It’s all about incremental progress in life.
No matter what it is you are doing or pursuing, incremental progress can really add up and make amazing things happen over time.
This is especially true when talking about investing.
And that’s because of how compounding works – with old interest earning new interest ad infinitum, creating exponential growth.
When you zoom in even more and start to parse the different investing strategies, the dividend growth investing strategy might be the most effective of all when it comes to leveraging compounding and incremental progress.
This is a long-term investment strategy whereby one buys and holds shares in high-quality businesses which reward shareholders with steadily rising cash dividend payouts.
You can see hundreds of stocks that fit the strategy by taking a look 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.
And it’s those growing dividends at the heart of why dividend growth investing is such a phenomenal way to apply incremental progress, as growing dividends being reinvested back into more companies paying growing dividends slowly creates a runway passive dividend income snowball which can grow all by itself with ever-more momentum.
And that can lead to the holy grail of investing: financial freedom.
It certainly worked out that way for me.
By pursuing dividend growth investing and incremental progress myself, I was able to build the FIRE Fund – my real-money portfolio generating enough five-figure passive dividend income to live off of – and even retire in my early 30s.
Being in a position to retire at such a young age is incredible, and I detailed how that’s possible in my Early Retirement Blueprint.
A lot of what I’ve achieved is owed to what I just laid out above, but a relentless focus on valuation when making investments has also been instrumental to my success.
And 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.
It’s protection against the possible downside.
Participating in the power of compounding and incremental progress via slowly accumulating undervalued high-quality dividend growth stocks opens up a clear path to financial freedom.
That said, the whole concept of valuation seems intimidating.
Well, it shouldn’t be.
Lesson 11: Valuation, written by fellow contributor Dave Van Knapp, aims to dispel this intimidation by breaking down the concept into easy-to-digest nuggets, even providing a template you can easily apply 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…
Lockheed Martin Corp. (LMT)
Lockheed Martin Corp. (LMT) is an American defense and aerospace company.
Founded in 1912, Lockheed Martin is now a $106 billion (by market cap) defense mammoth that employs approximately 120,000 people.
This is the largest (by revenue) defense contractor in the world.
The company reports results across four segments: Aeronautics, 40% of FY 2024 revenue; Rotary and Mission Systems, 24%; Space, 18%; and Missiles & Fire Control, 18%.
Lockheed Martin generates nearly 75% of its revenue from the US government (primarily from the the US Department of Defense), while the rest of revenue is mainly derived from foreign governments (with almost no commercial-sourced revenue)
This company manufactures and supplies several critical, large military aircraft platforms, including the F-35 Lightning II, the F-22 Raptor, the F-16 Fighting Falcon, and the SH-60 Seahawk.
The F-35, a fifth-generation combat aircraft, is the largest and most expensive military weapons system in the world.
In addition, Lockheed Martin is a major provider of sovereign missile programs vital for both offensive and defensive capabilities.
In a perfect world, a company like Lockheed Martin wouldn’t even exist.
In that world, there’d be no violence; humans would live in complete harmony with one another.
However, that’s not the world we live in.
In this reality, weapons have been used for attacks and made necessary for defense since the dawn of civilization.
It was true when we used sticks and rocks, and it’s true now that we’re using aircraft and missiles.
If a nation doesn’t defend itself, it puts its very survival at risk.
And that leads right to the purchasing of the defense products that Lockheed Martin sells.
Moreover, those products are inherently advantaged by the way in which they become ever-more advanced and expensive.
We’ve moved from cheap and simple rocks to very expensive and complex machinery, and the complexity of defense systems is likely only set to grow (which also means growing sales).
Lockheed Martin has built-in, nearly-guaranteed revenue from the human condition, and that revenue is constantly rising from the progressive nature of defense systems.
If all of that weren’t enough to set the company up well, we have to remember that Lockheed Martin is headquartered inside the borders of the world’s biggest spender on defense products (i.e., the US).
