The US stock market’s resilience is amazing.
It started off November with a hard dip in response to the Omicron variant news.
The following week, it bounced back and hit new all-time highs.
However, that’s speaking about the broader market.
There are still many individual stocks out there sitting well below their all-time highs.
This chasm between the market itself and many stocks within the market could be a huge opportunity.
I’ve seen this opportunity pop up many times over the years.
And it’s something I’ve routinely taken advantage of.
But I’m not talking about random stocks here.
No, I’m talking about high-quality dividend growth stocks.
These are stocks that pay reliable, rising dividends to shareholders.
And they’re able to do that because they’re generating reliable, rising profit.
You can find hundreds of US-listed dividend growth stocks by checking out the Dividend Champions, Contenders, and Challengers list.
Finding and taking advantage of gaps between individual high-quality dividend growth stocks and the market helped me to build the FIRE Fund.
That’s my real-money portfolio, which produces enough five-figure passive dividend income for me to live off of.
Indeed, this portfolio and the passive dividend income it produces allowed me to retire in my early 30s.
I lay out in my Early Retirement Blueprint exactly how I managed to retire so early in life.
Taking advantage of the difference between individual stocks and the market implies a difference in valuation.
This is crucial.
And I’ll tell you why.
Price is only what you pay. But it’s value that you actually get for your money.
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.
Taking advantage of the valuation gap between the market and individual dividend growth stocks sets you up for tremendous investment results, wealth, and passive dividend income over the years to come.
Of course, taking advantage of this gap requires an understanding of valuation in the first place.
Fortunately, it’s not that difficult.
Fellow contributor Dave Van Knapp’s Lesson 11: Valuation demystifies the entire subject.
Part of an overarching series of “lessons” on dividend growth investing, it provides a valuation framework that can be simply applied toward 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…
Bristol-Myers Squibb Co. (BMY)
Bristol-Myers Squibb Co. (BMY) is a global biopharmaceutical company that is engaged in discovering, developing, and delivering a range of medicines to help people overcome serious diseases.
Founded in 1887, Bristol-Myers Squibb is now a $125 billion (by market cap) healthcare giant that employs 30,000 people.
The company focuses on oncology, cardiovascular, and immunology treatments.
Three primary drugs together accounted for almost 70% of sales: Revlimid, Opdivo and Eliquis. Eliquis is jointly developed and commercialized with Pfizer Inc. (PFE).
Bristol-Myers Squibb has long been a major player in the pharma space.
But they become much larger with the 2019 acquisition of Celgene Corporation for $74 billion.
This acquisition added blockbuster cancer drug Revlimid to the sales mix.
Revlimid produced more than $12 billion in sales in 2020, making it one of the top-selling drugs in the whole world. It’s the crown jewel for the combined business.
Global pharmaceutical companies are basically money machines. And there’s no end in sight for the money printing.
People are living longer than ever before.
While longevity is wonderful, older human beings tend to incur health issues that require medical intervention (like therapeutics).
And since people are also wealthier than ever before, on average, they have the financial resources with which to acquire these medical interventions.
Simultaneously, our global population continues to grow.
It’s possible that we hit 10 billion people by 2050.
That’s a lot of older, wealthier people needing medicine.
If these long-term demographic tailwinds weren’t enough, global pharmaceutical companies are steadily developing more advanced medicines – and charging more money for them.
Ever-more treatments, sold to ever-more people, at ever-higher prices.
This bodes extremely well for growing profits and dividends for years to come.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Already, the company has increased its dividend for 13 consecutive years.
Now, the 10-year dividend growth rate of 3.5% isn’t exactly my cup of tea.
However, their most recent dividend increase, announced only days ago, was over 10%.
That follows up a 9%+ dividend increase last year, indicating a rapid acceleration in dividend growth.
I welcome this development.
And it’s layered on top of a market-beating 3.6% yield.
This yield, by the way, doesn’t just beat the market – it’s also 80 basis points higher than the stock’s own five-year average yield.
With a payout ratio of only 28.9%, based on midpoint adjusted EPS guidance for this fiscal year, there’s plenty of room here for the dividend to go a lot higher.
I like 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 high-single-digit (or better) dividend growth.
Clearly, this stock is in the sweetest part of that sweet spot.
Revenue and Earnings Growth
As sweet as these dividend metrics are, though, they’re largely looking backward.
But investors are always risking today’s capital for tomorrow’s rewards.
Thus, I’ll now assemble a forward-looking growth trajectory for the business, which will later help when estimating 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.
And I’ll then reveal a professional prognostication for near-term profit growth.
Lining that historical result up against a future forecast in this way should allow us to have a good idea as to where the business is going from here.
Bristol-Myers Squibb increased its revenue from $21.2 billion in FY 2011 to $42.5 billion in FY 2020.
That’s a compound annual growth rate of 8.0%.
This is impressive.
However, a lot of this absolute growth is due to the big Celgene acquisition. Bristol-Myers Squibb simply became much larger through acquisition.
Keep in mind, Bristol-Myers Squibb issued new equity shares to Celgene shareholders as part of the acquisition. The outstanding share count is substantially higher today than it was a decade ago.
As such, relative profit growth on a per-share basis should give us better insight into the true growth profile.
Earnings per share increased from $2.16 to $6.44 (adjusted) over this period, which is a CAGR of 12.9%.
