Investing has so many benefits.

Of course, the direct financial benefits (i.e., building wealth) are powerful.

But there are a lot of ancillary, indirect benefits.

These include learning more about finance, human psychology, and the way the world around you works.

Oh, and there’s, perhaps, the biggest benefit of all: freedom.

Having the freedom to live life on your terms is priceless.

Yet, it’s reasonably attainable.

The best and most straightforward method for attaining it, in my experience, is through the long-term investment strategy of dividend growth investing, which involves buying and holding shares in high-quality businesses that pay safe, growing dividends to shareholders.

If one can build a portfolio of dividend growth stocks that’s large enough to generate the kind of passive dividend income they need to cover their bills, they’re free.

You can find hundreds of stocks that qualify for the strategy over at the Dividend Champions, Contenders, and Challengers list.

This list has invaluable information on US-listed stocks that have raised dividends each year for at least the last five consecutive years.

I’ve been using the DGI strategy for nearly 15 years now.

It unlocked financial freedom for me some time ago.

The FIRE Fund, which is my real-money portfolio, throws off enough five-figure passive dividend income for me to live off of.

My Early Retirement Blueprint shares the journey of going from in debt to unlocking that freedom and retiring in my early 30s.

All this said, selecting the right businesses for investment (by buying their shares) is only part of the puzzle.

There’s also the matter of valuation.

Price is simply what you pay, but it’s value that you ultimately 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.

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.

Building a portfolio of undervalued high-quality dividend growth stocks can give you powerful benefits over time that are both direct (financial) and indirect (freedom).

The whole topic of valuation does presume a basic understanding of how all of this works.

If that understanding isn’t already in place, do be sure to give Lesson 11: Valuation a read.

Written by fellow contributor Dave Van Knapp, it lays out the whole concept of valuation in simple-to-understand terms and even provides an easy-to-use valuation template that you can use on your own.

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…

PepsiCo, Inc. (PEP)

PepsiCo, Inc. (PEP) is an American multinational food, snack, and beverage corporation.

Founded in 1898, PepsiCo is now a $196 billion (by market cap) snack and beverage beast that employs nearly 320,000 people.

The company reports results across seven segments: PepsiCo Beverages North America, 30% of FY 2023 revenue; Frito-Lay North America, 27%; Europe, 14%; Latin America, 13%; Africa, Middle East, and South Asia, 7%; APAC (Asia Pacific), 5%; and Quaker Foods North America, 3%.

The company generates approximately 57% of revenue from the US; the remainder is generated internationally.

PepsiCo has built a simple business model that has thrived for more than 125 years.

It produces and then sells a variety of in-demand snacks (such as chips) and beverages (such as sodas) that billions of people all over the world regularly consume and enjoy.

There’s no newfangled, sexy technology to be found here.

But there’s comfort to be found in the simplicity.

There’s also money to be found in the success.

To be sure, PepsiCo has built up more than 20 different billion-dollar brands (i.e., brands that do more than $1 billion per year in sales) – including the likes of Aquafina, Doritos, Lay’s, Mountain Dew, and the eponymous Pepsi.

These brands have pricing power, giving PepsiCo the ability to slowly raise prices over time in order to protect the business (and, thus, shareholders) against inflation through rising input costs.

Because consumers enjoy the consistent flavors and experiences from PepsiCo’s products, modest increases in prices over time are usually acceptable.

Also, it’s important to note that these timeless products are consumable.

Once consumed, they must be purchased all over again.

And since these products feature low price points in nominal dollar terms, they’re easy repeat purchases to make for most consumers.

PepsiCo has taken the idea of selling timeless products that lead to recurring revenue through repeated small purchases, and supercharged it by layering on top of it the power of brands.

This is what has led to decades upon decades of consistent revenue, profit, and dividend growth.

Dividend Growth, Growth Rate, Payout Ratio and Yield

Indeed, PepsiCo has increased its dividend for an incredible 52 consecutive years.

It easily qualifies as a Dividend Aristocrat and Dividend King, marking PepsiCo as one of the greatest and most consistent dividend growers ever.

The 10-year dividend growth rate is 7.9%, which is very solid and handily beats the inflation rate (keeping shareholders’ purchasing power ahead of the game).

The rate of dividend growth is another area in which PepsiCo has been extremely consistent, as the company tends to hand out a 7%+ dividend raise pretty much every year.