Pairing the world’s biggest defense contractor with the world’s biggest spender on defense is a match made in heaven, and this creates a symbiotic and mutually-beneficial relationship.
This is why Lockheed Martin continues to grow its revenue, profit, and dividend.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Already, Lockheed Martin has increased its dividend for 21 consecutive years.
Its 10-year dividend growth rate of 8.8% is certainly quite solid (and well in excess of the inflation rate, keeping shareholders’ purchasing power ahead of the game), but more recent dividend raises have been in a mid-single-digit range.
Dividend growth over the last couple of years has been challenged by cost overruns, inflation, and execution issues (particularly in regard to the F-35 program), but these temporary issues are not structural in nature.
Once Lockheed Martin tightens the ship a bit and starts to execute better, dividend growth should normalize.
And that would be coming on top of the stock’s market-beating yield of 2.9%.
Getting a ~3% starting yield and ~9% dividend growth is a pretty easy path to a low-double-digit annualized total return from here.
By the way, this yield is 20 basis points higher than its own five-year average, giving us an indication of some dislocation being present.
The payout ratio of 74.3% is unusually high, but that’s because EPS has been unusually (and temporarily) low.
Again, Lockheed Martin is shooting itself in the foot (pun not intended) with poor execution, but I’ve seen even the best companies go through periods of wobbly execution.
Those periods tend to be the best times to invest in great companies on sale, and that could be the case here.
While you wait for things to improve, you’re getting a ~3% yield almost implicitly backed by the US government.
Good stuff.
Revenue and Earnings Growth
As good as all of it may be, though, these dividend metrics are largely using backward-looking data.
However, investors must have a forward-looking mindset, as today’s capital is risked for tomorrow’s rewards.
As such, I’ll now build out a forward-looking growth trajectory for the business, which will be instrumental 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 way should give us the ability to confidently assess where the business could be going from here.
Lockheed Martin moved its revenue from $40.5 billion in FY 2015 to $71 billion in FY 2024.
That’s a compound annual growth rate of 6.4%.
Very respectable top-line growth out of a mature company that is actually the largest of its kind.
Meanwhile, earnings per share increased from $11.46 to $22.31 over this period, which is a CAGR of 7.7%.
Really solid results here.
We see some accretion on the bottom line, explained by material buybacks that reduced the outstanding share count by almost 25% over the last decade.
Looking forward, CFRA believes that Lockheed Martin will compound its EPS at an annual rate of 3% over the next three years.
CFRA cites “…continued execution challenges on troubled programs…” as a key hurdle holding Lockheed Martin back right now.
It’s hard to disagree about that.
On the other hand, CFRA notes: “Positives include $167B backlog growth, combat-proven platforms (F35, PAC-3, THAAD), market-leading scale, and exposure to hypersonics/missile defense. Strong free cash flow and $6B+ annual returns remain attractive alongside strategic national security importance.”
The execution challenges are short-term headwinds, but the positives are long-term tailwinds.
As a long-term investor, I naturally mentally gravitate toward those structural advantages.
Lockheed Martin has a backlog exceeding the entire market cap of the company, as well as a symbiotic relationship with the world’s most well-heeled defense spender.
While I do think the next year or two is tough going, Lockheed Martin has all the tools necessary to grow the business and dividend at high-single-digit rates, respectively.
It’s done it before.
There’s absolutely no reason why it can’t do it again.
Financial Position
Moving over to the balance sheet, Lockheed Martin has a good (but not great) financial position.
The long-term debt/equity ratio is 3.1, while the interest coverage ratio is 7.
That former number is artificially high because of low common equity.
Lockheed Martin carries a long-term debt load of approximately $20 billion, which is not cumbersome or egregious for a $100+ billion company.
There’s room for improvement here, and I’d like to see the balance sheet get back to where it was a decade or so ago (there has been clear deterioration in recent years), but I also don’t notice anything particularly worrisome at this time.
