One of my favorite Warren Buffett quotes goes like this:
“You only find out who is swimming naked when the tide goes out.”
With the economy and stock market convulsing, we’re finding out who’s swimming naked and who isn’t.
The companies that are low quality and indebted are facing a lot of trouble right now.
But the high-quality companies are fully clothed and prepared to deal with any shifts in the tide.
How do you spot these fully-clothed, high-quality companies?
One of the best indicators of business quality is a lengthy track record of growing cash dividends to shareholders.
Cash separates the wheat from the chaff.
Don’t tell me how profitable you are; show me.
It’s easy for a company to talk about how well they’re doing. However, it’s much more difficult to write checks.
This is a big reason why I’m a dividend growth investor.
Dividend growth investing helped me to go from below broke at age 27 to financially free at 33, as I recount in my Early Retirement Blueprint.
That’s my real-money early retirement dividend growth stock portfolio.
And it generates enough five-figure passive dividend income for me to live off of.
You can find more than 700 stocks writing the checks and paying out growing dividends by perusing the Dividend Champions, Contenders, and Challengers list.
However, not every stock on that list is a good investment at this time.
Intelligent investing involves fundamental analysis and valuation.
Valuation in particular plays a critical role in the outcome of an investment.
Price is only 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.
Buying the highest-quality stocks out there, and doing so when valuations are attractive, means you’re extremely unlikely to find yourself naked when the tide goes out.
With valuation so important, you might think it’d be difficult to value stocks.
Well, it’s actually not.
Fellow contributor Dave Van Knapp’s Lesson 11: Valuation, part of a larger series on dividend growth investing, provides an easy-to-follow valuation template that you can apply to 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…
3M Company (MMM) is a diversified global manufacturing conglomerate.
Founded in 1902, they’re an $87 billion (by market cap) industrial behemoth that employs over 90,000 people worldwide.
3M operates across four business segments: Safety and Industrial, 36% of FY 2019 sales; Transportation and Electronics, 30%; Healthcare, 23%; Consumer, 16%. Corporate and Unallocated accounted for -5% of sales.
The company focuses on applying science across 12 areas of expertise: Automotive; Design & Construction; Manufacturing; Commercial Solutions; Electronics, Mining, Oil & Gas; Communications; Energy; Safety; Consumer; Healthcare; and Transportation.
Their products are used in various end applications. Think appliances, packaging, aerospace, electronics, construction, surgical supplies, telecommunications networks, and renewable energy.
And they have numerous brands that convey quality and consistency both on the consumer and industrial sides.
These brands include the likes of Scotch, Scotchgard, Post-it, Scotch-Brite, ACE, and the eponymous 3M.
Simply put, 3M is a diversified, global, high-quality, powerhouse industrial firm.
Their products touch almost every facet of life across the world.
The nature of this product necessity and diversification bodes well for 3M’s ability to weather all storms.
And that portends good things for their dividend, which is already legendary.
Dividend Growth, Growth Rate, Payout Ratio and Yield
As it sits, 3M has increased its dividend for 62 consecutive years.
That’s one of the most impressive track records in the world.
The ten-year dividend growth rate of 10.9% is made to be even more spectacular when you consider that’s coming after decades of dividend raises already.
However, dividend raises over the last few years have been rather small.
The stock yields 3.78%.
That’s almost twice the broader market’s yield.
It’s also more than 100 basis points higher than the stock’s own five-year average yield.
The payout ratio, at 69%, is slightly elevated.
This will limit the firm’s ability to aggressively grow the dividend for the foreseeable future. But the dividend is firmly covered.
Revenue and Earnings Growth
Now, this is looking at what’s already transpired. It’s what’s yet to come that matters most, though.
Investors put today’s capital at risk for tomorrow’s results.
I’ll now build out a forward-looking growth trajectory for 3M, which will later help us estimate intrinsic value.
The first thing I’ll show you is what the company has done over the last 10 years in terms of top-line and bottom-line growth.
Then I’ll reveal a professional prognostication for near-term profit growth.
Blending the proven past with a future forecast like this should allow us to come to some reasonable conclusions about growth expectations moving forward.
3M grew its revenue from $26.662 billion in FY 2010 to $32.136 billion in FY 2019.
That’s a compound annual growth rate of 2.10%.
It’s mildly disappointing; I usually look for mid-single-digit top-line growth from a mature business like this.
However, 3M has pulled some levers and made the most of this mediocre revenue growth.
A small expansion in margins along with a big buyback story both helped to propel excess bottom-line growth.
