With volatility way up and many stocks well off of recent highs, the US stock market is off to a rough start this year.
Or is it?
If you’re still young and accumulating stocks, I’d argue that it hasn’t been a rough start at all.
If anything, this might be exactly what you want to see.
As I always say, short-term volatility is a long-term opportunity.
Indeed, young investors actively accumulating assets are “forced buyers” of stocks.
It’s much in the same way that you’re a “forced buyer” of food for the rest of your life.
This is a mantra I’ve lived by myself as I’ve gone about building my own portfolio, which I call the FIRE Fund.
That portfolio produces enough five-figure passive dividend income for me to live off of.
By living well below my means and intelligently investing my excess capital, I was able to retire in my early 30s.
I share the details of how I accomplished that in my Early Retirement Blueprint.
A pillar of that Blueprint is the investing strategy I used and continue to use.
That strategy is dividend growth investing.
It’s all about investing in world-class businesses paying reliable, rising dividends to their shareholders.
And they’re able to fund those reliable, rising dividends from the reliable, rising profits they’re generating.
You can find hundreds of examples of these businesses in the Dividend Champions, Contenders, and Challengers list.
It comes down to valuation.
This brings me back to my original point.
While price only tells you what you pay, value is 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.
It’s protection against the possible downside.
Using short-term volatility as your long-term opportunity by buying high-quality dividend growth stocks when they’re undervalued can lead to exceptional investing results over the long term.
Of course, this requires an investor to understand and estimate intrinsic value.
Fellow contributor Dave Van Knapp has made that easier than it might seem.
His Lesson 11: Valuation, which is part of an overarching series of “lessons” on dividend growth investing, provides a valuation template that you can apply 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…
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 $58 billion (by market cap) industrial gases monster that employs 20,000 people.
The company’s FY 2021 sales were reported through four Industrial Gases business segments organized by geography: Americas, 40%; Asia, 28%; EMEA, 24%; and Global, 5%. Corporate and other accounted for the remaining 3%.
Industrial gases are critical input for the manufacturing processes of many different end products. This applies to all kinds of everyday products – everything from electronics to vehicles.
Because of the critical nature of these industrial gases, a manufacturer will set up a long-term contract with a reliable provider of these gases.
Complex infrastructure is often installed at a site to ensure reliability. This can make it costly and difficult to switch providers later.
In addition, Air Products & Chemicals is part of a global oligopoly. Three major companies in this space split most of the global market share.
Layering this oligopoly on top of the critical nature of their gases is a very powerful combination that puts Air Products & Chemicals in a great position to continue growing its revenue, profit, and dividend for many years into the future.
Dividend Growth, Growth Rate, Payout Ratio and Yield
To that point, Air Products & Chemicals has already increased its dividend for 40 consecutive years.
In fact, they increased their dividend for the 40th consecutive year only days ago.
They easily live up to their status as a vaunted Dividend Aristocrat.
Their 10-year dividend growth rate is 10.1%.
After the 8% dividend increase that was announced only days ago, the stock now yields 2.5%.
That yield handily beats the market.
It’s also 30 basis points higher than the stock’s own five-year average yield.
With a payout ratio of 62.9%, based on the midpoint of guidance for this fiscal year’s adjusted EPS, the dividend is secure and positioned to continue growing roughly in line with the business.
I like dividend growth stocks in what I call the “sweet spot” – a yield of between 2.5% and 3.5%, paired with a high-single-digit (or better) dividend growth rate.
You can see that we’re right in the sweet spot with this one.
Revenue and Earnings Growth
As great as these dividend metrics are, though, they’re largely looking backward.
However, investors are always risking today’s capital for tomorrow’s growth and rewards.
As such, I’ll build out a forward-looking growth trajectory for the business, which will later help when it comes time to estimate the stock’s intrinsic value.
I’ll first show you what the company has done over the last decade in terms of top-line and bottom-line growth.
Then I’ll line that up against a professional prognostication for near-term profit growth.
Comparing the proven past with a future forecast in this way should allow us to extrapolate out future growth with a reasonable degree of confidence.
Air Products & Chemicals has increased its revenue from $9.6 billion in FY 2012 to $10.3 billion in FY 2021.
That’s a compound annual growth rate of 0.8%.
While that’s disappointing at first glance, the limited top-line growth can mostly be attributed to the company’s decision to purposely make the business smaller and more efficient.
They put together their “Five-Point Plan”, focusing them on industrial gases by jettisoning non-core businesses.
The execution of this plan led to spinning off the electronics material division in 2016, as well as selling the performance materials division in 2017 for $3.8 billion in cash.
