Dividend Aristocrats Part 43: Automatic Data Processing (ADP)

Margin expansion of 4% per year

Can any company expand its margins at 4% a year consistently? I certainly don’t think so. Margins can only expand so much in a competitive environment. ADP’s net profit margin in 2005 was 12.4%. In 2015, it was 12.6%. A better margin expansion estimate is 1% to 2% per year.

With the above adjustments above, investors in ADP should expect total returns of 7.7% to 12.7% a year from the following sources:

– Dividend yield of 2.7%

– Share repurchases of 1.0% per year

– Revenue growth of 3% to 7% per year

– Margin expansion of 1% to 2% per year

Valuation – Is Now the Time to Buy ADP?

With a payout ratio range of 55% to 60% and a dividend yield range of 2% to 3%, this means management is estimating a fair price-to-earnings ratio of 18.3 to 30.

Based on ADP’s expected total returns, shareholder friendly management, stability, and competitive advantage, I believe a fair price-to-earnings multiple for the company is around 20.

ADP is currently trading for a price-to-earnings multiple of 26.2. This is near the higher end of management’s price-to-earnings ratio estimate, and above my estimate of fair value. For comparison, the S&P 500 is currently trading for a price-to-earnings ratio of 20.3.

For investors looking to initiate or add to a position in ADP, I would wait until the company is trading below a price-to-earnings ratio of 20. A price-to-earnings ratio below 18 would make ADP a bargain.

ADP’s Recession Performance

ADP performed very well during the recession of 2007 to 2009. The company’s revenue per share and earnings per share increased each year from 2007 to 2009.

Despite economic downturns, businesses must pay employees and keep up with government regulation.

As a result, ADP is fairly well insulated from the effects of recessions. The company’s earnings-per-share through the Great Recession are shown below:

– 2007 earnings-per-share of $1.83

– 2008 earnings-per-share of $2.20

– 2009 earnings-per-share of $2.39

– 2010 earnings-per-share of $2.39

Final Thoughts

Automatic Data Processing (NASDAQ:ADP) is a high quality blue chip stock with good future growth prospects.  The company is the dominant player in the payroll and human resources industry and offers shareholders safety due to its competitive advantages and conservative balance sheet.

The downside to the company is that it appears to be somewhat overvalued at this time. As a result, ADP does not rank particularly well using The 8 Rules of Dividend Investing.

Disclosure: None