One of the biggest aspects of investing in stocks that scares people?
The thought of losing money.
But here’s the thing.
Spending money on consumption usually results in a 100% loss of capital.
Meantime, investing properly rarely results in any permanent loss at all.
If you go out to the bars on a Saturday night and spend $100, that $100 is gone forever.
On the other hand, investing $100 into a great business will likely multiply that sum numerous times over.
And the odds of losing 100% of it are nearly zero.
It’s funny to me how people look at investing money as risky when spending it is the real risk.
Given the choice, I’d much rather invest than spend.
Regarding the proper application of investing, I’d argue that comes down to the dividend growth investing strategy.
In my mind, it’s the only way to invest.
You can find hundreds of examples on the Dividend Champions, Contenders, and Challengers list.
That list contains invaluable data on US-listed companies (and their shares) that have raised dividends each year for at least the past five years.
I’ve personally used the dividend growth investing strategy for more than a decade now, building my FIRE Fund in the process.
That’s my real-money portfolio, and it produces enough five-figure passive dividend income for me to live off of.
In fact, this portfolio, and the dividend income it produces, allowed me to retire in my early 30s.
I share in my Early Retirement Blueprint how I accomplished that feat.
Suffice it to say, much of my success has come down to choosing investing over spending, investing the right way, and loading up on great businesses at the appropriate time.
When I say appropriate time, I’m referring to valuation.
While price is what you pay, value is what 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.
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.
Choosing investing over spending, and investing in the right businesses at the right valuations, should allow you to build substantial wealth and passive income over the course of your life.
But how does one spot undervaluation?
Fortunately, it’s not as difficult as you might think.
Fellow contributor Dave Van Knapp has made it quite simple, via Lesson 11: Valuation.
Part of a comprehensive series of “lessons” designed to teach dividend growth investing, it describes how to go about estimating fair value of just about any dividend growth stock you’ll find.
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…
Gilead Sciences, Inc. (GILD) is a biopharmaceutical company that develops and markets therapies to treat a variety of life-threatening diseases.
Founded in 1987, Gilead is now a $78 billion (by market cap) drug giant that employs more than 14,000 people.
The company’s three primary disease areas are viral diseases, inflammatory diseases, and oncology.
Gilead focuses heavily on HIV and hepatitis B and C.
Their HIV franchise accounted for approximately 60% of FY 2021 sales.
Geographically, the US is by far their biggest market. The US accounted for approximately 74% of FY 2021 sales.
Biktarvy, which treats HIV, is their crown jewel. This single drug comprised about 32% of total FY 2021 sales.
Biktarvy is the the most prescribed HIV treatment in the US. Gilead’s biggest drug is also one of their fastest-growing products – Biktarvy FY 2021 sales showed 19% YOY growth.
Unfortunately, Gilead’s massive success in HIV has been overshadowed and undercut by their other massive success in hepatitis c.
Why would massive success in one area be a bad thing?
Well, Gilead became a victim of their own success.
That’s because they developed Sovaldi, a cure for hepatitis c.
When you cure people rather than simply treat them, that naturally leads to less product sales down the line. Cured people no longer need treatment.
In addition, Gilead’s somewhat narrow focus on HIV, which impacts a relatively small percentage of the population, limits the size of their customer pool.
Gilead should undoubtedly be lauded for providing life-saving treatments to people that desperately need them.
However, investors have had to be more patient with Gilead than the average pharmaceutical company. Because patience is often in short supply, the market has been unkind to the company’s stock over the last several years.
That said, Gilead does pay a large, growing dividend, which has made it a lot easier for its shareholders to remain patient.
Dividend Growth, Growth Rate, Payout Ratio and Yield
As it sits, Gilead has increased its dividend for eight consecutive years.
The five-year dividend growth rate is at 9.1%.
That’s strong.
However, more recent dividend increases have been in the mid-single-digit range.
On the flip side, the stock yields a very healthy 4.7%.
By the way, this market-smashing yield is 90 basis points higher than its own five-year average.
And with the payout ratio at 59.2%, the dividend is secure and positioned to continue growing.
I think there’s a lot to like about the dividend here, especially for income-oriented dividend growth investors.
Revenue and Earnings Growth
As likable as the dividend may be, a lot of this is looking backward.
But investors have to risk today’s capital for tomorrow’s rewards.
Thus, I’ll now build out a forward-looking trajectory for the business, which will later be instrumental when it comes time to estimate intrinsic value.
I’ll first show you what the company has done in terms of top-line and bottom-line growth over the last decade.
And then I’ll reveal a professional prognostication for near-term profit growth.
Lining the proven past up against a future forecast in this way should allow us to develop a reasonable idea of where the business might be going from here.
Gilead’s revenue has increased from $9.7 billion in FY 2012 to $27.3 billion in FY 2021.
That’s a compound annual growth rate of 12.2%.
That’s actually rather impressive for a fairly mature pharmaceutical business.
Now, it is important to point out that revenue has seen a recent and temporary bump from sales of Veklury.
