Charlie Munger, Warren Buffett’s right-hand man for decades before his unfortunate passing late last year, used to talk about an “adequate life”.
Specifically, he noted that simply getting rich with stocks in a passive way isn’t an adequate life.
And while that may be true, it’s still a pretty nice way to go.
At the very least, having wealth and passive income sets one up to prosper and achieve whatever an adequate life may be.
So how do we do that?
Well, that’s where dividend growth investing comes in.
This is a long-term investment strategy that advocates buying and holding shares in world-class businesses that pay safe, growing dividends to shareholders.
Growing dividends are only sustained when growing profits are there to underpin those rising cash payments, and only great businesses can steadily and reliably increase their profits.
As such, this strategy tends to funnel investors right into some of the world’s best businesses.
You can see what I mean by looking over the Dividend Champions, Contenders, and Challengers list – a compilation of US-listed stocks that have raised dividends each year for at least the last five consecutive years.
Because of what I just laid out, I’ve been personally using the dividend growth investing strategy for more than a decade now.
It’s guided me as I’ve gone about building the FIRE Fund.
That’s my real-money portfolio, and it generates enough five-figure passive dividend income for me to live off of.
This situation – being able to live off of dividends – allowed me to retire in my early 30s.
My Early Retirement Blueprint details the ins and outs of exactly how that occurred.
Now, as powerful as dividend growth investing can be, there’s more to it than only selecting the right businesses to invest in.
After all, price is only what you pay, but it’s value that you 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.
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.
Investing in the right businesses at the right valuations can allow one to become fabulously wealthy over time and enjoy lots of passive and growing dividend income, upon which time one will have the ability to pursue the “more” that Charlie Munger talked about.
Of course, all of that does require a person to already have a basic understanding of how valuation works.
This is why Lesson 11: Valuation, penned by fellow contributor Dave Van Knapp, is so helpful.
It was written in order to simplify the entire concept of valuation, and it even provides an easy-to-follow valuation template that can be used to estimate 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…
Hershey Co. (HSY) is an American multinational confectionery and snack food company.
Founded in 1894, Hershey is now a $37 billion (by market cap) confectionary principal that employs nearly 20,000 people.
The company reports results across three segments: North America Confectionery, 82% of FY 2023 sales; North America Salty Snacks, 10%; and International, 8%.
To put Hershey’s size and dominance into perspective, the company controls approximately 100 different brands.
These brands include Reese’s, Twizzlers, SkinnyPop, and Pirate’s Booty, Reese’s, SkinnyPop, and Reese’s.
Of course, there’s also the namesake Hershey brand.
Per Euromonitor, it’s estimated that Hershey controls 36% of the domestic chocolate market.
That is massive.
I think the recipe for Hershey’s success is actually pretty simple: Since chocolate is a low-cost, high-value occasional treat, paying up for the consistent, familiar, and distinctive flavor of Hershey’s candies makes a lot of sense for many consumers.
Private-label products have difficulty competing in that type of environment,
This leads to strong brand power and entrenched competitive positions for dominant players like Hershey.
But the company is not resting on its chocolatey laurels.
Instead, it continues to spend on marketing to protect existing brands (advertising and related consumer marketing expenses were up 12% YOY for the most recent quarter), as well as invest in R&D in order to fund innovation and new growth vectors.
In addition, Hershey has used this commanding lead within its main competitive arena to bolster other areas of the business and broaden out into complementary salty snacks (salty tends to pair nicely with sweet).
Hershey acquired Amplify Snack Brands, which makes Skinny Pop ready-to-eat popcorn, for $1.6 billion in 2018.
There was then the 2021 acquisition of Dot’s Pretzels for $1.2 billion, and this boosted Hershey’s salty snack lineup.
While nothing is guaranteed in this world, it’s difficult to imagine a future in which Hershey doesn’t continue to dominate and expand.
And that kind of activity will almost certainly lead to the company posting up higher revenue and profit over the coming years, which will allow for the dividend to steadily increase.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Hershey has already increased its dividend for 15 consecutive years.
The 10-year dividend growth rate is 9.4%, which is already pretty strong, but there’s actually been an acceleration in dividend growth of late – the most recent dividend raise of 14.9% is more indicative of what Hershey has been doing over the last several years.
And that kind of dividend growth comes on top of the stock’s yield of 3%.
If you can get a 3% yield and low-double-digit dividend growth, you’re setting yourself up for a low-teens total return profile.
This 3% yield, by the way, is 110 basis points higher than its own five-year average.
It’s simply very unusual to see a yield this high from this stock.
Outside of crashes and crises, this is the highest yield I’ve ever seen on the stock over the course of my investing experience (which goes back nearly 15 years).
And with a payout ratio of 49.2%, which is nearly perfectly balanced between retaining earnings for growth against returning cash to shareholders, Hershey’s dividend is about as safe as it’s ever been.
I really can’t find anything to complain about here.
It’s a safe, relatively high yield that comes with double-digit dividend growth – all coming from one of America’s most storied companies.
You’re just not going to find something like that every day.
Pretty special stuff.
Revenue and Earnings Growth
As special as all of this is, though, many of these dividend metrics are looking into the past.
However, investors must always have their eyes on the future, because the capital of today gets put on the line for the rewards of tomorrow.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will be extremely helpful for the valuation process.
