Dividend growth investing is predicated on picking above-average quality stocks at fair or better valuations. Doing so over years or decades can allow an investor to reach financial independence, which is what I am striving toward.
One stock that is a core position within my portfolio is the supplemental insurer Aflac (AFL). For the first time since last May, I’ll explain why I like Aflac and the risks that go along with the stock.
Aflac Is Consistently Hiking Its Dividend
Aside from Aflac’s well-known track record as a Dividend Aristocrat with 39 consecutive years of dividend increases under its belt, dividend growth has accelerated in recent years. For context, the most recent 21.2% increase in Aflac’s quarterly dividend to $0.40 per share was the biggest percentage raise since 2008 (interpretation of largest percentage increase since 2008 from Aflac’s dividend page).
But can Aflac afford such a massive payout increase? An initial glance at Aflac’s 2.46% dividend yield compared to the insurance – life industry average of 3.47% implies that the stock can afford the generous raise.
And Aflac generated $5.94 in adjusted diluted EPS during 2021 against $1.32 in dividends per share paid during that time, which works out to a 22.2% adjusted diluted EPS payout ratio. This further proves that Aflac’s dividend is quite safe going forward.
Based on the $5.26 in adjusted diluted EPS that analysts are forecasting this year and the $1.60 in dividends per share slated to be paid, Aflac’s adjusted diluted EPS payout ratio will still only be 30.4% this year.
Such a low payout ratio combined with a 6% annual earnings growth rate expected over the next five years leads me to conclude that a 7.25% long-term annual DGR is justified.
Aflac’s Operating Fundamentals Remain Strong
Aflac had a magnificent 2021, which is reflected by both the company’s sales and adjusted diluted EPS.
Despite Aflac’s primary market of Japan being in various degrees of COVID-19 restrictions and the limited face-to-face sales opportunities as a result, revenue was only down 0.2% to $22.11 billion in 2021 (all info according to pages 3 and 6 of Aflac’s Q4 2021 earnings press release).
As face-to-face sales opportunities return (or even if it takes a while, Aflac has had time to adequately develop its virtual sales capabilities), sales activity should pick up. This should allow Aflac’s revenue to return to growth soon.
This is especially the case when taking Aflac’s recent product launches into consideration like Aflac Dental and Vision Insurance in January 2021. While sales were only $23 million for dental and vision insurance in the year, Aflac was able to sell another $15 million of other voluntary products. Because Aflac was planning for the launch of dental and vision insurance before COVID, the launch came out of the gate a bit slow. Fortunately, 50% of 2021 quote activity occurred in the last four months of the year per COO Fred Crawford’s opening remarks during Aflac’s Q4 2021 earnings call. Thus, Aflac Dental and Vision Insurance is ramping up and should be a nice growth driver for the business as well.
Aflac’s flat revenue paired with lower claims utilization rates (as the pandemic resulted in lower frequencies of behavior that can result in accidents like traveling) led adjusted earnings 13.1% higher to $4.02 billion in 2021 (page 11 of Aflac’s Q4 2021 earnings press release). The 5.5% year-over-year reduction in Aflac’s diluted share count was what helped to propel its adjusted diluted EPS 19.8% higher to $5.94 in 2021 (pages 6 and 11 of Aflac’s Q4 2021 earnings press release).
Aflac produced marvelous operating results in 2021 considering all of the challenges that were faced. But what’s just as positive for the company is its unquestionably investment-grade credit ratings.
Aflac’s respective A- and A3 credit ratings from S&P and Moody’s would need to be downgraded four times before the stock wouldn’t boast an investment-grade balance sheet anymore. Considering Aflac’s reputation as being quite conservative with its nearly $143 billion in investments at the end of 2021, one downgrade let alone several seems unlikely ($143 billion per page 7 of Aflac’s Q4 2021 earnings press release.
Aflac’s healthy operating fundamentals and top-notch balance sheet are two reasons why the stock could be a great buy for dividend growth investors at the right price.
Risks To Consider:
Even with Aflac doing well in many respects, there are still risks that shareholders need to occasionally monitor in the years ahead that are capable of breaking the investment thesis. With that in mind, I’ll be going over several notable risks facing Aflac as discussed in the 10-K filing released last year.
The first risk facing Aflac is that defaults or downgrades of investments in its portfolio could reduce the company’s earnings and capital position (page 13 of Aflac’s 10-K). Negative changes in the global economy or the health of credit markets among other factors could harm Aflac’s operating and financial results at any given time.
