As the US stock market continues to break records, there are cheers and jeers to be had.
On one hand, investors are cheering the rise of their wealth as they watch their investment accounts explode in value.
On the other hand, they jeer the lack of opportunities for new investment capital.
I wouldn’t say there’s a lack of these opportunities, per se.
But an investor has to be extra vigilant right now when it comes to finding great long-term investment opportunities.
Now, there are a number of methods you can use to find them.
I would say using the right investment strategy is the best method of all.
For example, I use the dividend growth investing strategy.
I invest in stocks like those you’ll find on the Dividend Champions, Contenders, and Challengers list.
These stocks often represent equity in world-class enterprises.
After all, they’re only able to pay out reliable, rising dividends because they’re producing reliable, rising profits.
Investing in these stocks helped me to retire in my early 30s, as I describe in my Early Retirement Blueprint.
As important as it is to use the right strategy, getting the right deals on the right stocks can be just as important.
Price is simply what you pay. But 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.
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.
Using the right strategy, and finding the right deals on the right stocks, can help you to build immense long-term wealth and passive income, even in a stock market at all-time highs.
Fortunately, finding the deals through the process of valuation isn’t as difficult as it might seem.
Fellow contributor Dave Van Knapp put together Lesson 11: Valuation to aid investors with valuation.
As part of his entire series of “lessons” on dividend growth investing, it provides a valuation guide that can be applied 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…
Omnicom Group Inc. (OMC) is an advertising, marketing, and corporate communications company.
With a corporate history dating back to the late 1800s, Omnicom is now a $16 billion (by market cap) marketing giant employing over 64,000 people.
Through over 1,500 subsidiaries and over 200 brands, Omnicom serves more than 5,000 clients across more than 100 countries.
The company operates across the following fundamental business disciplines: Advertising, 59% of FY 2020 revenue; CRM Consumer Experience, 16%; Public Relations, 10%; CRM Execution & Support, 9%; and Healthcare, 9%.
Their 100 largest clients account for approximately 54% of revenue. North America is their largest market, representing about 58% of revenue.
Omnicom has exposure to almost every industry in every country. They practically have their fingertips on the pulse of the entire global economy.
Investing in Omnicom Group stock is almost analogous to investing in the global economy all in one go.
While investors might initially mistake Omnicom for a 20th century advertising company in a 21st century world, I see this as a comprehensive corporate communications company fit for the new environment.
They help their clients shape the message that’s communicated to customers. Omnicom does this in a very holistic way, managing that communication from top to bottom.
Proper shaping, management, and distribution of a company’s message is arguably more important than ever, as the rise of the Internet has allowed for rapid and unfettered dissemination of information.
The experience and breadth that Omnicom provides should therefore become even more critical and valuable.
But one of the most compelling reasons to invest in the likes of Omnicom is the sticky client base.
Once a company like Omnicom becomes attached to a client’s marketing department, it’s difficult to make a change due to switching costs.
Furthermore, since Omnicom controls the likes of acclaimed BBDO and DDB, the company can just move a client from one network to another. This would be a far easier solution for a client than switching providers wholesale.
This should mean rising profits and dividends for many years to come.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Omnicom has already increased its dividend for 12 consecutive years.
Dividend growth took a short pause during the pandemic, but there was never a cut. And the company got back on track with a 7.7% dividend increase earlier this year.
That’s a bit off from their double-digit 10-year dividend growth rate of 13.2%, but I think they deserve the benefit of the doubt during an unprecedented period.
In addition, high-single-digit dividend growth is all you really need from this stock – it yields a market-beating 3.8%.
And with a payout ratio of 45.0%, the dividend is safe.
I like dividend growth stocks in what I refer to as the “sweet spot” – a yield of between 2.5% and 3.5%, paired with a high-single-digit (or better) dividend growth rate.
This stock is, in some ways, on the very sweet side of that sweet spot.
Revenue and Earnings Growth
As great as these dividend metrics are, though, they’re viewing things through the rearview mirror.
Investors are risking today’s capital for tomorrow’s rewards.
It’s future dividend raises and returns we care most about.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will later help in the estimation of the stock’s intrinsic value.
I’ll first show you what this company has done over the last decade in terms of top-line and bottom-line growth.
I’ll then compare that to a near-term professional prognostication for profit growth.
Blending the proven past with a future forecast like this should give us a very good idea as to what the future growth path might look like.
