When the market tanked in March, cheap stocks could be found everywhere.
Investors didn’t have to reach for value or yield, and they didn’t have to sacrifice quality.
It was one of those rare moments when investors couldn’t go wrong.
But with the S&P 500 up more than 60% from its March low, investors once more have to be choosy.
You shouldn’t invest in low-quality businesses.
And you shouldn’t pay way too much for your investment.
This theme of balance has guided me as I’ve built out my real-money, six-figure stock portfolio.
This portfolio allowed me to retire in my early 30s.
I now live off of dividends, as I describe in my Early Retirement Blueprint.
I’ve found it pretty easy to maintain this balance within the broader investment strategy of dividend growth investing.
The Dividend Champions, Contenders, and Challengers list contains a treasure trove of data on more than 700 US-listed dividend growth stocks.
When you’re investing in world-class enterprises, the quality aspect is built right in.
And as long as you have a valuation process that you stick to, you should usually avoid paying too much for a stock.
The latter part is very important.
Price only tells you 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.
Balancing quality and value with your investments will almost certainly lead you to the promised land of incredible wealth over time.
Fortunately, that valuation process I mentioned earlier isn’t difficult to master.
Fellow contributor Dave Van Knapp’s Lesson 11: Valuation is worth a read if you need help in this department.
Part of a larger series of “lessons” on DGI, it lays out an easy-to-follow valuation process 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…
Amgen, Inc. (AMGN) is a global biotechnology company that develops and manufactures a range of human therapeutics.
Founded in 1980, Amgen is now a $132 billion (by market cap) healthcare colossus that employs more than 23,000 people.
Amgen offers treatments for a range of ailments, including anemia, rheumatoid arthritis, psoriasis, cancer, and osteoporosis.
FY 2019 total product sales break down geographically as follows: US, 74%; Rest of World, 26%.
This is a premier biotechnology company, with one of the best long-term track records across both drug development success and shareholder returns.
Regarding the former, Amgen has a diverse portfolio of high-profile drugs.
And unlike some competitors, the company is not overly dependent on any one product.
Some of its larger products are: Enbrel, 24% of FY 2019 sales; Neulasta, 14%; Prolia, 12%; XGEVA, 9%; Aranesp, 8%; and Kyprolis, 5%.
Enbrel is their biggest blockbuster, with over $5 billion in total sales last fiscal year.
While Enbrel is a huge seller, Amgen is starting to rely on newer products to drive growth. Enbrel’s growth has slowed markedly of late – FY 2019 showed 4% YOY growth for Enbrel alone.
The great news here is, Amgen doesn’t face a near-term patent cliff on Enbrel; it’s protected until almost the end of this decade.
An investment in Amgen takes advantage of three major long-term demographic trends simultaneously playing out: The world is growing larger, older, and richer.
With a larger and wealthier pool of older people, the need for and access to quality healthcare products is almost guaranteed to rise.
This bodes well for Amgen.
And since the company has been such a fantastic return vehicle for so long – its stock is up more than 320% over the last 10 years – this also bodes well for its shareholders.
That’s especially true as it relates to Amgen’s ability to pay out a growing dividend.
Dividend Growth, Growth Rate, Payout Ratio and Yield
The company has increased its dividend for 11 consecutive years.
In fact, they just marked their 11th year with a 10% dividend increase announced on December 16.
This yield is obviously much higher than what the market offers.
It’s also more than 50 basis points higher than the stock’s own five-year average yield.
And with a payout ratio of only 56.7%, the dividend remains protected.
These are fantastic dividend metrics.
Revenue and Earnings Growth
However, this is looking at what’s already transpired.
It’s ultimately tomorrow’s dividends and returns that matter most to today’s investors.
Thus, I’ll now build out a forward-looking growth trajectory for Amgen, which will later help us estimate the stock’s intrinsic value.
I’ll first rely on 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 for profit growth.
