Prudential Financial: Blue-Chip High-Yield is a Buy (NYSE: PRU)

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Concerns about inflation and the possibility of a recession led the S&P 500 index to down 16% since the start of the year. The current market correction highlights the importance of being invested in high quality assets that can help you to sleep well at night.

Given its stability, it’s no surprise that insurer and asset manager Prudential Financial (NYSE: PRU) has largely outperformed the S&P 500 so far this year — losing only 8%.

For the first time since my previous post in February, I will dig deeper into Prudential’s risks and 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 insurance industry average of 4.40%. This implies that the market considers Prudential’s dividend to be about as safe as its peers.

Prudential’s dividend payout ratios further demonstrate that the dividend has minimal risk of being cut. Indeed, in 2021, Prudential produced $14.58 after-tax adjusted operating profit per share. Compared to the $4.60 dividend per share paid out during the year, this equates to a payout ratio of after-tax adjusted operating earnings per share of 31.6%.

Although analysts expect Prudential’s after-tax adjusted operating profit per share to drop temporarily to $11.59 in 2022, the dividend seems viable. Compared to the $4.80 per share dividend expected to be paid this year, Prudential’s after-tax adjusted operating earnings payout ratio per share would still be just 41.4%.

This should give the stock the chance to increase its dividend slightly ahead of its earnings going forward. And since I expect annual earnings growth of 5-6% over the next five years, I believe that an annual dividend growth rate of 5.5% is a realistic assumption.

The fundamentals seem to be intact

Highlights from Prudential's first quarter 2022 earnings press release.

Prudential Financial Q1 2022 Earnings Press Release

Earlier this month, Prudential released its results for the first quarter of 2022. Overall, the results show that the fundamentals for the stock are still strong.

Prudential posted $3.17 of after-tax adjusted operating earnings per share in the quarter, down 20.6% from the same period last year. It looks bad on the face of it, but Prudential faced a tough comparison starting in the first quarter of 2021. That’s because the company sold its share of an asset management joint venture in Italy for a gain of 378 million in Q1 2021 (all details from Press release on Prudential’s results for the first quarter of 2022).

In this case, I would say that the most appropriate comparison to draw is that of the first quarter of 2019 pre-pandemic. Prudential posted a growth rate of 5.7% in after-tax adjusted operating earnings per share during this period (data points according to Prudential Q1 2022 Earnings Press Release and Press release on Prudential’s results for the first quarter of 2020).

Prudential’s adjusted book value per share jumped 6.6% year-over-year to $107.16 in the first quarter (figures according to Prudential’s Q1 2022 earnings press release) . This shows that the company continues to create value for its shareholders on a regular basis.

Prudential maintained $3.6 billion in cash in the first quarter, which would be more than enough to keep the company afloat in a recession (details from Prudential’s Q1 2022 earnings press release) . This is why rating agencies S&P and Moody’s have assigned good quality credit ratings from A and A3, respectively, to Prudential.

Thanks to the company’s strong liquidity and ability to generate cash flow, large share buybacks like the $375 million executed in the first quarter are expected to continue (data according to Prudential’s earnings press release Q1 2022).

Risks to consider:

Like any big business, Prudential always has its risks.

The first risk that could arise in the near future comes from high inflation rates. This will benefit Prudential’s investment income as interest rates will gradually rise over the next few quarters.

But with the American economy 1.4% decline in the first quarter, the Federal Reserve will need to be cautious about the pace and magnitude of rate hikes going forward. Indeed, failure to do so could trigger a recession or make it worse if we are already inside it and we won’t know until the second quarter GDP data is released.

Since Prudential’s revenues are partly dependent on the health of the stock market, a recession would temporarily put pressure on Prudential’s financial results in the short term. This would also likely lead to a further drop in the stock.

Double digit discount

Prudential is a blue-chip dividend-paying 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 dividend discount model shows that Prudential shares are slightly undervalued.

Investopedia

The first valuation model I will use to value Prudential’s stock is the dividend discount model, which has three inputs.

The first entry in the DDM is the expected dividend per share, which is the annualized dividend per share of a stock. Prudential’s annualized dividend per share is currently $4.80.

The next input for the DDM is the cost of equity, which is simply the annual total rate of return an investor needs. My personal preference is for 10% total annual returns.

The last entry in the DDM is the DGR or annual dividend growth rate.

To correctly predict long-term DGR, an investor must consider several things: these include a stock’s dividend payout ratios (and whether those payout ratios are positioned to contract, expand, or stay even in the future), the potential for annual earnings growth, the state of a stock’s balance sheet and industry fundamentals.

I will use an annual DGR of 5.5%, as I explained in the dividend section earlier.

Plugging these inputs into the DDM, I get a fair value output of $106.67 per share. This suggests that Prudential shares are trading at a 4.9% discount to fair value and may offer a 5.2% upside from the current price of $101.44 per share (as of May 13 2022).

The discounted cash flow model implies that Prudential's shares are valued at a significant discount to fair value.

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The second valuation model that I will use to estimate the fair value of Prudential shares is the discounted cash flow model.

The first input to the DCF model is the 12-month after-tax adjusted operating profit per share. This amount was $13.76 for Prudential.

The second input of the DCF model concerns the growth assumptions. Building in a safety margin, I’ll plan zero earnings growth over Prudential’s base of $13.76 in after-tax adjusted operating earnings per share.

The third input to the DCF model is the discount rate, which is another term for the required annual total rate of return. I will use 10% for this entry.

Using these inputs, I arrive at a fair value of $137.60 per share. This indicates 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.

By averaging these two fair values, I calculate a fair value of $122.14 per share. This means that Prudential’s shares are trading at a 16.9% discount to their fair value and can offer a 20.4% upside from the current share price.

Summary: Prudential Isn’t a Get-Rich-Quick Stock, But It’s Reliable

Prudential is certainly a “boring” title. It won’t be a 10-bagger in the next 10 years. But the title has increased its dividend for 14 consecutive years. And with a payout rate expected to be in the low 40% range for this year, that streak isn’t likely to end anytime soon.

Prudential’s adjusted book value per share is steadily increasing, which is a sign that it can continue to enrich shareholders over time. Moreover, the rock-solid balance sheet significantly reduces the risk of the company going bankrupt in the decades to come.

At worst, with earnings growth below my expectations and an unchanged valuation multiple, Prudential looks set to generate high single-digit annual total returns over the next decade. But if my assumptions are correct, Prudential could generate annual total returns of 12% for the next 10 years. This is an exceptional risk-reward ratio that makes Prudential a buy at the current valuation.

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