I’ll first show you what the business has done over the last decade in terms of its top-line and bottom-line growth.
I’ll then reveal a professional prognostication for near-term profit growth.
Blending the proven past with a future forecast in this manner should give us the information we need to gauge where the business might be going from here.
Hershey has advanced its revenue from $7.4 billion in FY 2014 to $11.2 billion in FY 2023.
That’s a compound annual growth rate of 4.7%.
I like to see a mid-single-digit (or better) top-line growth rate from a fairly mature company like this (and Hershey is definitely mature), so I’m pleased with this.
Meantime, earnings per share grew from $3.77 to $9.06 over this period, which is a CAGR of 10.2%.
Very nice excess bottom-line growth here, driven by a combination of improving profitability and a reduction in the outstanding share count.
Regarding the latter point, regular buybacks have reduced the outstanding share count by 8.4% over this 10-year period.
I like this growth, and it’s been consistent and secular in nature.
Again, just so difficult to find fault.
Looking forward, CFRA believes Hershey will compound its EPS at an annual rate of 6% over the next three years.
CFRA notes near-term headwinds that include higher input costs (especially cocoa, which has more than doubled in price over the last year) and softness in certain areas of the product portfolio (such as SkinnyPop).
On the flip side, cost efficiency, buybacks, strong market share, and possible accretive M&A are all counted as near-term tailwinds.
Surging cocoa prices due to yield issues in West Africa have caused challenges for all companies in this space, but Hershey’s scale gives it a leg up on smaller competitors that may actually suffer serious and long-term financial consequences from this (which may end up giving Hershey even more market share in the future).
There’s also the matter of pricing on Hershey’s products, as the company has taken price in the marketplace in order to offset inflation but will be unable to continue this behavior indefinitely (because of consumer pushback and the risking of volumes).
Overall, I find CFRA’s forecast to be reasonable.
This would obviously be a reduction in growth relative to what Hershey did over the last decade, but we’re in the middle of a pretty difficult and tricky period (inflation, soaring cocoa prices, price taking, etc.).
If Hershey can operate within a challenging period and still put up 6% bottom-line growth, I actually think that’s encouraging and indicative of just how dominant this business really is.
It would also allow for the company to hand out like, or better, dividend raises over the next few years, with the opportunity to get back to its normal ways (i.e., HSD dividend growth) once the environment normalizes.
If “difficulty” means 6% growth and a 3% yield, you know you’ve got something special on your hands.
In my view, Hershey shareholders stand to do very, very well over the coming years, even if the next year or two may be a bit “ho-hum”.
Financial Position
Moving over to the balance sheet, Hershey has a solid financial position.
The long-term debt/equity ratio is 0.9, while the interest coverage ratio is nearly 16.
Hershey finished last fiscal year with barely more than $3 billion in L-T debt, which is relatively immaterial for a company with a $35+ billion market cap.
I’m not concerned at all by this balance sheet.
Profitability is quite robust.
Return on equity has averaged 63.9% over the last five years, while net margin has averaged 16%.
Hershey is routinely posting up very high returns on capital.
Although ROE is juiced by low common equity, even ROIC is regularly north of 20%.
Plus, you have fat margins here.
It’s clear to me that Hershey is among the world’s best businesses.
And the company does benefit from durable competitive advantages that include economies of scale, R&D, IP, brand/pricing power, and dominant market share.
Of course, there are risks to consider.
Litigation, regulation, and competition are omnipresent risks in every industry.
The rise of new GLP-1 weight-loss drugs could reduce demand for Hershey’s indulgent products.
Input costs can be volatile, and soaring cocoa prices over the last year is a prime example of this.
Hershey’s long-term growth profile is largely tied to the US confectionary market, which is mature.
Hershey’s small international segment exposes the company to currency exchange rates and different markets with different rules and tastes.
The company has long been reliant on sales channels such as gas stations and convenience stores, which may see unfavorable changes as more commerce moves online and more EVs come to market.
I don’t see any of these risks as insurmountable, particularly when weighed against the quality of this business.
And with the valuation being as low as it’s been in years, even while the broader market is causing near all-time highs, this could be one of the best steals out there…
Valuation
The stock’s P/E ratio is 18.1.
That compares favorably to its own five-year average of 25.9, and it’s also much lower than the broader market’s earnings multiple.
There’s also the cash flow multiple of 14.3, which is noticeably off of its own five-year average of 18.3.
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 growth rate is at the higher end of what I’ll allow for in the model, and I think Hershey is more than deserving of the designation.
This growth rate is conservative when viewed against Hershey’s own demonstrated EPS and dividend growth over the last decade.
But the near-term EPS growth expectation is actually slightly lower than this level.
The next couple of dividend raises could be modest, but we have to keep in mind that this is a long-term model.
And over the long run, I believe Hershey will actually outpace this level of dividend growth, but I like to err on the side of caution.
The DDM analysis gives me a fair value of $235.64.
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.
This stock looks materially undervalued to me.
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 HSY as a 4-star stock, with a fair value estimate of $210.00.
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 HSY as a 3-star “HOLD”, with a 12-month target price of $204.00.
I came out on the high end, but we all agree that the stock looks to be priced too low. Averaging the three numbers out gives us a final valuation of $216.55, which would indicate the stock is possibly 15% 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 HSY’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 80. 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, HSY’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
Disclosure: I’m long HSY.