Once execution improves and results bounce back, the interest coverage ratio should shoot higher (assuming L-T debt doesn’t also shoot higher).
Profitability is robust.
Return on equity has averaged 89.5% over the last five years, while net margin has averaged 9.2%.
Leverage boosts ROE, but even ROIC is routinely north of 30%.
It’s clear Lockheed Martin is generating high returns on capital, which I love to see.
Since the human condition results in conflict and spending on defense systems, and since Lockheed Martin is the world’s largest producer of defense systems headquartered inside of the world’s largest spender on said defense systems, the company basically cannot lose over the long run.
And with economies of scale, high barriers to entry, long-term contracts, unique/established government relationships, R&D, IP, and technological know-how, 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.
Being in an oligopolistic industry with only a few prime defense contractors in existence, competition is limited, but new entrants focusing more on newer technologies easier to produce (such as drones) are making headway and starting to threaten the entrenched incumbents.
While having a direct, somewhat symbolic relationship with the US government creates certain advantages and makes backing the company easier from a national security standpoint, this close government contact can invite more scrutiny and regulation.
In addition, since the US government is the company’s largest customer, any changes in US government spending can have a serious impact on Lockheed Martin’s fortunes.
The very nature of the business model introduces massive geopolitical risks.
Execution risks have recently been clear and present, with cost overruns on the F-35 program being a prime example, and Lockheed Martin must execute better going forward in order to maintain/restore credibility and leadership.
The company is linked to the overall health of the US economy, as a stronger economy creates more capital and leeway for defense spending, although defense spending has historically been resilient and resistant to reductions (especially when it comes to the mission-critical systems Lockheed Martin specializes in).
Being global, there’s exposure to currency exchange rates, although most of the company’s business is done in the US.
I do see some risks to be aware of.
However, I’m also aware of the long-term, structural tailwinds, and the valuation doesn’t seem to fully reflect these tailwinds…
Valuation
The P/E ratio of 25.3 doesn’t look low at all, but that’s only because of massive charges the company has taken in order to account for troubled programs.
If we take out the most recent charge, the P/E ratio drops to 19.
I think that’s the more accurate representation of the multiple being paid right now, which is a below-market multiple on what is pretty close to a surefire long-term bet.
Although that’s close to its five-year average, earnings lumpiness makes it hard to fully comp it out.
On the other hand, the sales multiple of 1.5, which is a bit lower than its own five-year average of 1.7, is a pretty good comparison to make, as revenue is less affected by the lumpiness.
And the yield, as noted earlier, is 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%.
I’ve almost always reverted to a 7% long-term growth rate when analyzing and valuing Lockheed Martin’s stock, and I continue to stick with it.
In my view, that’s an appropriate expectation out of this business over time in terms of its EPS and dividend growth.
This is lower than the demonstrated EPS and dividend growth rates, respectively, over the last 10 years, which opens up room for some modest slowing over the next decade (in order to reflect execution risks and rising competition).
The DDM analysis gives me a fair value of $470.80.
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 see the stock as being mildly undervalued right now.
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 LMT as a 4-star stock, with a fair value estimate of $529.00.
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 LMT as a 3-star “HOLD”, with a 12-month target price of $458.00.
I’m somewhere in the middle this time around. Averaging the three numbers out gives us a final valuation of $485.93, which would indicate the stock is possibly 8% undervalued.
Bottom line: Lockheed Martin Corp. (LMT) benefits from conflict being a natural outcome of the human condition, giving rise to demand for defense systems in order to maintain security and sovereignty. Not only that, but it’s the world’s largest producer of these systems, all while being headquartered inside of the world’s largest spender on these systems. With a market-beating yield, high-single-digit dividend growth, a maintainable payout ratio, more than 20 consecutive years of dividend increases, and the potential that shares are 8% undervalued, long-term dividend growth investors interested in sure shots should strongly consider this idea.
-Jason Fieber
Note from D&I: How safe is LMT‘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, LMT‘s dividend appears Safe with an 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 LMT.