The most recent dividend increase came in at 7.2%, further illustrating my point.

What’s particularly nice about this dividend growth is the fact that you get to layer that on top of the stock’s market-beating 3.7% yield.

Let’s just dwell on this for a moment.

That’s a near-4% yield on a world-class beverage and snack business.

I’ve been investing for a long time, and seeing this stock with a yield approaching 4% is shocking.

To put it in perspective, this yield is 90 basis points higher than its own five-year average.

Now, with bonds offering competitive yields, along with certain challenges impacting businesses like PepsiCo (which I’ll delve into later), it’s not surprising to see the yield get lifted.

Still, it wasn’t that long ago that this kind of yield was reserved for something like a utility, not something like PepsiCo.

With a payout ratio of 66.5%, based on FY 2024 core EPS guidance, the dividend is sustainable and poised for more growth ahead (albeit at a rate which will be limited to that of the business itself).

While nobody should expect explosive growth and returns out of PepsiCo, it’s a blue-chip business providing a sleep-well-at-night yield near 4% that’s growing far faster than inflation.

The dividend story is about as predicable as it gets, which is highly alluring.

Revenue and Earnings Growth

As alluring as it may be, though, a lot of this based on what’s already happened in the past.

However, investors must always be thinking about the future, as today’s capital gets risked for tomorrow’s rewards.

Thus, I’ll now build out a forward-looking growth trajectory for the business, which will be useful when it comes time later to estimate fair value.

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 way should give us the ability to build a good case of where the business could be going from here.

PepsiCo grew its revenue from $66.7 billion in FY 2014 to $91.5 billion in FY 2023.

That’s a compound annual growth rate of 3.6%.

This isn’t outstanding, but it’s respectable.

I prefer to see a mid-single-digit top-line growth rate (or something better) from a large, mature business like this, and PepsiCo does come close.

It’s good enough, in my view.

Meanwhile, earnings per share grew from $4.27 to $6.56 over this period, which is a CAGR of 4.9%.

If we use core EPS for FY 2023 ($7.63), the profit measurement management relies on when communicating its growth, the 10-year CAGR jumps to 6.7%.

Regular share buybacks helped to drive excess bottom-line growth, as did some modest margin expansion.

Regarding the former, the outstanding share count has been reduced by about 10% over the last decade.

Again, this is good (but not outstanding) growth out of PepsiCo.

We can see that dividend growth has been outpacing business growth, and the elevated payout ratio will limit how much more of this can be done.

While it’s hard for management to bend the curve very much, I would like to see an acceleration off of what’s transpired above.

And there appears to be some good news on that front.

Looking forward, CFRA is calling for a 9% CAGR for PepsCo’s EPS over the next three years.

CFRA believes taking price will continue to propel higher overall sales (although higher prices will be somewhat mitigated by moderating volumes).

CFRA also sees some levers to pull in terms of its product portfolio: “We think [PepsiCo] has the optionality to drive growth in both beverages and snacks, and has been shifting its portfolio toward healthier products (e.g., Bubly flavored sparkling water and Sabra Hummus) and energy drinks, as it agreed to purchase Rockstar Energy in March 2020.”

All that said, 9% seems a bit optimistic to me.

For its part, PepsiCo itself is guiding for 7% YOY growth in core EPS for FY 2024, and that’s a number that management has recently been anchoring to.

So that kind of growth expectation is something I’d feel more comfortable with, which would still be quite nice (and decently above what played out over the last 10 years).

In the end, one invests in PepsiCo not for high rates of growth but for its dependability as a blue-chip company.

CFRA sums that up well with this passage: “…[PepsiCo] is a higher-quality, low-beta, blue-chip company with a strong balance sheet and high degree of earnings stability.”

Supporting the high-single-digit growth profile is the pricing power across the brands, as CFRA highlights: “We also like the power of its various brands, such as Frito-Lay, Gatorade, Pepsi, and Mountain Dew, in an inflationary environment, as we believe they give the company the ability to successfully pass through higher costs to consumers in the form of price increases. Longer term, we see faster-growing international markets and the Frito-Lay business as the primary growth drivers. [PepsiCo]’s focus on healthier snacks and beverages will also continue to drive the top line, in our view.”

With a starting yield near 4%, I think a ~7% EPS and dividend growth rate is more than enough to get the job done and get one to a ~10% annualized total return (assuming no major change to the valuation).

