US capitalism is one of the greatest gifts in the world.
It’s an economic miracle, providing everyday people (like us) the opportunity to participate in the world’s growth and the power of long-term compounding.
Because it’s open to all, it democratizes the process of building wealth and financial freedom.
And it’s to be taken advantage of at every single chance.
The very best way to take advantage of it might be through dividend growth investing, which is a long-term investment strategy that advocates buying and holding shares in great businesses that pay reliable, rising dividends to shareholders.
I say that because great businesses are particularly adept at compounding money and making investors rich over time, and the dividend growth investing strategy (by its very nature) tends to almost automatically funnel investors right into the world’s great businesses (since it takes rising profits to fund rising dividends).
You can see what I mean by pulling up the Dividend Champions, Contenders, and Challengers list, which has compiled invaluable information on hundreds of US-listed stocks that have raised dividends each year for at least the last five consecutive years.
Here’s how dividend growth investing is especially powerful: If one can build a portfolio of high-quality dividend growth stocks that generate enough rising dividend income for them to live off of, they’re financially free without having to resort to to slowly selling off shares and risking running out of money.
It’s a dream of a strategy, and that’s why I’ve been personally using it for 15 years myself as I’ve gone about building the FIRE Fund.
That’s my real-money portfolio that produces enough five-figure passive dividend income for me to live off of.
In fact, this dividend income has been enough to support my lifestyle since I quit my job and retired in my early 30s.
My Early Retirement Blueprint lays out how I was able to retire at such a young age.
Now, as dreamy as dividend growth investing can be, it involves more than simply investing in the right businesses.
There’s also the matter of investing at the right valuations.
That’s because price only tells you what you pay, but value tells you what 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.
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.
Participating in US capitalism is practically a no-brainer, and buying high-quality dividend growth stocks at attractive valuations is quite possibly the best way to participate.
Now, the preceding discussion on valuation does, to a degree, assume that there’s already a basic understanding in place of how valuation works.
If that’s not in place, no worries.
This is where you’ll want to give Lesson 11: Valuation a quick read.
Written by fellow contributor Dave Van Knapp, it’s part of an overarching series of “lessons” designed to teach the ins and outs of dividend growth investing – including valuation.
This lesson also includes a simple-to-use valuation template that is super helpful.
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…
Prudential Financial, Inc. (PRU) is US-based global insurance company that offers life insurance, annuities, investment management, retirement plan services, and other financial products and services.
Founded in 1875, Prudential is now a $39 billion (by market cap) financial powerhouse that employs more than 35,000 people.
The company serves approximately 50 million customers across 50 different countries.
Prudential reports operations across the following four segments: U.S. Businesses, 48% of FY 2024 pretax segment operating profit; International Businesses, 40%; and Investment Management, 11%.
In business for 150 years, Prudential has grown into one of the largest insurance and investment management businesses in the world.
Prudential has combined two terrific and complementary business models under one roof.
Because insurance involves the collecting of premiums today for the assumption of risk, with payment on claims potentially coming much later on, the business model results in the building of a “float” – the capital that accumulates between collection and payment.
This capital gets invested and earns income for the firm (alongside profit from core underwriting) that drops straight down to the bottom line.
Insurers must be almost just as good at managing capital as underwriting risk, making investment management a natural fit.
That leads us to the massive investment management arm at Prudential.
To put its scale into context, Prudential has $1.5 trillion in assets under management.
Prudential is able to directly leverage the rising tide lifting all boats that is global assets, collecting rising fees (which are based on the rising asset values) along the way.
And it’s able to do so in a circular, self-reinforcing manner, whereby the expertise at investment management helps the success across insurance and retirement products, further elevating the scale and brand power of the entire firm.
This is why, 150 years into business, Prudential might be just getting started, setting up a continued runway for revenue, profit, and dividend growth over the coming decades.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Already, Prudential has increased its dividend for 17 consecutive years.
In fact, it’s 17th consecutive dividend increase was announced only weeks ago, coming in at 3.8%.
That is a bit lower than the five-year dividend growth rate of 5.4%.
First, more income – regardless of how much – is always nice.
Second, I believe dividend growth over the next several years will be even better and come closer to that five-year mark (as I’ll outline later).
Third, this is still a respectable level of dividend growth when you consider the stock’s market-smashing 4.8% yield.
This yield, which is basically in line with its own five-year average, is rather high to start with and negates the need for an exceptional level of dividend growth.
With the payout ratio at 72% on GAAP EPS, or 42.8% on Prudential’s preferred metric of after-tax adjusted operating income per share, the dividend is healthy and positioned to grow roughly in line with the business itself.
If Prudential can grow its dividend at a ~5% rate on a ~5% starting yield, that gets one to a ~10% annualized total return (assuming no major changes to the valuation), with about half of it coming in the form of pure dividend income.
That’s a nice, balanced road to a very respectable return.
Revenue and Earnings Growth
As nice as this may be, though, many of these dividend metrics are based on what’s happened in the past.
However, investors must always be thinking about the future, as today’s capital gets put on the line and risked for tomorrow’s rewards.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will be highly useful when the time comes 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.
And 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 enough to confidently build a model which evaluates where the business could be going from here.
Prudential increased its revenue from $57.1 billion in FY 2015 to $70.4 billion in FY 2024.
That’s a compound annual growth rate of 2.4%.
Decent growth here, but the tepid movement of the top line is indicative of Prudential’s mature nature and its competitive markets.
Prudential’s GAAP EPS swing wildly from year to year, making it difficult to ascertain a true growth profile.
So I basically took a look at growth of the company’s preferred metric of after-tax adjusted operating income.
