To point out that financial markets have been volatile to date would be stating the obvious. The war in Ukraine, rising interest rates and high inflation have sent the S&P 500 index down 24% so far this year.
This begs the question: What should an investor do to stay calm and stay in the market for the long term? What has worked for me in my five-year investing career is to focus primarily on dividend growth stocks.
One such stock that has been the cornerstone of my portfolio is the insurer and asset manager Prudential Financial (New York Stock Exchange: PRU). For the first time since May, I will be discussing my case for buying the stock and the risk associated with it.
A well-protected and devastating dividend for the market
Prudential’s 5.30% dividend yield is significantly higher than the life insurance industry average dividend yield of 3.57%. And it’s well above the 1.76% return of the S&P 500 Index. However, Prudential does not appear to be a performance trap either.
This is supported by the fact that Prudential generated $14.58 in adjusted after-tax operating income per share in 2021 (page 8 of 11 of the Prudential Q4 2021 earnings press release). Against the $4.60 in dividends per share paid during that time, this equates to 31.6% after-tax adjusted operating income per pay-per-share ratio.
The collapse of the stock markets will weigh on the company’s adjusted after-tax operating income per share in the short term. That’s why analysts anticipate $10.04 in adjusted after-tax operating income per share for this year. Compared to the $4.80 in dividends per share to be paid in 2022, this results in a payout rate of 47.8%.
This is a bit high for Prudential, so I expect dividend growth to lag slightly behind earnings growth for the foreseeable future. Assuming an annual earnings growth rate of 5% to 6%, my forecast is an annual dividend growth rate of 5% over the long term.
The first semester was characterized by a significant macroeconomic challenge
At first glance, Prudential’s earnings results for the first half of 2022 may appear weak. But with more context and a fuller understanding of your headwinds, the results aren’t as bad as they seem.
Prudential reported $4.91 in after-tax adjusted operating income per share in the first half of the year. This was 35.4% lower than the same period the previous year.
This was the result of declines in each of Prudential’s next three main segments: PGIM, US business and international business.
The broader market decline saw Prudential’s assets under management fall from $1.73 trillion in the previous year to $1.41 trillion at the end of the first half. That’s how the company’s asset management segment, dubbed PGIM, saw a 59.2% year-over-year drop in pre-tax adjusted operating income to $394 million during the first half of 2022.
The US Corporate segment posted a similar 30.5% drop from the prior year period in pre-tax adjusted operating income to $1.31 billion for the first half of the year. And the international business segment posted a 19% year-over-year drop in pre-tax adjusted operating income to $1.36 billion during the first half of 2022.
Prudential’s adjusted book value per share was relatively flat, declining just 0.2% to $104.19 to close the second quarter of 2022.
The good news is that the economy eventually recovers after every recession. And with $7.1 billion in highly liquid assets, Prudential has the financial strength to come through the other side of an economic downturn intact. That is why the rating agencies S&P, Moody’s and Fitch gave Prudential investment grade credit ratings of A, A3 and A- respectively.
Risks to consider:
Prudential is a fundamentally and financially sound business. But no stock is risk free. With that universal truth in mind, this is the biggest risk the company faces going forward.
Due to the concerns I alluded to at the beginning of this article, Ned Davis Research warns that there is a 98.1% chance of a serious global recession sometime in 2023. If the economic depression is deep enough and protracted, a temporary dividend cut could be on the table. That’s because depressed stocks would lead to a massive drop in earnings, which could also lead to Prudential stock selling off even more.
A wonderful bargain valued at a discount
Buying quality companies is a start for investors looking to do well, but it is only half of the equation. The other half is to avoid overpaying.
Fortunately, Prudential appears to be attractive value at the moment. This is based on my assumptions for two valuation models.
The first valuation model I will use to approximate the value of Prudential’s stock is the discounted cash flow model, or DCF model. The DCF model has three inputs.
The first input in the DCF model is twelve months’ adjusted after-tax operating income per share. In the case of Prudential, that amount is $11.87.
The next input to the DCF model is the growth assumptions. I will not view further earnings growth at Prudential as erring on the side of caution.
The final input in the DCF model is the discount rate, which is the required annual total rate of return. My personal preference is 10% annual total return, so that’s what I’ll use.
Given these inputs, I arrive at a fair value of $118.70 per share. This suggests that Prudential shares are trading at a 23.7% discount to fair value and offer a 31.1% advantage over the current price of $90.57 per share (as of October 7, 2022).
The other valuation model I will use to evaluate Prudential stock is the dividend discount model, which also involves three inputs.
The first entry for the DDM is the expected dividend per share, which is the annualized dividend per share of a stock. Prudential’s current annualized dividend per share is $4.80.
The second entry in the DDM is the cost of equity capital, which refers to the annual total rate of return required by an investor. I will use 10% again for this entry.
The third input for the DDM is the DGR or annual dividend growth rate. As I noted earlier in the dividend section, I will use a 5% annual dividend growth rate for Prudential.
Taking these entries into the DDM into account, I get a fair value output of $96.00 per share. This indicates that Prudential shares are priced at a 5.7% discount to fair value and may provide a 6% capital appreciation from current price.
When I average these two fair values together, I get a fair value of $107.35 per share. This implies that Prudential shares are trading at a 15.6% discount to fair value and offer an 18.5% advantage over the current share price.
Summary: Prudential is a reliable income stock to buy
Having increased its dividend for 14 consecutive years, Prudential is a dividend candidate. And the relatively sustainable pay rate should give the company the flexibility to continue building on this track record for years to come. Not to mention, Prudential has plenty of liquidity on hand to weather a looming economic downturn.
If that’s not enough for income investors to hit the buy button, Prudential is also 16% undervalued and offers income investors a whopping 5.3% dividend yield. That’s why I think the stock is a compelling choice for yield-hungry investors.