Blending the proven past with a future forecast should allow us to have a realistic idea as to where the company might be going from here.
Amgen increased its revenue from $15.053 billion in FY 2010 to $23.362 billion in FY 2019.
That’s a compound annual growth rate of 5.0%.
I usually look for mid-single-digit top-line growth from a fairly mature business such as this.
Amgen hit it right on the nose.
Meanwhile, earnings per share advanced from $4.79 to $12.88 over this period, which is a CAGR of 11.62%.
We can see how Amgen has been able to grow its dividend at a double-digit rate – they’ve been growing the business at a double-digit rate.
Notably, there’s been a large amount of excess bottom-line growth. This was fueled by a combination of margin expansion and buybacks.
To put the latter in perspective, the outstanding share count is down by approximately 37% over the last decade. That’s one of the more aggressive buyback programs I know of.
Looking forward, CFRA is anticipating that Amgen will compound its EPS at an annual rate of 9% over the next three years.
This wouldn’t be too far off from what Amgen has done over the last 10 years.
CFRA calls out Amgen’s diverse product portfolio, robust cash flow, buybacks, and acquisition possibilities as strong points.
Relating to that last point, Amgen acquired the worldwide rights to inflammatory disease drug Otezla for $13.4 billion in November 2019. CFRA expects this drug to surpass $4 billion in annual sales before the expiration of certain patents in 2028.
I think a 9% EPS growth projection from Amgen is quite reasonable. There’s nothing that indicates this is out of line.
This kind of EPS growth can easily underpin similar dividend growth, especially when factoring in the moderate payout ratio.
And a dividend growth rate of near 10% on top of a 3% yield is an appealing combination and yield and growth.
Financial Position
Moving over to the balance sheet, Amgen has a solid financial position.
The long-term debt/equity ratio is 2.79.
That looks high. However, it’s mostly high because of low common equity rather than a huge debt load.
The interest coverage ratio of over 7 indicates no issues with servicing the debt.
Moreover, they have almost $9 billion in total cash.
Profitability, as you might expect, is exceptional.
Over the last five years, the firm has averaged annual net margin of 28.55% and annual return on equity of 37.92%.
Amgen is a world-class business across the board.
And with patents, R&D, IP, and global scale, the company has durable competitive advantages.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
Biosimilar competition is starting to hit some of Amgen’s smaller products, including Neulasta and Epogen.
Any major changes to healthcare in the US, particularly as it relates to drug pricing, would impact Amgen.
Amgen’s expensive Otezla acquisition must prove out.
And the company’s balance sheet, while still strong, has weakened a bit in recent years.
Even with these risks known, I remain convinced that Amgen will be a tremendous long-term investment.
The valuation only serves to convince me more.
With the stock down almost 14% from its 52-week high, I think the stock is attractively valued here…
Stock Price Valuation
The stock’s P/E ratio is 18.42.
That’s below the broader market.
It’s also well below the stock’s own five-year average P/E ratio of 25.2.
The sales multiple is at 5.4, which is lower than the stock’s five-year average P/S ratio of 5.6.
And the yield, as noted earlier, is materially 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 is on the high end of what I ordinarily allow for.
But I think Amgen deserves it.
It has one of the best long-term track records out there, and I see nothing to indicate a dramatic slowdown in growth.
Also, this DGR is below the three-year DGR, the 10-year EPS growth rate, CFRA’s near-term EPS growth projection, and even the size of the most recent dividend increase. I don’t think I’m being overly aggressive.
The DDM analysis gives me a fair value of $302.72.
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.
Even with what could be argued as a conservative valuation, the stock looks cheap.
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 AMGN as a 3-star stock, with a fair value estimate of $215.00.
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 AMGN as a 4-star “BUY”, with a 12-month target price of $268.00.
I came out high this time around. Averaging the three numbers out gives us a final valuation of $261.91, which would indicate the stock is possibly 15% 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 AMGN’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 74. 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, AMGN’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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