This increased from $4.2 billion in FY 2015 to $4.6 billion in FY 2024.
After accounting for the significant drop in the outstanding share count (~22%) from buybacks, the per-share compound annual growth rate is 3.8%.
From what I can see, Prudential has been basically growing its bottom line and dividend at a mid-single-digit rate.
For a large, diversified, mature, global financial services company, this is not bad and very unsurprising to me.
That said, better days may be ahead.
Looking forward, CFRA believes that Prudential will compound its EPS at an annul rate of 10% over the next three years.
CFRA highlights Japanese expansion, pension risk transfer activity, price hikes, expense control, risk control, product revamps, and positive flow trends as reasons to be enthusiastic about Prudential over the foreseeable future.
This passage stands out: “We believe improved results at PGIM (particularly in the form of positive fund flow trends) and stable to improved results at [Prudential]’s other two core units – Retirement Strategies and U.S. Businesses – will provide the shares with a catalyst to close their valuation gap to peers.”
Regarding flow trends, Prudential recorded net inflows of $8.6 billion in Q4 FY 2024, finishing a solid 2024 (with net flows for the whole year coming in at $37.7 billion).
This stands in stark contrast to a number of other mature asset managers which are experiencing net outflows (and slowly becoming melting ice cubes).
Japan’s aging population bodes well for Prudential’s various products.
And with retirements moving from pension to self-funded accounts, this also leads right to the likes of Prudential.
Prudential’s management recently introduced financial targets through 2027, projecting annual core EPS growth of 5% to 8% and an adjusted ROE of 13% to 15%.
This isn’t quite 10% (CFRA’s number looks aggressive to me), but it’s markedly better than the ~4% that came through over the last decade.
And this circles back around to my belief in Prudential’s ability to slightly accelerate dividend growth over the next several years and get back to the 5%+ level that was prominent until just the last year.
Again, when that kind of dividend growth is coming on top of the ~5% starting yield, it’s enough to make sense of.
For income-oriented, risk-averse investors keen to receive a large chunk of their return in the form of dividend income, Prudential Financial appears poised to deliver the goods.
Moving over to the balance sheet, the company has a solid financial position.
Financial Position
The long-term debt/equity ratio is 0.7.
The company’s long-term senior debt has the following investment-grade credit ratings: A, Standard & Poors; A3, Moody’s; A-, Fitch.
Prudential finished last year with approximately $19 billion in long-term debt, which is not very cumbersome for a company of its size.
Profitability for the firm is only okay, but oscillating results cloud the reality.
Return on equity has averaged 5.7% over the last five years, while net margin has averaged 3.5%.
These numbers belie Prudential’s true nature, as ROE is (in good/normal years) closer to 11% or so; wild swings in GAAP results yank profitability all over the place.
I’d point to management’s near-term guidance on ROE, which is very good and definitely competitive with some of the best firms in this space.
Prudential isn’t growing super fast, but it is slowly inching its way down the field and providing shareholders with healthy and growing dividends along the way.
And with economies of scale, “sticky” assets, brand recognition, and established policies in force, 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.
The industry is extremely competitive, and Prudential is a mature company (limiting its growth somewhat).
AUM, and the fees Prudential can collect from AUM, are subject to the volatility across global asset markets.
Further pressuring fees, the investment management industry as a whole is facing a secular move toward passive instruments with lower fees.
Underwriting must remain prudent, but the long-term nature of life insurance (COGS isn’t known until well into the future) makes this difficult to assess in real-time.
Prudential’s results swing quite a bit from year to year, making it difficult to determine just how much success and growth is being enjoyed.
The company has direct exposure to interest rates, which can be volatile.
A global footprint diversifies the firm, but it also adds exposure to geopolitics and fluctuating currency exchange rates.
I definitely see some risks here, but Prudential is in the business of managing risk and has deftly done so for 150 years.
Furthermore, the undemanding valuation prices in plenty of risk already…
Valuation
The stock is trading hands for a P/E ratio of 14.6.
And that’s based on GAAP EPS, which can vary wildly and be inaccurate.
Using after-tax adjusted operating income per share, the P/E ratio drops to 8.7.
Either way, we are not looking at high multiples here.
The P/B ratio, which is a common anchor for insurance/financial businesses, is 1.4.
Again, not high at all (I commonly see this ratio range between 1 and 2 for a lot of diversified financial companies).
And the yield, as noted earlier, is in line with its own recent historical averages.
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 5%.
This is the dividend growth rate I’ve typically used when analyzing and valuing Prudential over the years.
Based on what I consistently see when looking at Prudential from year to year, I think 5% is a reasonable expectation out of the business in terms of what kind of dividend growth it can bestow upon shareholders over time (averaged out).
Some years might be disappointing, and some years might be better.
But I think that’s a pretty good baseline expectation.
It lines up almost perfectly with the five-year demonstrated dividend growth rate, it’s not far off from (albeit slightly higher than) the 10-year EPS CAGR, and it’s in the same ballpark (albeit slightly lower than) as management’s near-term projection for core EPS growth.
This is a number I’ve been comfortable with in the past, and it’s a number I’m still comfortable with.
The DDM analysis gives me a fair value of $113.40.
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.
In my view, the stock’s valuation is favorable (although no material cheapness exists).
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 PRU as a 3-star stock, with a fair value estimate of $108.00.
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 PRU as a 4-star “BUY”, with a 12-month target price of $130.00.
I came out close to where Morningstar is at on this one. Averaging the three numbers out gives us a final valuation of $117.13, which would indicate the stock is possibly 4% 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 PRU’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 75. 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, PRU’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
Disclosure: I’m long PRU.