
For perspective, Keytruda did slightly over $11 billion in sales in FY 2019. That’s 55% higher than the ~$7.2 billion in sales the product logged in FY 2018.
CFRA cites Keytruda as the major growth engine for Merck.
Merck also has a robust pipeline, supported by world-class R&D. They have 17 programs in Phase 2, and 25 programs in Phase 3.
In addition, there’s the announced spin-off of Merck’s women’s health, legacy brands, and biosimilars into a new company called Organon.
Expected to complete in the first half of 2021, this could be an exciting business for legacy Merck shareholders. Spin-offs historically perform well.
The 10% EPS growth rate forecast seems more than reasonable, and it sets Merck up for high-single-digit dividend raises for the foreseeable future.
Financial Position
Moving over to the balance sheet, Merck lays claim to a very strong financial position.
The long-term debt/equity ratio is 0.88, while the interest coverage ratio is over 14.
Shareholders’ equity has been artificially lowered by treasury stock. This relates back to the share buybacks. Truth be told, the company has an excellent balance sheet.
Profitability is solid, and it’s only improved in recent years. Blockbuster Keytruda is largely responsible for this.
Over the last five years, the firm has averaged annual net margin of 12.56% and annual return on equity of 16.60%.
Merck is operating at a very high level right now. It’s arguably a better business than it’s ever been.
I mentioned the importance of durable competitive advantages at the outset of this article.
Well, Merck has these in spades.
Economies of scale, a global distribution network, patents, IP, and a massive R&D base are all durable competitive advantages that protect the business.
They’ll survive the present. And they’ll thrive in the future.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
There’s always the risk that a single-payer healthcare system could come to the United States. This would fundamentally alter the entire pharmaceutical landscape.
Keytruda is a blockbuster drug for Merck; however, the company is heavily reliant on this one product.
The company needs to continue to produce blockbuster drugs in order to rationalize the R&D.
Overall, I see Merck as a high-quality company with numerous durable competitive advantages.
It could be a fantastic long-term investment at the right valuation.
With the stock down 19% YTD, I think the valuation is very appealing right now…
Stock Price Valuation
The stock’s P/E ratio is 19.46.
That’s slightly lower than the broader market’s P/E ratio.
It’s also about half that of the stock’s own five-year average P/E ratio.
That said, the volatile nature of Merck’s GAAP EPS causes the P/E ratio to unreliably fluctuate.
However, we can also go straight to cash flow and look at that multiple.
The current P/CF ratio is 15.4. That’s well off of the stock’s three-year average P/CF ratio of 20.7.
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%.
This DGR looks aggressive or cautious depending on what area of the business you’re focusing on.
With a slightly elevated payout ratio and a low five-year DGR, it looks aggressive.
But with Keytruda taking flight, a 10% EPS growth forecast, and accelerating dividend growth of late, it looks cautious.
I think the real answer is somewhere in the middle.
It’s a sensible DGR that accounts for both the middling pre-Keytruda results and the new Merck that’s as good as it’s ever been.
The DDM analysis gives me a fair value of $104.92.
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.
The stock looks cheap from where I’m standing.
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 MRK as a 4-star stock, with a fair value estimate of $100.00.
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 MRK as a 5-star “STRONG BUY”, with a 12-month target price of $92.00.
I came out pretty close to Morningstar’s number. Averaging the three numbers out gives us a final valuation of $98.97, which would indicate the stock is possibly 29% undervalued.
-Jason Fieber
Note from DTA: How safe is MRK’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, MRK’s dividend appears Very Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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