To point out that financial markets have been volatile since the start of the year would be stating the obvious. The war in Ukraine, soaring interest rates and high inflation caused the S&P 500 index to fall by 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 over my five-year investing career is focusing primarily on dividend-growth stocks.
The insurer and asset manager Prudential Financial (NYSE: PRU). For the first time since May, I will discuss my buy case for the stock and the risk associated with it.
A well-protected and market-crushing dividend
Prudential’s dividend yield of 5.30% is significantly higher than the life insurance industry’s average dividend yield of 3.57%. And it’s well above the 1.76% return of the S&P 500. Yet Prudential doesn’t appear to be a yield trap either.
This is supported by the fact that Prudential generated $14.58 of after-tax adjusted operating income per share in 2021 (page 8 of 11 of Prudential’s fourth quarter 2021 earnings press release). Compared to the $4.60 in dividends per share paid during this period, this equates to an after-tax adjusted operating profit of 31.6% per share payout ratio.
The stock market slump will weigh on the company’s after-tax adjusted operating earnings per share in the near term. That’s why analysts are forecasting $10.04 in after-tax adjusted operating profit per share for this year. Compared to the $4.80 in dividends per share that will be paid in 2022, this equates to a payout ratio of 47.8%.
That’s a bit high end for Prudential, so I expect dividend growth to lag slightly behind earnings growth for the foreseeable future. Given an annual earnings growth rate of 5% to 6%, my forecast is for an annual dividend growth rate of 5% over the long term.
A first half characterized by a major macroeconomic challenge
At first glance, Prudential’s results for the first half of 2022 may seem weak. But with more context and a better understanding of its headwinds, the results aren’t as bad as they look.
Prudential reported after-tax adjusted operating profit of $4.91 per share in the first half of the year. This is a decrease of 35.4% compared to the previous year.
This is the result of declines in each of Prudential’s three main segments: PGIM, US operations and international operations.
The broader market decline led Prudential’s assets under management to fall from $1.73 trillion the previous year to $1.41 trillion at the end of the first half. That’s how the company’s asset management segment, called PGIM, saw a 59.2% year-over-year decline in pretax adjusted operating profit to $394 million in first half of 2022.
The US corporate segment saw a similar 30.5% year-over-year drop in pretax adjusted operating profit to $1.31 billion for the first half of the year. And the international corporate segment saw a 19% year-over-year decline in pretax adjusted operating income to $1.36 billion in the first half of 2022.
Prudential’s adjusted book value per share remained relatively flat, declining just 0.2% to $104.19 to end the second quarter of 2022.
The good news is that the economy eventually bounces back after every recession. And with $7.1 billion in highly liquid assets, Prudential has the financial courage to emerge intact from the other side of an economic downturn. This is why rating agencies S&P, Moody’s and Fitch have assigned Prudential credit ratings of A, A3 and A- respectively.
Risks to consider:
Prudential is a fundamentally and financially sound company. But no action is without risk. With this universal truth in mind, here is the biggest risk facing business in the future.
Because of the concerns I alluded to in the opening of this article, Ned Davis Research warns that there is a 98.1% chance of a severe global recession at some point in 2023. If the economic bottom is deep and prolonged enough, a temporary dividend cut could be on the table. Indeed, depressed stocks would lead to a massive drop in earnings, which could also lead Prudential’s shares to sell further.
A wonderful business valued at a discount
Buying quality companies is a start for investors looking to do well, but it’s only half of the equation. The other half is to avoid overpaying.
Fortunately, Prudential seems to have an attractive valuation right now. This is based on my assumptions for two valuation models.
The first valuation model that I will use to approximate the value of Prudential’s shares is the discounted cash flow model or DCF model. The DCF model has three inputs.
The first input to the DCF model is year-over-year after-tax adjusted operating earnings per share. In the case of Prudential, this amount is $11.87.
The next input for the DCF model is the growth assumptions. I won’t factor in any additional earnings growth from Prudential to err on the side of caution.
The final input to the DCF model is the discount rate, which is the required annual total rate of return. My personal preference is 10% annual total returns, 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% upside from the current price of $90.57 per share (as of October 7, 2022) .
The other valuation model that I will use to value Prudential’s 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, which refers to the annual total rate of return required by an investor. I will again use 10% for this entry.
The third data for the DDM is the DGR or annual dividend growth rate. As I indicated earlier in the section on dividends, I will use a 5% annual dividend growth rate for Prudential.
Factoring in these entries in the DDM, I get a fair value output of $96.00 per share. This indicates that Prudential’s stock price is discounted by 5.7% from fair value and can provide capital appreciation of 6% from the current price.
When I average these two fair values together, I arrive at a fair value of $107.35 per share. This implies that Prudential’s shares are trading at a 15.6% discount to fair value and offering an 18.5% upside from the current share price.
Summary: Prudential is a reliable income stock to buy
Having raised its dividend for 14 consecutive years, Prudential is a dividend contender. And the relatively sustainable payout ratio should give the company the flexibility to continue to build on this track record in years to come. Not to mention that Prudential has plenty of cash to ride out an impending economic downturn.
If that’s not enough for income investors to press the buy button, Prudential is also 16% undervalued and offers income investors a dividend yield of 5.3%. That’s why I think the stock is a compelling choice for yield-hungry investors.