Many investors pay too much attention to the US stock market.
In doing so, they’re not paying enough attention to stocks.
Huh?
How is that possible?
Well, the stock market is a market of stocks.
That’s right.
The entire US stock market is thousands of stocks.
The S&P 500 alone is made up of approximately 500 individual stocks.
Looking at what the S&P 500 is doing doesn’t give you very much insight into what any one particular stock is doing.
See, stocks represent equity in real businesses.
And it should be obvious that not all businesses are performing exactly the same at all times.
You then have to factor in individual stock performance on top of that individual business performance.
Looking only at the stock market as a whole is like looking at only the surface of a giant ocean and trying to draw inferences about everything going on underneath that surface.
Finding individual stock gems is one of the most rewarding aspects of being an investor.
Personally, I’ve always sifted through high-quality dividend growth stocks to find those gems.
These are stocks that represent equity in some of the world’s very best businesses.
You can find hundreds of examples of these stocks on the Dividend Champions, Contenders, and Challengers list.
By sifting through these stocks and buying the best at any given time, I built up my FIRE Fund.
That’s my real-money dividend growth stock portfolio.
It produces enough five-figure passive dividend income for me to live off of.
In fact, these stocks and the passive dividend income they produce allowed me to retire in my early 30s.
I describe in my Early Retirement Blueprint exactly how I achieved this feat.
Price only tells you what you pay. It’s value that 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.
It’s protection against the possible downside.
Finding the individual stock gems – undervalued high-quality dividend growth stocks – within a big stock market can set you up for tremendous long-term wealth and passive income creation.
While valuation might initially seem like a complex topic, it’s really not.
Fellow contributor Dave Van Knapp’s Lesson 11: Valuation greatly simplifies things.
Part of a larger and more comprehensive series of “lessons” on dividend growth investing, it lays out a valuation process that can be easily 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…
Medtronic PLC (MDT) is a global developer and manufacturer of medical devices for chronic diseases.
Founded in 1949, Medtronic is now a $157 billion (by market cap) healthcare giant that employs 90,000 people.
The company reports results across four segments: Cardiovascular, 36% of FY 2021 revenue; Medical Surgical, 29%; Neuroscience, 27%; and Diabetes, 8%.
Their product portfolio includes implantable defibrillators, heart valves, insulin pumps, pacemakers, stents, and surgical tools.
Medtronic is in the business of providing healthcare that saves and/or improves lives.
And they’re a leader in doing so. From Morningstar: “Medtronic has historically held roughly 50% share in its core heart devices. It’s also the market leader in spinal products, insulin pumps, and neuromodulators for chronic pain.”
What’s appealing about Medtronic from an investor’s point of view is the secular growth of healthcare in general, as well as the non-discretionary nature of this kind of healthcare specifically.
With the world growing larger, older, and wealthier, you naturally end up with a bigger pool of people who need, and can financially access, quality healthcare options.
That’s the secular growth story.
In addition, these products specifically aren’t a discretionary expenditure in most cases.
If, for instance, you need heart surgery, this is not something you’re going to negotiate or delay.
You get a level of certainty here in terms of the business model.
And that translates to a level of certain growth in profits and certain growth in dividends.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Already, Medtronic has increased its dividend for 44 consecutive years.
This is a vaunted Dividend Aristocrat, which is reserved for stocks with at least 25 consecutive years of dividend increases.
The 10-year dividend growth rate is 10.0%.
That is well ahead of what the broader market offers in terms of yield.
This is also slightly higher than the stock’s own five-year average yield.
With a low payout ratio of 44.2%, based on midpoint guidance for this fiscal year’s adjusted EPS, the dividend is secure and positioned to continue growing.
One might wish to see a higher yield, but the dividend growth rate makes this an excellent long-term compounder.
Revenue and Earnings Growth
As excellent as that might be, these dividend metrics are looking backward.
However, investors are risking today’s capital for tomorrow’s rewards.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will later help in the valuation process.
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 in this way should give us a good idea as to where the business might be going.
Medtronic grew its revenue from $16.2 billion in FY 2012 to $30.1 billion in FY 2021.
That’s a compound annual growth rate of 7.1%.
Very solid top-line growth.
But we have to keep in mind that much of this growth was a result of the acquisition of Covidien PLC in 2015 for almost $50 billion.
This complementary addition to the company (with Covidien focusing on endomechanical instruments, adding to Medtronic’s cardiovascular and orthopedic offerings) gave a large boost to the top line.
Meanwhile, earnings per share increased from $3.41 to $4.44 (adjusted) over this period, which is a CAGR of 3.0%.
