The Shiller PE ratio adjusts earnings from the past 10 years to account for inflation, which can help determine what sectors are cyclically overvalued or undervalued. It's no secret that the current Shiller PE ratio of 38.8 suggests the stock market is meaningfully overvalued, which means that investors must tread with caution if they hope to do well in the long run.
One high-quality stock that appears to still be a surefire buy at this time is the asset manager and insurer Prudential (NYSE:PRU).
For the first time since my previous article on Prudential in September, let's discuss the risks of investing in Prudential, as well as three reasons to consider buying the stock.
As an investor seeking dividend growth stocks for my portfolio, the name of the game is to steer clear of stocks whose payouts could be at risk of getting slashed.
I believe that glancing at a stock's dividend yield compared to its industry average and digging down into said stock's payout ratio is the best combination to avoid stocks with risky dividends.
Prudential's 4.35% yield is only moderately elevated against the insurance - life industry average 3.78% yield. This signals that the dividend isn't really at any more risk of being cut than the average life insurance stock.
Delving deeper into Prudential's dividend safety, the stock is set to pay $4.60 in dividends per share this year against the average analyst adjusted operating income per share estimate of $14.11 this year. That equates to a 32.6% payout ratio.
Looking ahead to next year, I anticipate that Prudential will pay $4.88 in dividends per share (equivalent to a 6.1% raise in the dividend that will be announced in February). Stacked against the $12.56 in adjusted operating income per share that is expected for next year, this works out to a 38.9% payout ratio.
Given that this gives Prudential room to slightly expand the payout ratio and analysts are forecasting 8% annual earnings growth over the next five years, I will reiterate my long-term 5.75% annual dividend growth rate for shares of the stock.
Image Source: Prudential Q3 2021 Earnings Press Release
Prudential put together another admirable quarter, which was evidenced by its $1.05 beat on analysts' consensus non-GAAP EPS estimate.
The company reported $3.78 in adjusted operating income per share in the third quarter, which was a 22.7% year-over-year growth rate compared to the year-ago period (data sourced from page 8 of 11 of Prudential's Q3 2021 earnings press release). This impressive adjusted operating income per share growth was made possible by double-digit increases in both the U.S. Businesses and International Businesses, which was the result of higher investment income and appreciation in equity markets (data according to pages 2 and 3 of 11 of Prudential's Q3 2021 earnings press release). This was partially offset by a double-digit percentage decline in the smaller investment management segment known as PGIM, which was driven by lower co-investment income and higher expenses (data per page 2 of Prudential's Q3 2021 earnings press release).
Prudential also managed to grow its adjusted book value per share 13.2% year-over-year to $106.85, which is a reflection of the ongoing economic recovery (data sourced from page 8 of 11 of Prudential's Q3 2021 earnings press release).
Year-to-date, Prudential's adjusted operating income per share compounded at a 64.7% rate year-over-year to $11.38 (data according to page 8 of Prudential's Q3 2021 earnings press release).
In addition to the double-digit year-over-year increase in adjusted operating income, a 1.1% decline in Prudential's average weighted diluted share count helped to explain the aforementioned healthy adjusted operating income per share growth rate (data per page 8 of 11 of Prudential's Q3 2021 earnings press release).
Image Source: Slide 11 of Prudential's 3Q21 Investor Update Presentation
With the Federal Reserve expecting not one but three rate hikes next year to combat inflation, Prudential will be one of the biggest beneficiaries as its investment income should go much higher.
And Prudential also benefits from a particularly powerful balance sheet. This is backed up by the company's $3.8 billion in liquid assets, which is access to enough capital to pay for more than three years of annual fixed expenses (data sourced from slide 11 of Prudential's 3Q21 Investor Update Presentation). Throw in the billions of additional capital that it has access to via its credit facilities, and the company undoubtedly has sufficient resources to withstand just about any situation.
That explains why Prudential enjoys firmly investment grade A, A3, and A- credit ratings from S&P, Moody's, and Fitch, respectively.
Put it all together and Prudential has the potential to be a tremendous investment if shares are purchased at the right price.
Despite Prudential's robust year thus far, every stock faces its share of risks that shareholders must track now and then to ensure that the investment thesis is intact. Therefore, I will go over a few major risks facing the stock as noted in its most recent 10-K.
The first risk facing Prudential is from an insurance risk standpoint (pages 41-42 of Prudential's recent 10-K).
While the omicron variant of COVID-19 appears to be less severe than the Delta variant, the risk of elevated mortalities remains for Prudential. This could result in continually high life insurance payouts, which would negatively weigh on Prudential's profitability given the importance of its life insurance business. If pronounced enough, the company could even face a liquidity crisis (pages 45-46 of Prudential's recent 10-K).
At any rate, the risk of a more deadly mutation of the COVID-19 virus remains a possibility. That's why shareholders need to monitor this risk periodically going forward.
The second risk to Prudential is from a market risk aspect (page 43 of Prudential's recent 10-K).