That’s actually even more impressive than the top-line growth.
Admittedly, I used adjusted EPS for FY 2020. That’s because the acquisition integration and one-time charges greatly skewed the GAAP EPS result for FY 2020.
Looking forward, CFRA is forecasting that Bristol-Myers Squibb will compound its EPS at an annual rate of 10% over the next three years.
This wouldn’t be far off from what the company has produced over the last decade.
CFRA cites a healthy pipeline and the strength of its marketed brands as key long-term tailwinds.
Regarding the pipeline, there are more than 50 compounds in development.
This healthy pipeline is a necessity at this point.
Patents on Revlimid start to expire in 2022, with unrestricted competition slated to begin in 2026.
Since Revlimid is the company’s crown jewel, the upcoming patent cliff is a serious threat. Continued development of successful drugs, through healthy R&D, is absolutely critical to their long-term success.
I view CFRA’s near-term EPS growth forecast as sensible.
To put it in perspective, Bristol-Myers Squibb’s own non-GAAP EPS guidance for FY 2021 would imply 16.1% YOY growth at the midpoint.
In addition, the company just announced a huge $15 billion buyback program. That’s more than 10% of the company’s market cap.
With a justifiable expectation for 10% annual EPS growth in place, I see a high likelihood for similar annual dividend growth over the foreseeable future. And that’s more than enough when you’re also locking in a 3.6% yield.
Financial Position
Moving over to the balance sheet, the financial position is satisfactory.
While the company did take on heavy debt to partially fund the Celgene acquisition, they went into the acquisition with a phenomenal balance sheet.
What happened is, the balance sheet basically dropped from an excellent level to a level that’s just good.
The long-term debt/equity ratio is 1.3.
The interest coverage ratio is currently N/A. That’s due to skewed earnings before taxes for FY 2020. On the other hand, their interest coverage ratio in FY 2018 – the last full year before the Celgene acquisition – was over 30.
I believe that once we see an increased earnings base normalizing against higher interest expenses, the interest coverage ratio will be fine.
Profitability is robust as it sits, but I suspect this will also look a lot better once things normalize.
Over the last five years, the firm has averaged annual net margin of 7.8% and annual return on equity of 12.8%.
Both numbers would be a lot higher if not for the skewing of GAAP numbers for FY 2020.
I happen to think that Bristol-Myers Squibb is more investable now than it’s ever been.
The healthy pipeline, blockbuster drug lineup, big buyback, and recent acceleration of growth all point to a very bright future.
And the company is protected by durable competitive advantages that include global economies of scale, R&D, IP, established sales relationships, and patents.
Of course, there are risks to consider.
Litigation, regulation, and competition are omnipresent risks in every industry.
Revlimid’s upcoming patent cliff is a material risk.
Acquisition integration risk remains. Regarding this, there has to be a lot of growth from the Celgene acquisition in order to rationalize the equity dilution and weaker balance sheet.
The increased debt load also increases the company’s exposure to interest rates, and it limits future M&A opportunities.
Any major changes to healthcare in the US, especially around drug pricing, would impact Bristol-Myers Squibb.
And while the branded drug portfolio is strong, the company remains concentrated around only a small handful of highly successful drugs. There is pressure on the pipeline to develop new blockbusters.
These risks shouldn’t be taken lightly, but I still think this company can be a great long-term investment.
The current valuation only serves to make me more enthusiastic about it…
Stock Price Valuation
The forward P/E ratio is only 8.0, based on midpoint guidance for this fiscal year’s adjusted EPS.
That’s ludicrously low for a business growing at a double-digit rate.
There’s also a severe disconnect in the cash flow multiple.
The current P/CF ratio of 8.6 is well off of the stock’s five-year average P/CF ratio of 15.9, despite an acceleration in growth.
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%.
This DGR is just a tad lower than what I ordinarily use in the pharmaceutical space.
Compared to the company’s long-term EPS growth rate, CFRA’s near-term EPS growth projection, and the last two dividend increases, it’s very conservative.
But I would argue that it’s appropriate to be cautious.
The large Celgene acquisition is still new and unproven. The balance sheet is now leveraged. And there’s a looming patent cliff on the company’s most important drug.
It’s certainly possible, if not likely, that the company will grow its dividend at a higher rate than I’m modeling, but I’d rather err on the side of caution.
The DDM analysis gives me a fair value of $77.04.
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 feel like I was being careful and prudent with my valuation, yet the stock still looks downright 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 BMY as a 4-star stock, with a fair value estimate of $68.00.
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 BMY as a 3-star “HOLD”, with a 12-month target price of $60.00.
I ended up on the high end this time, but CFRA’s number looks light to me. Averaging the three numbers out gives us a final valuation of $68.35, which would indicate the stock is possibly 15% undervalued.
Bottom line: Bristol-Myers Squibb Co. is a high-quality biopharmaceutical company that looks more investable than ever before to me. A big buyback program, growth acceleration, a strong branded drug portfolio, and a healthy pipeline all bode well. With a market-beating 3.6% yield, more than 10 consecutive years of dividend increases, a recent 10%+ dividend raise, a low payout ratio, and the potential that shares are 15% undervalued, this high-quality dividend growth stock is a highly worthy long-term idea here.
-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 BMY’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 79. 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, BMY’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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