Another risk to Aflac is that the company is dependent on IT systems to run its business (page 21 of Aflac’s 10-K).
While Aflac is constantly investing in its IT systems to keep them running smoothly and stave off cyberattacks, there are no guarantees that the company will be able to do both of those things indefinitely.
If Aflac’s IT systems fail or experience a major breach, its operations could be interrupted for one. This could weigh on the company’s financial results in at least the short term. The greater fallout from such an event would arguably be compromised customer data, which could result in lawsuits beyond Aflac’s insurance coverage. The financial hit to Aflac and the damage to its reputation could be irreversible and have an undesirable impact on future dividend growth.
The final risk to Aflac is one that all insurers face as well, which is the potential for unanticipated risk to manifest itself and hurt the company’s operating and financial results (pages 22-23 of Aflac’s 10-K).
Significant natural disasters, deadly pandemics, and terrorist attacks each carry the risk of Aflac not adequately pricing such risk into its insurance products. This could result in claims exceeding Aflac’s premiums, which would be an unfavorable impact on the company’s operating and financial results.
While I have gone over a few key risks associated with an investment in Aflac, this wasn’t an exhaustive discussion of the stock’s risks. I would refer readers to pages 12-26 of Aflac’s most recent 10-K, as well as my prior articles on the stock for a more comprehensive discussion of its risk profile.
A World-Class Stock At A Decent Price
Aflac is a tremendous business, but investors must pay a reasonable valuation to do well in the long term. How can we tell what a reasonable price to pay is for Aflac?
Well, I’ll be using a couple of valuation models to arrive at a fair value for Aflac’s shares.
The first valuation model that I will employ to get a fair value output for shares of Aflac is the dividend discount model, which consists of three inputs.
The first input for the DDM is the expected dividend per share, which is the annualized dividend per share. Aflac’s annualized dividend per share is currently $1.60.
The second input into the DDM is the cost of capital equity, which is another way of stating the annual total return rate that an investor requires on their investments. Although this rate often varies for each investor, my personal preference is for 10% annual total returns.
The third input for the DDM is the annual dividend growth rate or DGR for the long run.
Unlike the first two inputs into the DDM that require data retrieval to find the annualized dividend per share and subjectivity to arrive at an annual total return rate, precisely guessing the long-term DGR requires an investor to consider numerous variables: 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 health of a stock’s balance sheet, and industry fundamentals.
Given that Aflac’s payout ratios are likely to expand in the years ahead and that Aflac should deliver 6-7% annual earnings growth over the next decade, I’m comfortable with a 7.25% dividend growth rate annually.
Using the above inputs for the DDM, I get a fair value output of $58.18 a share. This indicates that Aflac’s shares are trading at an 11.6% premium to fair value and pose a 10.4% downside from the current price of $64.93 a share (as of February 4, 2022).
The second valuation model that I’ll utilize to value shares of Aflac is the discounted cash flows model or DCF model, which also has three inputs.
The first input for the DCF model is the previous twelve months of earnings, which is $5.94 in adjusted diluted EPS for Aflac.
The next input into the DCF model is growth assumptions, which is crucial to accurately forecast.
For the sake of conservatism, I will factor in an adjusted diluted EPS growth rate of just 2.5% over the next five years and a subsequent drop-off to 1.25% annually thereafter.
The last input for the DCF model is the discount rate, which is the annual total return rate. I’ll again use 10% for this input.
Based on these inputs into the DCF model, I arrive at a fair value of $72.44 a share. This implies that Aflac’s shares are priced at a 10.4% discount to fair value and can provide 11.6% capital appreciation from the current share price.
Upon averaging these two fair values together, I compute a fair value of $65.31 a share. This signifies that shares of Aflac are trading at a 0.6% discount to fair value and offer a 0.6% upside over the current share price.
Summary: Market-Beating Yield And Robust Dividend Growth At A Fair Price
Aflac is a Dividend Aristocrat with nearly four consecutive decades of payout raises. But the most important takeaway from an analysis of Aflac’s dividend is that the growth looks like it will continue for many more years due to the low dividend payout ratio.
In addition, Aflac’s flat revenue and nearly 20% adjusted diluted EPS growth in 2021 was encouraging. Throw in the company’s firmly investment-grade credit ratings and you have one of the best stocks in the entire world.
And since my inputs into two valuation models show the stock to be fairly valued, investors could do much worse than buying Aflac at this time. Aflac’s 2.5% yield and upper-single-digit annual earnings growth potential are why I continue to rate the stock a buy for income investors.