Because Prudential generates a portion of its revenue from investment management, annuity products, and the investment income from its insurance float, a downturn in the financial markets could have an unfavorable impact on the company's financial results.
The final risk to Prudential stems from its material operations outside of the U.S., especially in Japan (page 44 of Prudential's recent 10-K). This is noteworthy because it opens the company up to a variety of risks like currency translation, as well as more regulations with which to comply.
If the Japanese Yen experiences any weakness against the U.S. Dollar, this could hurt Prudential since it translates its revenue and earnings in Japan into U.S. Dollars.
But since these currency fluctuations generally are neutralized over time, the more important risk is regulatory. If laws governing Prudential's operations in Japan were to change, this would require significant resources on the company's part to interpret and follow.
While I have discussed several key risks associated with an investment in Prudential, this was by no means a complete discussion of Prudential's risks. I would encourage readers to check out pages 39-52 of Prudential's recent 10-K, in addition to my previous articles on the stock, for a more exhaustive summary of its risk profile.
Prudential is an above-average quality dividend stock. But even with that being the case, the price that investors pay must be rational if they are to stand a chance of doing well. That's because buying the stock at a lower starting yield and excessive valuation multiple will inevitably harm future total returns at some point.
The only way that an investor can know whether they are overpaying for a stock or building in a margin of safety is to determine the fair value of that stock, which is what I'll be doing. In this effort, I will utilize two valuation models to do so.
Image Source: Investopedia
The first valuation model that I'll use to estimate the fair value of shares of Prudential is the dividend discount model or DDM, which is comprised of three inputs.
The first input into the DDM is the expected dividend per share, which is a stock's annualized dividend per share. While I fully expect Prudential will raise its quarterly dividend in the next six to eight weeks, I'll stick with the current annualized dividend per share of $4.60.
The next input for the DDM is the cost of capital equity, which is simply the annual total return rate that an investor requires. While this rate often varies from one investor to another, I require 10% annual total returns. It's my belief that this offers ample reward for my work scouring for investment opportunities and watching my portfolio.
The final input into the DDM is the long-term annual dividend growth rate or DGR.
While investors just need to find the annualized dividend per share and decide upon an annual total return rate for the first two inputs into the DDM, correctly predicting the long-term DGR requires an investor to weigh multiple variables: These include a stock's dividend payout ratios (and whether those payout ratios are poised to remain the same, expand, or contract over the long-term), annual earnings growth potential, the health of a stock's balance sheet, and industry fundamentals.
Given that Prudential will likely grow its earnings at a 5% to 6% clip annually over the next decade and the payout could slightly tick up, I am keeping my 5.75% annual dividend growth forecast for the long run.
Factoring the inputs above into the DDM, I arrive at a fair value output of $108.24 a share. This suggests that Prudential's shares are trading at a 2.2% discount to fair value and provide a 2.3% upside from the current price of $105.81 a share (as of December 17, 2021).
Image Source: Money Chimp
The second valuation model that I will make use of to value shares of Prudential is the discounted cash flows model, which is also made up of three inputs.
The first input for the DCF model is the last twelve months of adjusted operating income per share. This figure is $14.31 for Prudential.
The second input into the DCF model is growth assumptions. These must be correct to get an actionable fair value output.
Building in a margin of safety, I will suppose that Prudential will not grow its earnings at all ever again. This is a stark contrast to the 8% annual earnings growth that analysts are projecting over the next five years.
The third input for the DCF model is the discount rate, which is again the required annual total return rate. Once again, I will use 10% for this input.
Plugging these three inputs into the DCF model, I am left with a fair value output of $143.10 a share. This implies that Prudential's shares are priced at a 26.1% discount to fair value and offer 35.2% capital appreciation from the current share price.
Averaging these two fair values together, I compute a fair value of $125.67 a share. This indicates that shares of Prudential are trading at a 15.8% discount to fair value and provide an 18.8% upside from the current share price.
Having raised its dividend for 13 consecutive years (including through the challenging environment last year), Prudential has established itself as a blue-chip dividend stock. And based on its payout ratios in the 30% range for this year and the next, this streak of dividend hikes likely won't be ending anytime soon.
This is further supported by the fact that Prudential's adjusted operating income per share skyrocketed 64.7% higher year-over-year. Prudential also made shareholders richer, delivering a 13.2% year-over-year increase in adjusted book value per share.
Even if the company encounters another difficult time, it has access to plenty of liquidity via its solidly investment-grade balance sheet.
Despite Prudential's quality and possibly three interest rate hikes on the way next year, I estimate that shares of the stock are priced at a 16% discount to fair value.
Taking all of these factors into consideration, I would argue that Prudential is one of the best blue-chip dividend stocks available that investors can buy at a deep discount. That's why I will continue to rate shares of the stock a buy at this time.
This article was written by
Disclosure: I/we have a beneficial long position in the shares of PRU either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.