It’s not getting one rich overnight, but that steady compounding can really add up over time.

Plus, a lot of the return is coming in the form of a very nice dividend.

Tough to dislike any of that.

Financial Position

Moving over to the balance sheet, PepsiCo’s financial position is good (but not excellent).

The long-term debt/equity ratio is 2, while the interest coverage ratio is nearly 15.

Low shareholders’ equity artificially inflates the former number; however, PepsiCo’s ~$38 billion in long-term debt is not overly cumbersome for a company of its size.

I wouldn’t mind seeing an improved balance sheet, but the blemishes are certainly acceptable.

Profitability is terrific.

Return on equity has averaged 56.9% over the last five years, while net margin has averaged 11.2%.

The debt load has fueled extra ROE, but we can also see that ROIC is usually between 15% and 20%.

PepsiCo is generating fairly high returns on capital, which I love to see.

Overall, PepsiCo isn’t a fast-growing business, but it remains a blue-chip stalwart fully capable of funding and growing its dividend.

And with economies of scale, a global distribution network, IP, R&D, brand power, and established retail relationships with a large amount of dedicated shelf space, the company does benefit from durable competitive advantages.

Of course, there are risks to consider.

Regulation, litigation, and competition are omnipresent risks in every industry.

Regulation, especially with the incoming administration in the US, could be a rising risk for companies, like PepsiCo, that sell processed foods.

Adding to the regulatory pressure, there are general trends toward healthier foods, which may negatively impact PepsiCo and the sales of many of its products which cater to taste rather than health.

Technology and the rise of alternative forms of media make it easier for new entrants to come to market, advertise, make themselves known to consumers, and compete with entrenched giants like PepsiCo.

PepsiCo must continue to navigate different tastes in different markets, as well as changing consumer tastes and preferences.

The company’s international footprint exposes it to exchange rates.

Input costs can be volatile, and input costs have risen sharply in recent years.

Passing on higher costs by raising prices on products can lead to lower volumes and strained relationships with retailers.

The balance sheet isn’t as strong and flexible as it used to be, which puts a lid on what management can do with capital allocation (M&A, buybacks, etc.).

PepsiCo’s size may be a hindrance to future returns, due to the law of large numbers.

I think it’s fair to say that the risks for PepsiCo are higher than they were 10 or 20 years ago.

At the same time, the valuation is also near a multiyear low, pricing in a lot more risk…

Valuation

The forward P/E ratio on the stock is sitting at 17.8, based on FY 2024 core EPS guidance.

The stock’s five-year average P/E ratio is 26.2, so we can see how much of a repricing has already occurred here.

Every other multiple I look at is also well below its respective recent historical average.

For instance, the cash flow multiple of 14.6 is far off of its own five-year average of 19.1.

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 growth rate projection lines up with demonstrated dividend growth over the last several years, including the most recent dividend raise.

It also comes close to PepsiCo’s 10-year EPS CAGR, using core EPS.

It’s rooted in reality.

Although it falls short of CFRA’s near-term EPS growth forecast for PepsiCo, I don’t see the company being able to sustain a ~10% EPS CAGR over any kind of extended period of time.

Plus, the payout ratio is currently elevated.

In my view, it would be wishful thinking to anticipate anything more than 7% dividend growth out of this company over the long run.

The DDM analysis gives me a fair value of $193.31.

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.

From my point of view, this stock has become too cheap for what it is.

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 PEP as a 4-star stock, with a fair value estimate of $174.00.

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 PEP as a 4-star “BUY”, with a 12-month target price of $190.00.

I’m very close to where CFRA is at on this one. Averaging the three numbers out gives us a final valuation of $185.77, which would indicate the stock is possibly 22% undervalued.

Bottom line: PepsiCo, Inc. (PEP) is a blue-chip snack and beverage business with 20 billion-dollar brands under its umbrella. It has immense brand awareness and pricing power, along with a global distribution network, giving the firm durable competitive advantages. With a market-beating yield, a high-single-digit dividend growth rate, a manageable payout ratio, more than 50 consecutive years of dividend increases, and the potential that shares are 22% undervalued, it could be extremely timely to buy shares in this Dividend King while sentiment is depressed.

-Jason Fieber

Note from D&I: How safe is PEP’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 93. 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, PEP’s dividend appears Very Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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.

Disclosure: I’m long PEP.