As I age, I’m starting to see people I grew up with perish.
These are cultural reference points for me, so these events hit home and remind me how fragile and short life really is.
Because of its fragility and brevity, it’s clear that we have to construct our lives in a way that allow us to live on our own terms.
This means owning our time.
This means becoming financially independent.
And that leads right to dividend growth investing, a long-term investment strategy whereby one buys and then holds shares in world-class businesses that are generating ever-more profit and sharing the spoils with shareholders in the form of ever-larger cash dividends.
You can find hundreds of such businesses by going over to the Dividend Champions, Contenders, and Challengers list – a rich source of data on US-listed stocks that have raised dividends each year for at least the last five consecutive years.
Rising cash dividend payments from a portfolio of great businesses can secure lasting financial independence.
Living purely off of dividends – a dream come true, honestly – is something I’ve been doing since I quit my job and retired in my early 30s.
The FIRE Fund, my real-money portfolio, generates enough five-figure passive dividend income for me to comfortably live off of.
That portfolio was built by steadily acquiring high-quality dividend growth stocks.
And, crucially, those acquisitions occurred when valuations were attractive.
See, price is what you pay, but value is what 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.
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.
By steadily acquiring undervalued high-quality dividend growth stocks, you put yourself in a position to achieve financial independence and live life on your terms.
Now, the whole concept of valuation might seem complicated at first glance.
But it’s really not.
Lesson 11: Valuation, which was put together by fellow contributor Dave Van Knapp, demystifies the concept using simple terminology and gives you tools to easily estimate valuations 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…
Automatic Data Processing Inc. (ADP) is a US-based global technology company providing cloud-based enterprise human resources management software and services.
Founded in 1949, ADP is now a $90 billion (by market cap) HR titan that employs nearly 70,000 people.
ADP does business in more than 180 countries worldwide.
The company reports results across two segments: Employer Services, 67% of FY 2025 revenue; and Professional Employer Organization Services, 33%.
Employer Services, which accounts for about two-thirds of the company, is where ADP does its bread and butter by providing a comprehensive range of cloud-based HR solutions such as payroll, human resource, benefits administration, attendance, tax filing, and reporting services.
Payroll is where all the magic happens, setting up the company with key advantages.
Payroll processing requires specialized software that, once installed, becomes very “sticky” by being fully integrated within an employer’s ERP.
This stickiness creates a high degree of visible, recurring revenue for ADP (with client retention close to 100%).
Although payroll is a small portion of an enterprise’s overall operating expenses, it’s vital to functionality, further cementing ADP’s role within any company’s ERP.
And since ADP is the biggest company in this space, it uses its capabilities, scale, and reputation for precision and excellence to gain and retain clients.
While there are fears that AI will displace the likes of ADP, this seems highly unlikely considering how vital accurate payroll servicing is compared to the low costs of providing it.
But wait.
There’s more.
During payroll processing, ADP holds onto client deposits until such time that employees are actually paid.
The time delay between ADP collecting deposits and employees taking their money gives the company a short-term, cost-effective source of capital that ADP can earn a return from.
This “float” is in addition to what it earns from the core business model, which is in and of itself a powerful cash machine.
ADP has effectively used this one-two payroll punch to grow into the world’s foremost HR company, producing extremely consistent revenue, profit, and dividend growth along the way.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Indeed, ADP has increased its dividend for a staggering 50 consecutive years.
Just think about that level of consistency and reliability.
It’s hard to do anything for 50 straight years, let alone sending out ever-larger payments, every year, for that long.
It’s dividend royalty.
Its 10-year dividend growth rate is 12.1%.
That’s an impressive number in isolation, but it’s especially impressive since it’s come after ADP already had 40 consecutive years of dividend growth when this rate started 10 years ago.
Again, speaking on the consistency, ADP hands out double-digit dividend raises pretty much every year.
It’s clockwork.
The payout ratio of 63.4%, which strikes me as appropriate for a mature company, indicates the dividend is easily covered and positioned to grow roughly in line with the business from here.
All of this dividend growth comes on top of the stock’s market-beating 3.1% yield.
To put the relative appeal of that into perspective, it’s 110 basis points higher than its own five-year average.
Over the 15+ years that I’ve been investing, I’ve almost never seen this stock with a 3%+ yield.
Getting a 3%+ yield and double-digit dividend growth on a Dividend King is hard to pass up.
This is quite possibly the most compelling setup this name has ever featured over my entire investing career.
Revenue and Earnings Growth
As compelling as it may be, though, a lot of what we’re seeing here is predicated on past activity.
However, investors must always be thinking the future activity to come, as today’s capital ultimately gets risked for tomorrow’s rewards.
That’s why I’ll now build out a forward-looking growth trajectory for the business, which will be incorporated into the valuation process.
I’ll first show you what the business has done over the last ten years in terms of its top-line and bottom-line growth.
I’ll then reveal a professional prognostication for near-term profit growth.
Lining up the proven past with a future forecast in this manner should allow us to piece together where this business might be going from here.
ADP improved its revenue from $11.7 billion in FY 2016 to $20.6 billion in FY 2025.
That’s a compound annual growth rate of 6.5%.
Strong top-line growth here, particularly in light of the fact that ADP is not extremely acquisitive.