Veklury is brand-name remdesivir. This broad-spectrum antiviral medication has been used to treat COVID-19. Veklury sales were up 98% for FY 2021 compared to FY 2020.
Factoring out Veklury, FY 2021 revenue came in at $21.4 billion.
Using that number would result in a 9.2% CAGR for revenue over the last decade, which is actually still rather impressive.
Meanwhile, EPS moved up from $1.64 to $4.93 over this period, which is a CAGR of 13.0%.
Again, we have a great 10-year result.
However, again, there’s a caveat.
This 13% CAGR was anything but a steady, secular increase in EPS. For instance, Gilead’s EPS came in at a whopping $11.91 in FY 2015. After a collapse in sales of their HCV miracle drug Sovaldi, the company’s revenue and profit had to realign and right-size themselves.
If you look at things over the long term, though, Gilead’s track record is better than it’s given credit for.
Looking forward, CFRA believes that Gilead will compound its EPS at an annual rate of 2% over the next three years.
That would represent a material growth slowdown for Gilead, if it comes to pass.
To be fair to CFRA, I think it’s difficult to pin things down in Gilead’s case.
There’s a lot of uncertainty, especially regarding the longevity of demand for Veklury.
But I also see three big things to be excited about.
First, the company’s biggest drug is also among its fastest-growing drugs. Biktarvy saw its sales grow 19% YOY for FY 2021. And there’s even been growth acceleration here. Biktarvy YOY sales growth came in at 22% for Q4 2021.
Second, the company has broadened itself out into oncology, most notably with their recent $21 billion acquisition of Immunomedics. Key cancer drug Trodelvy, which came with the Immunomedics acquisition, received FDA approval in April 2020. This drug is expected to do $3.5 billion in annual sales by 2026.
Third, Gilead’s 55 clinical stage programs indicates a healthy pipeline. Many of Gilead’s leading drugs enjoy patent protection through the end of the decade, giving the pipeline room to develop.
Look, Gilead’s stock price is the same as it was back in the summer of 2013. That’s despite the fact that Gilead’s revenue, net income, and FCF have all more than doubled since that time. And the company is generating all of that on 80% of the float.
The expectations here are super, super low.
I think Gilead can, and likely will, do better than low-single-digit EPS growth over the next few years.
But even if CFRA is accurate with their prediction, Gilead could still increase its dividend at a rate that’s at least in line with that level.
And you’re getting a near-5% yield to start with.
These are utility-like dividend numbers, except you get the pharmaceutical upside on top of it.
Financial Position
Moving over to the balance sheet, the company’s financial position is satisfactory.
The balance sheet has deteriorated in recent years, as Gilead has sought out growth through acquisitions. But the balance sheet is not poor. It’s simply not quite as strong as it once was.
The long-term debt/equity ratio is 1.2, while the interest coverage ratio is over 9.
Profitability is extremely robust.
Over the last five years, the firm has averaged annual net margin of 19.4% and annual return on equity of 24.8%.
Despite what the market might have you believe at first glance, Gilead is actually running a great business.
And the company does have durable competitive advantages that include economies of scale, IP, patents, R&D, inelastic demand for entrenched products, and established relationships with its various partners.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
I view all three of these risks as elevated within Gilead’s specific industry.
A shrinking HCV market, reduced demand for Veklury, and generic alternatives to legacy HIV drugs will threaten the company’s sales base.
There’s integration risk with Immunomedics, with pressure on Trodelvy to perform.
And there’s pipeline risk. New blockbuster drugs must overcome slowing sales from older drugs.
I think it’s important to consider these risks, but Gilead could still be a terrific long-term investment.
I say that because the stock’s low valuation seems to be more than pricing all of that in…
Stock Price Valuation
The stock’s P/E ratio is 12.5.
That’s well below the broader market’s earnings multiple.
We can also see that the P/CF ratio is at an undemanding 6.8.
That’s way off of the stock’s own five-year average P/CF ratio of 9.1.
And the yield, as noted earlier, is significantly higher than its own five-year 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 9% discount rate (to account for the high yield) and a long-term dividend growth rate of 5%.
I’m giving Gilead little benefit of the doubt here. I’m permanently building in low expectations.
The payout ratio is a bit elevated.
And CFRA is expecting only a 2% CAGR for the company’s EPS over the next few years.
I also think there are more questions than answers around the overall drug portfolio.
On the other hand, Gilead is actually running a great business when you look at the fundamentals.
And with the stock priced the same as it was nine years ago, even though the business is far ahead of where it was back then, I do see a disconnect between the stock and the business.
It wouldn’t take much for Gilead to exceed the low expectations being placed on it.
But I always like to err on the side of caution. I’m especially cautious in this case.
The DDM analysis gives me a fair value of $76.65.
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 conservative, valuation, yet the stock still looks very 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 GILD as a 4-star stock, with a fair value estimate of $81.00.
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 GILD as a 3-star “HOLD”, with a 12-month target price of $66.00.
I came out somewhere in the middle. Averaging the three numbers out gives us a final valuation of $74.55, which would indicate the stock is possibly 21% 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 GILD’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, GILD’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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