I’ve noticed a bifurcation playing out in the stock market over the last year.
The strong have become stronger.
And the weak have become weaker.
This growing separation between high-quality businesses and low-quality businesses isn’t surprising, but the speed at which it’s been happening has been surprising.
Simply put, the pandemic has greatly reinforced the need to invest in high-quality companies.
Fortunately, the strategy I follow and advocate practically forces one to invest in high-quality companies.
That strategy is dividend growth investing.
This investment strategy involves buying and holding shares in world-class enterprises that pay reliable, rising dividends.
As you might suspect, only great businesses can afford to pay out bigger dividends, year in and year out.
That’s because only great businesses can manage to produce bigger profits, year in and year out.
You can see what I mean by checking out the Dividend Champions, Contenders, and Challengers list.
This list contains invaluable information on more than 700 US-listed stocks that have raised dividends each year for at least the last five consecutive years.
Following the dividend growth investing strategy helped me to retire in my early 30s, as I describe in my Early Retirement Blueprint.
I now control a six-figure dividend growth stock portfolio.
This portfolio, which I call the FIRE Fund, produces enough five-figure passive dividend income for me to live off of.
I only follow and advocate this strategy because I’ve experienced the amazing power of it firsthand.
Valuation, for instance, is extremely important.
Whereas price is what you pay for something, value tells you what you actually 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.
I’d know. I’ve done it.
Fortunately, the valuation part of this equation isn’t as complicated as you might initially think.
Fellow contributor Dave Van Knapp’s Lesson 11: Valuation has demystified the entire process.
Part of a more comprehensive series of “lessons” on dividend growth investing, it provides a valuation template that you can easily apply to almost any dividend growth stock.
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…
Air Products & Chemicals, Inc. (APD) is a major global producer and supplier of industrial gases. They’re the largest supplier of hydrogen and helium in the world.
Founded in 1940, Air Products & Chemicals is now a $56 billion (by market cap) industrial gases behemoth that employs approximately 19,000 people.
The company’s FY 2019 sales were reported through four Industrial Gases business segments organized by geography: Americas, 43%; Asia, 30%; EMEA, 23%; and Global, 3%. Corporate and other accounted for the remaining 1%.
The company serves more than 170,000 customers across 30+ industries
This is one of those names that flies under the radar.
But make no mistake about it. It’s a very high-quality business by nearly every measure.
And the necessity of its products and services position it incredibly well for the future.
Industrial gases are critical to a number of industrial processes.
It’s simple. Many end products cannot be manufactured without industrial gases as input.
These gases are vital to operations ranging from food processing to energy product refining.
Best of all, Air Products & Chemicals is part of a global oligopoly. There are only three major industrial gas suppliers in the world, which helps to ensure rational pricing.
This all adds up to a very rosy picture, with growing profit and dividends almost certain to persist for years to come.
Dividend Growth, Growth Rate, Payout Ratio and Yield
As it stands, the company has increased its dividend for 39 consecutive years.
That easily makes it a Dividend Aristocrat.
They’ve been remarkably consistent about this. The company hands out ~10% dividend increases like clockwork. Their most recent dividend increase came in at just under 12%.
That dividend growth comes on top of the stock’s current yield of 2.37%.
This yield, by the way, is higher than both the broader market’s yield and the stock’s own five-year average yield of 2.3%.
The payout ratio of 70.4% is elevated. But that easily covers the dividend.
I view a yield of between 2.5% and 3.5%, paired with a high-single-digit dividend growth rate, to be the “sweet spot” for dividend growth investors. The yield is just below the lower end of that range, but the dividend growth is stellar.
Revenue and Earnings Growth
These are very, very good dividend metrics.
But they’re also backward-looking in nature.
Investors are risking their capital for future returns.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will later help us to estimate intrinsic value.
I’ll first reveal what the company has done over the last decade in terms of top-line and bottom-line growth.
I will then compare that to a near-term professional prognostication for profit growth.
Combing the proven past with a future forecast in this manner should tell us a lot about where the business is going from here.
Air Products & Chemicals has seen its revenue shrink slightly from $10.082 billion in FY 2011 to $8.856 billion in FY 2020.
A shrinkage in revenue is not something any investor likes to see.
