I know of a basic truth.
The human population continues to expand.
We’ll likely see a global population of 10 billion people within my lifetime.
What does that mean?
It means more people consuming more products and/or services.
And with inflation slowly increasing the costs of everything, these people will also be paying more.
It’s simple math.
This nearly guarantees success for long-term stock investors over the coming decades.
Of course, you want to be invested in the right stocks.
I’d argue the right stocks are high-quality dividend growth stocks.
These are stocks that represent equity in world-class enterprises that pay reliable, rising dividends.
They’re only able to do that by producing reliable, rising profits.
The Dividend Champions, Contenders, and Challengers list contains invaluable data on hundreds of these stocks.
I’ve been buying these stocks myself for the last 10+ years of my life.
I built the FIRE Fund in the process.
That’s my real-money dividend growth stock portfolio, and it produces enough five-figure passive dividend income for me to live off of.
Indeed, this portfolio allowed me to retire in my early 30s.
I explain exactly how I retired so early in my Early Retirement Blueprint.
As much as I believe high-quality dividend growth stocks are the right stocks, valuation at the time of investment is critical.
Whereas price determines what you pay, value determines what you get.
An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.
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.
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.
Improving upon an already favorable setup for long-term investors by buying the right stocks at the right valuations makes you almost bulletproof.
Fortunately, valuation is not a difficult concept to grasp.
Fellow contributor Dave Van Knapp has made that much easier through the introduction of Lesson 11: Valuation.
As part of a comprehensive series of “lessons” on dividend growth investing, it lays out in simple terms how to go about estimating the fair value of 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 $113 billion (by market cap) healthcare behemoth that employs more than 24,000 people.
Amgen offers treatments for a range of ailments, including anemia, rheumatoid arthritis, psoriasis, cancer, and osteoporosis.
FY 2020 total product sales break down geographically as follows: US, 74%; Rest of World, 26%.
Some of its major drugs include: Enbrel, 21% of FY 2020 sales; Prolia, 11%; Neulasta, 9%; Otezla, 9%; and XGEVA, 8%.
Their biggest blockbuster, Enbrel, generates over $5 billion in total annual sales and has patent protection until almost the end of this decade.
Amgen is benefiting from a rising tide that is lifting all boats.
The rising tide is demographics.
Our global population is growing larger, older, and richer.
There are simply more humans.
Simultaneously, on average, these humans are living longer than ever.
In addition, they’re wealthier than they’ve ever been before.
There’s essentially a straight line from the demographics to increased drug sales.
What’s particularly exciting about Amgen in this situation of a rising tide is that they’re not just any boat – they’re a world-class boat, as evidenced by their fundamentals.
This bodes very well for their ability to grow their profit and dividend for many years to come.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Already, Amgen has increased its dividend for 11 consecutive years.
The five-year dividend growth rate is an astounding 15.2%.
That double-digit dividend growth is paired with a starting yield of 3.5%.
This yield is substantially higher than what the broader market offers.
This is a highly appealing combination of yield and growth that I don’t often come across.
And with a payout ratio of only 41.9%, based on midpoint adjusted EPS guidance for this fiscal year, the dividend is in a great position to continue growing at a relatively high rate.
I love dividend growth stocks in what I refer to as the “sweet spot” – that’s a yield of between 2.5% and 3.5%, paired with a high-single-digit (or better) dividend growth rate.
As you can see, this stock is basically as “sweet” as it gets.
Revenue and Earnings Growth
While these dividend metrics are clearly fantastic, they’re largely looking in the rearview mirror.
Investors risk today’s capital for tomorrow’s rewards.
Thus, I’ll now construct a forward-looking growth trajectory for the business, which will help greatly when it comes time to estimate 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 line that up against a near-term professional prognostication for profit growth.
Comparing the proven past with a future forecast in this way should allow us to draw some reasonable conclusions about where the business is going from here.
Amgen increased its revenue from $15.6 billion in FY 2011 to $25.4 billion in FY 2020.
That’s a compound annual growth rate of 5.6%.