Meanwhile, earnings per share grew from $3.25 to $9.98 over this period, which is a CAGR of 13.3%.
Excellent.
For a large, mature company, low-teens EPS growth is remarkable.
And we can also see that it’s what’s been fueling all of that dividend growth, keeping the payout ratio from becoming unsustainable.
Steady buybacks and margin expansion helped to drive this excess bottom-line growth.
Regarding the former, ADP reduced its outstanding share count by nearly 11% over the last decade.
Looking forward, CFRA is projecting a 9% CAGR for ADP’s EPS over the next three years.
This forecast is calling for a pretty healthy growth rate, if a bit light in comparison to what ADP did over the past decade.
CFRA is building in some slight conservativeness based on cautious hiring trends, which may be exacerbated by AI’s capabilities negatively affecting the overall workforce.
While I don’t think AI is a direct threat to ADP in terms of outright displacement, a second-order effect could be a diminished human workforce, generally, which would reduce overall demand for payroll services from the likes of ADP.
I mean, it’s not like LLMs or robots are going to be collecting paychecks.
That said, ADP’s own FY 2026 guidance is calling for 10% to 11% YOY EPS growth.
Furthermore, ADP’s recent Q3 FY 2026 report showed client retention near a record high, and EPS came in at 10% higher YOY – despite AI already being prevalent for several years now.
Notably, ADP announced a gigantic $6 billion buyback program earlier this year – worth more than 6% of its market cap – and this buyback program could be quite accretive with the shares currently trading near five-year lows.
In my view, CFRA is striking a reasonable balance.
And that 9% number it’s putting forth would set the dividend up for like growth over the years ahead.
When paired with the starting yield, assuming no material change to the valuation, that positions one for a low-double-digit type of annualized total return – a very nice arrangement from what is dividend royalty.
Financial Position
Moving over to the balance sheet, ADP has a stellar financial position.
Its long-term debt/equity ratio is 0.6, while the interest coverage ratio is right around 13.
These are solid numbers, but they belie how strong ADP’s balance sheet actually is.
I say that because ADP has net cash on the balance sheet adding up to nearly $4 billion.
Moreover, its investment-grade credit ratings are well into prime territory: Aa3, Moody’s; AA-, S&P.
In fact, up until 2014, ADP was one of the very few companies in the world to have a AAA credit rating from S&P.
Despite the modest drop in grade, which followed a large spin-off, ADP retains a fortress balance sheet.
Profitability is outstanding.
Return on equity has averaged 76.4% over the last five years, while net margin has averaged 18.7%.
Doing ROE that high on net cash is almost unbelievable.
Even ROIC is routinely well over 40%.
Being a capital-light business model centered on software, ADP is generating sky-high returns on capital and fat margins – hallmarks of a high-quality business.
ADP is simply extraordinary.
And with economies of scale, “sticky” services with deep integration, high switching costs, IP, float usage, and brand reputation, the company does benefit from durable competitive advantages.
Of course, there are risks to consider.
Competition, regulation, and litigation are omnipresent risks in every industry.
Although ADP’s industry is fiercely competitive, its status as the clear industry leader with an impeccable reputation for capabilities, precision, and reliability does insulate it somewhat.
The company has exposure to the broader economy through overall employment levels, as employment feeds through into demand for its services.
There is now profound uncertainty regarding the ultimate impact from AI.
Speaking of AI, a future in which AI dramatically reduces human labor would have a two-pronged negative impact on ADP by both reducing demand for payroll services and reducing the float utilization.
Being an international company, ADP has exposure to geopolitics and exchange rates.
ADP has a very concentrated business model after spinning off various parts of the company over the years, resulting in a lot of dependence on its core payroll software.
Unless AI almost totally eliminates all jobs, in which case ADP’s ability to thrive is probably the least of one’s concerns, I find the risk profile here to be quite low.
However, the market has already assumed and started to price in a huge negative impact from AI, sending this stock down more than 30% from recent highs and creating one of the most attractive levels of valuation ever for this name…
Valuation
The stock is now available for a P/E ratio of 20.3.
That is well below its own five-year average of 29.7.
This is a stock that has usually commanded a healthy and deserved premium, but that’s all gone now.
Its cash flow multiple of 13.6, which is low even in isolation, is also way lower than the 19.5 it’s averaged over the last five years.
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 discount model analysis.
I factored in a 10% discount rate and a long-term dividend growth rate of 7%.
With proven double-digit EPS and dividend growth over the last decade, along with the expectation for growth ahead that vastly exceeds my mark, I don’t see anything unreasonable about the model.
If anything, with the company itself still guiding for double-digit EPS growth over the near term, 7% could prove to be way too conservative.
However, because there’s so much uncertainty over the ultimate impact of AI, I think it makes sense to err on the side of caution here.
The DDM analysis gives me a fair value of $242.53.
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’s valuation looks extremely favorable to me after a 30%+ drawdown.
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 ADP as a 4-star stock, with a fair value estimate of $249.00.
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 ADP as a 3-star “HOLD”, with a 12-month target price of $235.00.
We have a pretty tight consensus this time around. Averaging the the three numbers out gives us a final valuation of $242.18, which would indicate the stock is possibly 10% undervalued.
-Jason Fieber
Note from D&I: How safe is ADP‘s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 90. 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, ADP’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 ADP.