Concerns over inflation and the potential for a recession have led the S&P 500 index to drop 16% year-to-date. The current market correction underscores the importance of being invested in high-quality assets that can help you to sleep well at night.
Due to its stability, it’s not surprising that the insurer and asset manager Prudential Financial (NYSE: PRU) has significantly outperformed the S&P 500 so far this year – – falling just 8%.
For the first time since my prior article in February, I will dig into Prudential’s risks and the reasons to consider buying the stock.
Prudential’s Dividend Remains Secure
Prudential pays a generous dividend to its shareholders. But is it safe?
The stock yields 4.73%, which is only slightly higher than the insurance – life industry average of 4.40%. This implies that the market views Prudential’s dividend to be about as safe as its peers.
Prudential’s dividend payout ratios further demonstrate that the dividend is at minimal risk of being cut. This is because, in 2021, Prudential produced $ 14.58 in after-tax adjusted operating income per share. Compared to the $ 4.60 in dividends per share paid during the year, this is equivalent to an after-tax adjusted operating income per share payout ratio of 31.6%.
Even with analysts forecasting a temporary drop in Prudential’s after-tax adjusted operating income per share to $ 11.59 in 2022, the dividend looks viable. Against the $ 4.80 in dividends per share that are projected to be paid this year, Prudential’s after-tax adjusted operating income per share payout ratio would still only be 41.4%.
This should give the stock the ability to grow its dividend slightly ahead of its earnings moving forward. And since I’m expecting 5% to 6% annual earnings growth over the next five years, I believe a 5.5% annual dividend growth rate is a realistic assumption.
The Fundamentals Appear To Be Intact
Earlier this month, Prudential reported its earnings results for the first quarter of 2022. Overall, the results show that the stock’s fundamentals are still strong.
Prudential recorded $ 3.17 in after-tax adjusted operating income per share during the quarter, which was a 20.6% decline over the year-ago period. This sounds bad on the surface, but Prudential faced a difficult comparison from Q1 2021. That’s because the company sold its share of an asset management joint venture in Italy for a $ 378 million gain in Q1 2021 (all details sourced from Prudential Q1 2022 earnings press release).
In this case, I would argue that the more fitting comparison to draw is to the pre-pandemic first quarter of 2019. Prudential posted a 5.7% growth rate in after-tax adjusted operating income per share over that period (data points according to Prudential Q1 2022 earnings press release and Prudential Q1 2020 earnings press release).
Prudential’s adjusted book value per share surged 6.6% higher year-over-year to $ 107.16 in the first quarter (figures for Prudential Q1 2022 earnings press release). This shows that the company is still steadily creating value for its shareholders.
Prudential maintained $ 3.6 billion in liquidity as of the first quarter, which would be more than enough to keep the company afloat in a recession (details sourced from Prudential Q1 2022 earnings press release). This explains why the rating agencies S&P and Moody’s have assigned firmly investment-grade credit ratings of A and A3, respectively, to Prudential.
Thanks to the company’s strong liquidity and ability to generate cash flow, significant share repurchases like the $ 375 million executed in the first quarter should continue going forward (data according to Prudential Q1 2022 earnings press release).
Risks To Consider:
Like any great business, Prudential still has its risks.
The first risk that could present itself soon stems from elevated inflation rates. This will benefit Prudential’s investment income as interest rates are gradually raised over the next few quarters.
But with the US economy shrinking 1.4% in the first quarter, the Federal Reserve will need to be careful with the pace and extent of rate hikes going forward. That’s because a failure to do so could trigger a recession or exacerbate it if we are already in one and won’t know it until the release of the second-quarter GDP data.
Since Prudential’s revenue is, in part, dependent on the health of the stock market, a recession would temporarily pressure Prudential’s financial results in the near term. This would also likely lead to further downside in the stock.
Discounted By Double-Digits
Prudential is a top-notch dividend stock that also appears to be priced at an appropriate margin of safety for long-term investors. This is supported by my assumptions in two valuation models.
The first valuation model that I will use to value shares of Prudential is the dividend discount model, which has three inputs.
The first input into the DDM is the expected dividend per share, which is a stock’s annual dividend per share. Prudential’s annualized dividend per share is currently $ 4.80.
The next input for DDM is the cost of capital equity, which is simply the annual total return rate that an investor requires. My personal preference is for 10% annual total returns.
The last input into the DDM is the DGR or annual dividend growth rate.
Correctly predicting the long-term DGR requires an investor to contemplate several elements: These include a stock’s dividend payout ratios (and whether those payout ratios are positioned to contract, expand, or remain the same in the future), annual earnings growth potential, the state of a stock’s balance sheet, and industry fundamentals.
I will use a 5.5% annual DGR as I discussed in the dividend section earlier.
Plugging these inputs into the DDM, I get a fair value output of $ 106.67 a share. This suggests that Prudential’s shares are trading at a 4.9% discount to fair value and can provide a 5.2% upside from the current price of $ 101.44 a share (as of May 13, 2022).
The second valuation model that I’ll employ to estimate the fair value of shares of Prudential is the discounted cash flows model.
The first input for the DCF model is trailing twelve months after-tax adjusted operating income per share. This amount was $ 13.76 for Prudential.
The second input into the DCF model is growth assumptions. Building in a margin of safety, I will forecast zero earnings growth from Prudential’s base of $ 13.76 in after-tax adjusted operating income per share.
The third input for the DCF model is the discount rate, which is another term for the required annual total return rate. I will use 10% for this input.
Using these inputs, I arrive at a fair value of $ 137.60 a share. This signals that Prudential’s shares are priced at a 26.3% discount to fair value and offer 35.6% capital appreciation from the current share price.
Upon averaging these two fair values out, I compute a fair value of $ 122.14 a share. This means that shares of Prudential are trading at a 16.9% discount to fair value and can provide a 20.4% upside from the current share price.
Summary: Prudential Isn’t A Get-Rich-Quick Stock, But It Is Reliable
Prudential is admittedly a “boring” stock. It’s not going to be a 10-bagger in the next 10 years. But the stock has raised its dividend for 14 consecutive years. And with a payout ratio set to be in the low-40% range for this year, that streak shouldn’t be ending anytime soon.
Prudential’s adjusted book value per share is consistently climbing, which is a sign that it can keep making shareholders richer over time. Furthermore, the rock-solid balance sheet significantly reduces the risk that the company will go bankrupt in the decades ahead.
In a worst-case scenario with earnings growth below my expectations and the valuation multiple staying the same, Prudential looks like it will generate high-single-digit annual total returns over the next decade. But if my assumptions are correct, Prudential could generate 12% annual total returns for the next 10 years. This is an exceptional risk-reward ratio that makes Prudential a buy at the current valuation.