However, this drop can largely be attributed to the fact that Air Products & Chemicals purposely decided to make the business smaller and more focused. Their “Five-Point Plan” involved focusing on industrial gases and taking action on non-core businesses.
The execution of this plan led to spinning off its electronics material division in 2016, as well as selling the performance materials division in 2017 for $3.8 billion in cash.
In the meantime, earnings per share advanced nicely over the past decade.
EPS is up from $5.63 to $8.49, which is a CAGR of 4.67%.
A substantial expansion in margins, related to the aforementioned focusing, definitely helped to propel bottom-line growth in the face of revenue shrinkage.
I will say that the company’s GAAP EPS can be lumpy. Their growth can look mediocre or truly outstanding, depending on what time frame you’re looking at.
But I appreciate that the dividend growth is anything but lumpy.
Either way, I think the CAGR in EPS belies the true growth potential of the business.
Looking forward, CFRA is forecasting that Air Products & Chemicals will compound its EPS at an annual rate of 12% over the next three years.
They cite volume growth in 2021 as we move past the pandemic, winning agreements in large industrial gas projects, and a large backlog as key growth drivers over the near term.
And with gasification related to carbon capture and hydrogen mobility, the company has some very interesting long-term tailwinds working in its favor.
Notably, the company benefits from the very nature of the business model.
They work in sync with customers to build out large facilities that come attached with long-term contracts. These contracts are often more than a decade in length, which gives a lot of cash flow visibility.
This is why there’s so much consistency with the dividend raises – the company has a lot of confidence in future cash flow.
I think CFRA’s projection – which assumes a lot of EPS growth acceleration – is reasonable, as I simply view the last 10 years as more of an aberration than an accurate picture of the company’s growth profile.
And this kind of EPS growth would lay the groundwork for similar dividend growth. In turn, we’re looking at a continuation of the status quo. And that’s a lot to like when paired with the yield.
Financial Position
Moving over to the balance sheet, the company maintains an excellent financial position.
The long-term debt/equity ratio is 0.61. The interest coverage ratio is slightly under 20.
Furthermore, they have a healthy amount of cash.
Seeing as how this is a capital-intensive business model, the balance sheet is very impressive.
Profitability is quite robust.
Over the last five years, the firm has averaged annual net margin of 19.35% and annual return on equity of 18.08%.
I view this as an ultra high-quality company with one of the surest dividends you’ll find.
And with global scale, barriers to entry, high switching costs, a global oligopoly, and lengthy contracts, the company does benefit from competitive advantages.
Of course, there are risks to consider.
Litigation, regulation, and competition are omnipresent risks in every industry.
Competition is limited in this particular field. But the competition that does exist is formidable.
Demand for industrial gases is cyclical. Any reduction in economic output affects the company. The pandemic, for instance, shaved upward of $0.20 from the company’s Q4 FY 2020 EPS.
The company is heavily exposed to major energy projects around the world. Large changes in the global energy complex could diminish the company’s long-term growth story.
Overall, I think this stock should make for an excellent long-term investment.
And with the stock 23% off of its 52-week high, I think the valuation makes the stock extra compelling…
Stock Price Valuation
The P/E ratio on the stock is 29.79.
If we look at that in a vacuum, it’s high.
However, the pandemic has weighed on recent results. With the acceleration in growth that CFRA is forecasting, this P/E ratio could quickly compress and make the stock look cheap in hindsight.
I can also point to cash flow.
The P/CF ratio is 16.7 right now. That’s lower than the stock’s own three-year average P/CF ratio of 17.6.
And the yield, as noted earlier, is higher than its own recent historical average.
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 DGR is at the very high end of what I ordinarily allow for.
But this company’s consistency is almost legendary at this point.
The odds of continued dividend growth in the high-single-digit range, at the very least, are very high.
It’s surefire. There’s nothing to indicate that the dividend won’t continue growing the way it has been for decades.
The DDM analysis gives me a fair value of $324.00.
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 stock looks cheap from where I’m sitting.
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 APD as a 3-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 APD as a 5-star “STRONG BUY”, with a 12-month target price of $320.00.
We have a fairly tight consensus here. Averaging the three numbers out gives us a final valuation of $316.33, which would indicate the stock is possibly 25% 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 APD’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 95. 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, APD’s dividend appears Very Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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