I used adjusted EPS for FY 2021, as Medtronic moved its headquarters to Ireland following the Covidien acquisition. This has resulted in a lumpiness in GAAP EPS.
While this long-term EPS growth rate might seem disappointing, almost the entirety of FY 2021 was negatively impacted by the pandemic. Hospitals have had to prioritize COVID-19 issues, which has delayed elective procedures and other healthcare that isn’t imminently life threatening.
If we factor out the pandemic, Medtronic’s long-term bottom-line growth is actually more in line with its long-term dividend growth. That is to say, it’s in the high-single-digit range.
For perspective, Q3 FY 2020, the company’s most recent normal (pre-pandemic) quarter, reported in February 2020, showed 12% YOY growth in adjusted EPS.
Looking forward, CFRA is forecasting that Medtronic will compound its EPS at an annual rate of 10% over the next three years.
CFRA sees a near-term bottom-line growth acceleration for Medtronic. This makes sense.
Recent results for the company have been hurt by delays in elective surgeries. But these are delays, not cancellations. It’s simply a bottleneck that results in a backlog, which will likely end up causing an explosive unwinding of that pent-up demand as the healthcare complex normalizes.
Indeed, CFRA notes this: “Given MDT’s broad lineup of new products and its high exposure to elective procedures, we expect the company to generate strong results as healthcare systems recover from the impact of Covid-19.”
I can also point to Medtronic’s FY 2022 guidance, which calls for 28.4% YOY growth in adjusted EPS at the midpoint.
Of course, this is only a short-term tailwind.
However, CFRA believes there’s a more permanent benefit at play here: “MDT also stands out from medical device peers because of its strong financial position, which has probably helped the company capture market share during the pandemic.”
That viewpoint is supported by the company. CEO Geoff Martha recently spoke on CNBC and stated that the company has “…gained share in nearly every business that we have, with one or two exceptions.”
This is coming from a market position that was already very impressive.
In the end, I think it’s prudent to expect the status quo, more or less, over the long run.
And the status quo is very, very good here.
That would translate to high-single-digit or low-double-digit dividend growth, which is paired with a 2%+ starting yield. I imagine long-term shareholders would welcome this.
Financial Position
Moving over to the balance sheet, the company has a good financial position.
I actually disagree with CFRA’s language on this. They called Medtronic’s financial position “strong”. I think it’s only good. And it could, and should, be improved.
Medtronic actually used to have a phenomenal balance sheet. The Covidien acquisition changed that.
The long-term debt/equity ratio is 0.5, while the interest coverage ratio is slightly over 5.
It’s that latter number which concerns me, and I’d like to see some improvement there in coming years.
Profitability is quite robust.
Over the last five years, the firm has averaged annual net margin of 13.4% and annual return on equity of 7.9%.
I believe the profitability is better than it looks, as the GAAP numbers distort their true earnings power.
Medtronic offers long-term dividend growth investors a lot to like.
And the company has durable competitive advantages that include IP, R&D, switching costs, scale, a global distribution network, high barriers to entry, and a diversified portfolio of entrenched products.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
Regulation and litigation risks are both elevated relative to other business models.
Any changes in the way healthcare spending is managed, especially in the United States, would almost certainly impact the company.
These are recession-proof products for the most part, but economic slowdowns can cause a delay in some treatments.
The company is also exposed to technology risks. Any large, fast technological changes in medical devices can alter the competitive landscape.
With these risks out in the open, Medtronic still appears to be highly appealing as a long-term investment.
That’s especially so with the recent 17% drop in the stock’s price creating a compelling valuation…
Stock Price Valuation
The stock is trading hands for a forward P/E ratio of 19.9, based on midpoint guidance for this fiscal year’s adjusted EPS.
I think that’s quite reasonable in this market, particularly for a company of this quality.
Meantime, the P/CF ratio of 21.2 is right in line with its own five-year average.
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 is on the high end of what I normally allow for, although it’s not the highest I’ll go.
I think Medtronic earns this number.
It’s well below their own demonstrated long-term dividend growth rate. It’s also below the anticipated near-term bottom-line growth rate. And the payout ratio is low, giving them even more flexibility.
I believe Medtronic will have no problem with this kind of dividend growth over the long run. If anything, this is slightly conservative.
The DDM analysis gives me a fair value of $108.36.
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 put together a fair, if cautious, valuation that shows the stock closer to its fair value after a recent correction.
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 MDT as a 3-star stock, with a fair value estimate of $129.00.
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 MDT as a 4-star “BUY”, with a 12-month target price of $134.00.
I came out low this time around. Averaging the three numbers out gives us a final valuation of $123.79, which would indicate the stock is possibly 9% 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 MDT’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, MDT’s dividend appears Very Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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