I Just Bought More Shares of This Stock

October 1, 2014

Earlier this year, I explained why Procter and Gamble (PG) has appeared in all six editions of my Top 40 Dividend Growth Stocks series of eBooks. It is a classic dividend growth stock, and I started a position in it at about the same time that article was published in April.

Last week, I purchased more shares of PG not only for my public Dividend Growth Portfolio but also for my wife’s and my “Perpetual Dividend Portfolio” that is helping to fund our retirement.

Both portfolios follow essentially the same guidelines. Regarding dividend reinvestment, the guidelines for the Dividend Growth Portfolio state the following:

Reinvest dividends, but not automatically back into the company that issued them.
Rather, when the cash accumulates to $1000, select the best candidate at that time to buy.

Many dividend growth investors drip dividends, meaning that they have dividends automatically reinvested into the stock that issued them. It is automatic, easy, and allows one to build positions through dollar cost averaging.

I don’t do that.

Here’s why.

I want every investment that I make to be made at good valuations.

(See DGI Lesson 10 (Part I): Reinvest Your Dividends SELECTIVELY to Enhance Your Returns.)

Valuation, you may recall, is one of the two steps that I consider essential for evaluating a company for purchase.

Step 1 is analyzing the company’s quality.

There is no need here to rehash PG’s resume beyond what was stated in the April article. Nothing has changed PG’s status as the world’s largest household and personal-care company. The company has 25 blockbuster brands that generate more than $1B annually each. After the April article, PG raised its dividend 7% in May, marking its 58th consecutive annual dividend increase. Its 10-year dividend chart looks beautiful:

PG YWhereas a blue-chip company’s quality changes slowly, its valuation changes all the time. That’s because valuation depends on the company’s price, and price changes constantly when the market is open.

So let’s look at PG’s valuation from the point of view of the two valuation tools that I use.

As explained in “DGI Lesson 11: Valuation,” Morningstar’s analysts compute a fair value for each company based on fundamental analysis. They calculate forward estimates of the company’s earnings. Then they discount those back to the present to compute the company’s fair value, which they then compare it to the stock’s current price.

Morningstar uses a star system to convey the ratio of the actual price to their estimate of fair value. Five stars means the stock is very undervalued, 4 stars means undervalued, and 3 stars means fairly valued. If they assign 1 or 2 starts, they think the company is overvalued, or that its current price is too much to pay.

On the 5-star scale, here is what Morningstar thinks of PG’s valuation at the moment:

PG MThus Morningstar thinks that PG is undervalued right now. That is also what they thought in April when I first purchased shares. The implication is that PG is selling for less than it’s worth. That is exactly what we want – to buy stocks when they are on sale.

The second tool that I use is FASTGraphs.

GP FAt first glance, FASTGraphs tells a different story. The black line (PG’s actual price) is quite a bit above the fair value estimate (the orange line).

But notice in the orange box that the orange line has been computed at a P/E ratio (price-to-earnings ratio) of 15. That is the accepted historical P/E ratio of the whole stock market. But is it an appropriate choice for PG?

To answer that question, we can look at a historical graph to see what PG’s P/E ratio actually has been over many years. If it is not close to 15, then we have some more thinking to do.

PG F2On this graph, which goes back 15 years, we can see that PG has historically “always” been overvalued. The blue line displays PG’s average P/E ratio as being 19.9 (the number is shown in the blue box to the right of the graph.) 19.9 is a full 33% more than 15. Investors simply like PG quite a bit more than the average company.

Let’s manually plug that 19.9 ratio into FASTGraphs and see what the valuation looks like if that P/E ratio were used rather than 15.

PG 3The magenta line is drawn using the 19.9 P/E ratio, as shown by the magenta box to the right. By this reckoning, comparing PG’s actual price to the magenta line, PG is fairly valued, not overvalued.

By the way, everything I have just demonstrated with FASTGraphs is available to you from my eBook, Top 40 Dividend Growth Stocks for 2014. Through a special arrangement with FASTGraphs, I am able to provide free access throughout the year to the graphs for the Top 40 stocks, including all the options just shown.

Other Methods of Valuation
There are myriad ways of valuing a stock. Valuation is like a house appraisal: Reasonable minds can differ, and not every appraiser uses the same method to arrive at a result.

With dividend growth stocks, another data point you can look at is the stock’s historical yield compared to its yield right now. From the FASTGraphs above, you can see that PG is yielding 3.0%. Historically, its yield looks like this:

PG Y2This chart covers 10 years. You can see that PG’s yield spiked during the Great Recession, but since then it has hung in the 2.75% to 3.5% range. So its current yield (3.0%) is about its average for the past 5 years or so.

You can get similar information from the Valuation page at Morningstar.

PG M2Note on the “Dividend Yield %” line that PG’s current 3.0% yield is the same as its 5-year average yield shown in the last column.

Note also that the last line shows “Price/Fair Value” as 0.9 (or 90%). Remember earlier that I said that Morningstar’s fair value is available to Premium members. But if you do a little simple math, you can derive it from this free page. If Morningstar thinks that PG’s current price (about $84) is 90% of fair value, then it has calculated fair value at $84 / 0.9 = $93.

In other words, at $84, PG is selling for 10% less than Morningstar thinks it is worth. That’s not exactly a clearance-rack price, but then again PG doesn’t go on sale very often.

Putting It All Together
I believe that PG’s price is fair right now.

  • Morningstar sees it as undervalued.
  • FASTGraphs sees it as overvalued using a P/E ratio of 15.
  • But FASTGraphs also shows us that PG’s normal P/E ratio is 19.9, and a fair value line drawn with that P/E ratio suggests that PG is about fairly valued.
  • PG’s current yield of 3.0% is the same as its yield over the past 5 and 10 years. That seems fair.

As I said in April, don’t get me wrong, I would rather get a better price for PG than I got. But I got a fair price, which for an iconic, dependable company like Procter and Gamble is good enough.

The $1000 dividend reinvestment enabled me to purchase 12 new shares. That makes 44 shares of PG in my Dividend Growth Portfolio. When that is updated at the end of this month, the new share total will appear and the company’s new increased weight in the portfolio will be displayed. The purchase will add a few bucks to my annual dividend stream, which is the whole point of doing this.

Dave Van Knapp
Author of Top 40 Dividend Growth Stocks