I like to see a mid-single-digit top-line growth rate from a mature business such as this one.
Amgen more than delivered on this.
Meantime, earnings per share expanded from $4.04 to $12.31 over this time frame, which is a CAGR of 13.2%.
Truly impressive.
It’s obvious that Amgen has been able to fund double-digit dividend growth because it’s been producing double-digit EPS growth.
There’s a lot of excess bottom-line growth here, aided by meaningful share repurchases.
The outstanding share count is down by 35% over the last 10 years.
Looking forward, CFRA is forecasting a 9% compound annual growth rate for Amgen’s EPS over the next three years.
This would represent a slowdown in bottom-line growth compared to what Amgen has enjoyed over the last decade.
However, if this is what comes to pass, it would still be a very strong result. I doubt many shareholders would be terribly unhappy with this.
On one hand, CFRA notes that Amgen features a wide pipeline, a promising biosimilars business, a diverse product portfolio, and robust cash flow.
That robust cash flow has historically been used to support internal growth, acquisitions, buybacks, and increasing dividends to shareholders.
Regarding acquisitions, Amgen notably 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.
However, Amgen has a considerable headwind to overcome in the form of slowing growth across key legacy drugs, especially Enbrel. FY 2020 revealed a 4% YOY sales decline for Enbrel.
I see CFRA’s near-term EPS growth expectation as reasonable.
And this would allow for Amgen to grow its dividend at a corresponding rate. In fact, the low payout ratio gives them the flexibility to hand out rather generous dividend increases for the foreseeable future.
Financial Position
Moving over to the balance sheet, Amgen commands a good financial position.
The long-term debt/equity ratio is 3.5.
While that is very high, it’s only so high because of low common equity (not an outrageous debt load).
The interest coverage ratio of over 7 shows no problems with servicing debt.
Profitability is extremely robust.
Over the last five years, the firm has averaged annual net margin of 27.0% and annual return on equity of 46.3%.
There’s almost nothing to dislike about Amgen.
With a rising tide that’s lifting all boats, Amgen is one of the best boats to be in.
And the company does have durable competitive advantages, including patents, R&D, IP, established relationships, entrenched products, and global scale.
Of course, there are risks to consider.
Litigation, regulation, and competition are omnipresent risks in every industry.
I see both litigation and regulation as elevated risks for this specific business model.
Some of Amgen’s smaller drugs, including Neulasta and Epogen, are now looking at biosimilar competition.
Any major changes to the US healthcare system, especially around drug pricing, would impact Amgen.
Amgen’s Otezla acquisition was costly. This acquisition only makes sense if the drug sells very well.
And the company’s balance sheet, while still good, has weakened in recent years.
These risks should be carefully considered, but I think Amgen’s appeal as a long-term investment easily outweighs the risks.
With the stock down nearly 30% from its 52-week high, the attractive valuation only serves to boost its appeal…
Stock Price Valuation
The P/E ratio is 20.7.
That’s better than the broader market’s earnings multiple.
It’s also materially lower than the stock’s own five-year average P/E ratio of 24.6.
We can also see a disconnect on the sales multiple.
The current P/S ratio of 4.5 is well off of its own five-year average of 5.6.
And the yield, as noted earlier, is significantly 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 higher end of what I usually allow for (but not the highest).
However, I believe Amgen’s quality and growth profile warrants it.
This is about half of Amgen’s demonstrated long-term dividend growth. It’s also much lower than the 10-year EPS growth rate. And there’s a lot of daylight between this number and what CFRA is expecting from Amgen’s EPS growth over the next three years.
With a low payout ratio giving them additional flexibility on the dividend, I actually see this as rather conservative. .
It wouldn’t take much for Amgen to far exceed this dividend growth rate over the coming years, but I always like to err on the side of caution.
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.
I don’t see my valuation as aggressive at all, yet the stock looks very cheap here.
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 $200.00.
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 $245.00.
I came in surprisingly high, but I’d also argue that Morningstar is too low. Averaging the three numbers out gives us a final valuation of $249.24, which would indicate the stock is possibly 24% 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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