Earnings per share advanced from $5.63 to $9.10 over this period, which is a CAGR of 5.48%.
Notably, I used adjusted EPS for FY 2019. This factors out irregular but significant litigation and deconsolidation charges.
Free cash flow per share and EPS tend to closely track each other – the adjusted numbers do more accurately reflect the true earnings power in this case.
3M compounded its EPS at more than double the rate of revenue growth, which is owed to the aforementioned levers.
For context on the buybacks, the company reduced its outstanding share count by approximately 17% over the last decade.
Looking forward, CFRA is forecasting that 3M will compound its EPS at an annual rate of 8% over the next three years.
CFRA expects industrial and consumer end markets to both be weak throughout 2020 (due to COVID-19), but they see demand in healthcare and personal protective equipment (also due to COVID-19) as offsetting.
This forecast is down significantly from CFRA’s prior three-year EPS projection, which was 12%.
In my view, 8% is still aggressive.
I simply don’t see anything in 3M’s business that would warrant a major acceleration in bottom-line growth.
On the other hand, I don’t see anything that would warrant fears of any kind of collapse.
3M offers a very defensive business model. It’s a blue-chip stock.
The company has historically performed well through recessions.
This business won’t wow you with growth, but it is the type of investment you can “sleep well at night” owning.
If 3M were able to continue with its bottom-line status quo (~5% growth annually) over the next three years, that would actually be pretty impressive. After all, we’re in the midst of a recession as we speak.
That kind of EPS growth would allow for like dividend growth.
And pairing that dividend growth with a yield near 4% is not a bad outcome at all in this environment.
Financial Position
Moving over to the balance sheet, I’ll note that 3M used to have a fortress balance sheet.
However, the company recently closed on an acquisition of medical products maker Acelity, Inc. for $6.7 billion, which is 3M’s largest acquisition ever.
The purchase was arguably too expensive, and it did cause some balance sheet deterioration. That said, it added exposure to less cyclical healthcare end markets.
Even after the acquisition, 3M maintains a relatively rock-solid financial position.
The long-term debt/equity ratio, at 1.74, belies their financial strength.
That ratio is elevated largely because of so much treasury stock (relating back to share repurchases).
Meanwhile, the interest coverage ratio is sitting at near 14.
That’s a great number, indicating no financial issues.
While these numbers aren’t as good as they were even just five years ago, the company is undoubtedly still in fine shape.
Profitability is robust, as one might expect for a blue-chip.
Over the last five years, the firm has averaged annual net margin of 15.73% and annual return on equity of 45.08%.
This is a high-quality company almost across the board.
It’s in rare company when you think about their longevity and reverence as a business.
And they’re protected by durable competitive advantages like scale, brands, patents, and a large R&D platform to ensure innovation.
Of course, there are risks to consider.
Litigation, regulation, and competition are omnipresent risks in every industry.
As diversified as they are, a global recession will impact an industrial firm with cyclical end markets.
The large Acelity, Inc. acquisition adds a layer of uncertainty and execution risk, while also limiting flexibility.
Overall, I think 3M is a low-risk business and investment. Otherwise, they wouldn’t be able to pay out growing dividends for 60+ years.
At the right valuation, this could be a fantastic long-term investment.
With the stock down more than 10% YTD, I’d argue the valuation is attractive now…
Stock Price Valuation
The P/E ratio is sitting at 18.24.
That’s lower than the broader market.
It’s also favorable compared to the stock’s own five-year average P/E ratio of 23.1.
If we look at cash flow, we see another big disconnect.
The current P/CF ratio of 12.5 is well off of the stock’s own three-year average P/CF ratio of 18.9.
And the yield, as noted earlier, is significantly higher than its 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 6.5%.
This DGR is much lower than 3M’s 10-year DGR. It’s also conservative when you look at CFRA’s three-year EPS growth projection.
However, I’m also considering the 10-year EPS growth rate and the elevated payout ratio.
I see 3M as a very high-quality enterprise. But growth has undoubtedly slowed of late.
3M is “buying growth” with Acelity. As a result, the balance sheet has stretched.
I’d rather err on the side of caution here.
The DDM analysis gives me a fair value of $178.92.
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.
This looks like a blue-chip stock on a blue-light special.
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 MMM as a 3-star stock, with a fair value estimate of $170.00.
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 MMM as a 4-star “BUY”, with a 12-month target price of $177.00.
We have a very tight consensus here. Averaging the three numbers out gives us a final valuation of $175.31, which would indicate the stock is possibly 13% undervalued.
-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 DTA: How safe is MMM’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 75. 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, MMM’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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