Automatic Data Processing: Expensive Stock, Healthy Dividend Growth

Continuing our search for a stock to add to our portfolio of superior dividend yielding stocks, I will analyze Automatic Data Processing Inc. (ADP). It is a member of the S&P 500 Dividend Aristocrat which means that it has increased it yearly dividend for the last consecutive 25 years. That is a record worth evaluating. Let’s have a look.

Company Profile

From Yahoo Finance:

Automatic Data Processing, Inc. provides computerized transaction processing, data communication, and information services worldwide. It operates in four segments: Employer Services, Brokerage Services, Securities Clearing and Outsourcing Services, and Dealer Services. The Employer Services segment offers a range of human resource information, payroll processing, and benefit administration products and services. The Brokerage Services segment provides transaction processing services, desktop productivity applications, and investor communications solutions to the financial services industry. The Securities Clearing and Outsourcing Services segment offers clearing, custody, customer financing, securities lending, trade execution, and outsourcing solutions to broker-dealers. The Dealer Services segment provides integrated dealer management systems and business solutions to automotive, heavy truck, and power sports vehicle retailers.

This is a large cap stock with a market capitalization of $26.78B.

Company Fundamentals

When determining whether to add a company to my dividend yield portfolio, the first test that must be passed is the return on invested capital. Management must be able to keep a consistently high ROIC. In the case of ADP, management has done a terrific job with a rock solid 17% throughout the whole period.

The return on equity numbers confirm management’s success and also show that this company has relatively no debt. In fact, this company has total debt as 0.7% of capital. The ROE numbers are 18.39% over 10 years and 18.37% over 5 years.

The equity growth rate has been on the weak side. The 10 year average is 10.17% and the 5 year average is 7.32%. And last year, it was almost at the 5 year average at 7.41%. Definitely nothing to write home about.

Earnings per share growth rate nicely reflect the equity growth rate with a rate of 8.59% over the whole 10 year period. However, the 5 year average is 2.83% and last year’s EPS growth rate was 3.35%. Not the trend I want to see.

Sales growth rate has been on the decline as well. Over the 10 year period, the sales growth rate was 8.25%. However, that was thanks to some fairly decent sales growth rates in 1997 and 1998. Unfortunately, those growth rates have not been seen again since then. The 5 year average is 5.75% and last year’s growth rate was 4.50%.

Dividend Fundamentals

ADP is currently paying a dividend yield of 1.88%. That is the same as the S&P 500 dividend yield but lower than the Dow Jones Industrial Average dividend yield of 2.25%. ADP definitely seems to be paying the average dividend yield.

The current dividend yield is not as important as the dividend growth in the long run in my opinion. And ADP definitely has a long history of dividend raises. These last 10 years clock in at a dividend growth rate of 13.33% and that has definitely been very stable over the whole 10 year period. That is definitely a healthy dividend raise each year.

However, cash flow growth rates have not been keeping up with these dividend growth rates. Over the 10 years, the cash flow growth rate comes in at 6.63%. And it gets much worse from there. The 5 year average is a measly 1.05%, the 3 year average is 1.41% and last year’s was negative 6.23%. With the cash supply not growing as quickly as the dividends, and it takes cold hard cash to pay for dividends, this is a concern.

Looking at the dividend payout ratio, I see that ADP has consistently been at around 25% for the first 7 years. However, since then, it has grown over the last 3 years: 34.62%, 33.80% and 38.38% respectively. And this makes sense from the fundamental numbers that we have seen.

Valuation Models

You know that I like to put a hard number value on a stock. So let’s have a look at our different valuation methods.

Looking at yield, I see that the 10 year average high dividend yield is 1.28%. The 5 year average high dividend yield is 1.55%. At today’s current dividend yield of 1.88%, this stock currently has the highest dividend yield it has ever had over the last 10 years.

My model yield price is $59.35. That would mean that the stock is currently trading at a discount of 17.72%.

However, I think that the diminishing fundamentals are causing investors to demand a higher yield from this company. There may be concern that ADP cannot continue its 13% per year dividend growth.

Calculating Graham’s number, I come up with a model price of $21.45. That is a much lower price than I obtained from the yield method. This would imply a premium of 127%!

And lastly, let’s calculate the price of the stock 10 years from now. Of course, we need to determine the value that the earnings per share will grow at over the next 10 years. Looking at the equity growth rate, I see a 5 year average of 7.32%. And this correlates well with last year’s rate of 7.41%. Now, analysts have estimated a growth rate of 15%. I have no idea how they can defend that growth rate. Well, ok. I do know how. For 6 of the last 10 years, ADP has been able to grow their EPS at approximately 15%. But I feel that equity growth rate is a better proxy for future EPS growth rate.

Typically, investors have been willing to allow a stock to have a P/E that is roughly twice its EPS growth rate. Analysts are forecasting 15% EPS growth rate, and the stock currently is trading at a P/E of 25.57. And historically, ADP has had a P/E in the 25 - 29 range. However, with my estimate future EPS growth rate of 7.32%, no investor would be willing to pay that high a multiple. So, assuming twice the 7.32%, that would give me a future P/E of 14.64.

With that information, I determine the future price to be $56.67. Discounting that back to the present (using a rate of 15%), my model price is $14.01. Like my Graham number, this implies a huge premium of 248%!

See my calculations here.

Conclusion

Investors seem to be demanding a higher yield from this stock than they ever have in the past. Many of the fundamental numbers such as equity growth rate, earnings per share, and sales growth rate have been on the decline. Although the yield is high, my other valuation methods show this stock to be too expensive.

ADP still has a relatively low payout ratio. So they will definitely be able to continue to grow their dividends at their current historical rate of 13% for the next few years.

ADP 1-yr chart

Disclosure: I do not own any shares in ADP.