Omnicom’s revenue is roughly flat over the last decade, moving from $13.873 billion in FY 2011 to $13.171 billion in FY 2020.
Not great, but we have to consider that FY 2020, with its pandemic-induced lockdowns and economic sputtering, was an anomaly.
Backing things up just one year would reveal a much better picture for revenue.
Meanwhile, earnings per share grew from $3.33 to $4.37 over this period, which is a CAGR of 3.07%.
Significant buybacks helped to propel bottom-line growth in the face of flat revenue growth. The outstanding share count is down by ~24% over the last 10 years.
As with revenue, the long-term EPS growth picture would likewise look much better if we back things up only one year.
The nine-year CAGR for EPS between FY 2011 and FY 2019, for instance, is 7.77%. After studying the business and its various financial statements, I think that’s a more accurate long-term growth profile for the business.
Looking forward, CFRA is predicting that Omnicom will compound its EPS at an annual rate of 11% over the next three years.
CFRA sees a “a high-single-digit rebound in organic revenue in 2021” which should lead to a notable improvement across all of the businesses under the Omnicom corporate umbrella.
In my view, this is a reasonable expectation for the near term.
To put things in perspective, Omnicom has reported $2.93 in EPS for the first six months of this fiscal year. That’s a 171% YOY improvement over the first six months of last fiscal year.
Like I noted earlier, I see Omnicom as a company that should be able to grow its EPS in a high-single-digit range when looked at over a long period of time, smoothing results out for economic anomalies.
However, because the next three years of growth is starting from such a depressed base, after Omnicom’s earnings got hurt by 2020, a short period of outsized 11% annual EPS growth is a justifiable assumption.
I don’t necessarily see Omnicom increasing its dividend at that same rate over the foreseeable future, as I think they’ll want to moderate things and keep the payout ratio low.
As such, I would surmise that Omnicom will produce high-single-digit dividend growth for at least the next few years, loosely on par with what was delivered earlier this year.
Financial Position
Moving over to the balance sheet, Omnicom has a rock-solid financial position.
The long-term debt/equity ratio is 1.88.
That might look high, but it’s due to low common equity.
Their interest coverage ratio of over 7 indicates no trouble with servicing debt – and that’s on depressed EBIT.
Moreover, the company carries enough total cash on the balance sheet to offset long-term debt completely.
Profitability is robust and stable.
Over the last five years, the firm has averaged annual net margin of 7.91% and annual return on equity of 47.39%.
Despite the challenging year that was 2020, Omnicom is a high-quality company that is well on its way to a full recovery.
Of course, there are risks to consider.
Litigation, regulation, and competition are omnipresent risks in every industry.
Competition in this particular industry is limited to only a few major players. It’s an oligopoly. However, the limited competition that does exist is fierce.
Any lasting scars from the recent pandemic-induced recession could have an impact on Omnicom’s future earnings.
The digital marketing landscape continues to quickly evolve. Any missteps by the company’s various agencies in this regard would likely have consequences.
Lastly, I see some existential business model risk. If marketing moves in-house on a wide scale, this would greatly affect Omnicom.
With these risks known, I still believe this company can make for a great long-term investment.
That’s especially true right now, with the stock’s valuation looking rather appealing…
Stock Price Valuation
The stock trades hands for a P/E ratio of 12.0.
That’s significantly lower than the broader market’s earnings multiple.
It’s also notably lower than the stock’s own five-year average P/E ratio of 14.6.
We can also see a disconnect in the cash flow multiple.
The current P/CF ratio of 7.1 is well off of its own five-year average of 9.4.
And the yield, as noted earlier, is substantially 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 6.5%.
That’s rather conservative when you look at their demonstrated long-term dividend growth rate. And their most recent dividend increase, which came during a recovery from a global pandemic, was nearly 8%.
There’s also the fact that CFRA is expecting 11% near-term EPS growth.
To top it all off, the payout ratio is moderate.
However, I’d rather err on the side of caution with this particular business model, as I think there are valid long-term existential questions as society and business continues the slide into digitization.
The DDM analysis gives me a fair value of $85.20.
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.
I see my valuation as extremely cautious, yet the stock still 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 OMC as a 4-star stock, with a fair value estimate of $89.00.
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 OMC as a 3-star “HOLD”, with a 12-month target price of $82.00.
I came out right in the middle this time. Averaging the three numbers out gives us a final valuation of $85.40, which would indicate the stock is possibly 14% 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 OMC’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 70. 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, OMC’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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