It appears to have worked.
Earnings per share grew from $5.44 to $9.43 over this 10-year period, which is a CAGR of 6.3%.
Notably, most of this growth started to reveal itself after FY 2016. That’s when net margin started to increase dramatically. So they’re doing a lot more with what is effectively the same sales base.
Also, it’s worth pointing out that the company’s GAAP EPS can be lumpy. In my view, this number belies their true earnings power.
It can be instructive to instead look at adjusted EPS in this case. If we look at this, we can see that the company’s guidance for adjusted EPS for this fiscal year, at the midpoint, is calling for 14% YOY growth.
Looking forward, CFRA is projecting that Air Products & Chemicals will compound its EPS at an annual rate of 15% over the next three years.
That EPS growth forecast looks high when compared to the company’s 10-year demonstrated EPS growth. However, again, most of that growth came about after the transformation. And, again, I believe that the GAAP EPS number doesn’t fully convey what this business is capable of doing.
They’re structured to succeed based on providing high-value but low-cost gasification. They lock in long-term contracts as a part of huge projects within the framework of a global oligopoly. It’s hard to overstate how appealing that is.
Regarding this, CFRA states the following: “APD has a solid backlog of growth projects, with a focus on expanding the scope of syngas supply agreements, acquiring air separation units, and winning agreements in large industrial gas projects.”
Indeed, their backlog is currently at approximately $17 billion.
Moreover, new opportunities that didn’t even exist 10 years ago are now opening up for the company.
CFRA points this out: “APD is well positioned to capitalize on gasification related to carbon capture and hydrogen mobility, which are long-term secular tailwinds.”
There’s also green hydrogen. The company’s $5 billion partnership with Saudi Arabia’s ACWA Power and NEOM on the world’s largest green hydrogen plant in Saudi Arabia is a prime example.
Effectively, we’re taking what was already a really good business 10 years ago, improving it through additional focus on its core strengths, and then adding on new growth vectors.
I think that bodes extremely well for the business and its shareholders over the years to come.
And it sets them up to continue growing the dividend at a level that’s roughly in line with what they’ve done over the last decade. With a 2.5% starting yield, you’re looking at a great combination of yield and growth here.
Financial Position
Moving over to the balance sheet, the company maintains a very strong balance sheet.
The long-term debt/equity ratio is 0.5, while the interest coverage ratio is over 18.
Furthermore, the company has a healthy amount of cash.
Profitability is quite robust, which shouldn’t be a surprise for an oligopolistic enterprise.
Over the last five years, the firm has averaged annual net margin of 22.2% and annual return on equity of 19.7%.
Speaking on the margin expansion I highlighted earlier, the company was routinely printing single-digit annual net margin prior to FY 2017.
This Dividend Aristocrat is high quality across the board.
And with global economies of scale, barriers to entry, high switching costs, a global oligopoly, and long-term contracts with fixed infrastructure, the company does benefit from durable competitive advantages.
Of course, there are risks to consider.
Litigation, regulation, and competition are omnipresent risks in every industry.
There is direct exposure to economic cycles via oscillating demand for manufacturing output.
The company is tied to numerous large energy projects around the world. Any changes in the global energy complex could diminish the company’s long-term growth story.
Also, input costs can be volatile.
I view these risks as manageable, especially when lined up against the quality of the business.
And after a 20% drop from its 52-week high, the stock’s current valuation makes it highly appealing right now…
Stock Price Valuation
The P/E ratio is 26.5.
That’s measurably lower than the stock’s five-year average P/E ratio of 28.6.
The P/CF ratio of 17.2 is also showing a slight discount relative to its usual level.
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 8%.
That dividend growth rate might look high in isolation.
However, it’s quite a bit lower than the company’s long-term demonstrated dividend growth. And I’d argue the company is in a better position now than it was 10 years ago. Also, the dividend increase announced only days ago was right there – even as we’re still moving past a global pandemic.
With the payout ratio being where it’s at, I suspect that dividend growth will line up pretty well with bottom-line growth.
Since the company is expected to grow its EPS at a double-digit rate for the foreseeable future, 8% dividend growth shouldn’t be a difficult hurdle to clear.
The DDM analysis gives me a fair value of $349.92.
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’d argue I was conservative with the valuation, 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 APD as a 4-star stock, with a fair value estimate of $331.00.
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 $348.00.
We have a fairly tight consensus this time around. Averaging the three numbers out gives us a final valuation of $342.97, which would indicate the stock is possibly 32% 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 D&I: 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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