Undervalued Dividend Growth Stock of the Week: Praxair (PX)

yield-1-stockphotoWe keep hearing how the stock market is expensive. Overpriced. Ready for a major correction.

I don’t necessarily believe that, although the occasional 10% or so correction is healthy for the market.

But even if that were true, the stock market is simply a collection of thousands of stocks.

The market itself may be a bit elevated in comparison to historical norms, but that doesn’t mean every single stock within the market is as well.

And that’s because the stock market is just that – a market.

And within that market you have merchandise that’s cheap and you have merchandise that’s expensive.

I always try to focus on the cheap merchandise – stocks that are priced below their intrinsic value.

More importantly, I do my best to avoid stocks that are priced above their intrinsic value.

How do we know what the intrinsic value is?

Well, you have to become familiar with valuing stocks, and it just so happens that David Van Knapp put together a nice tutorial on exactly what valuation is and how one goes about valuing a stock.

It’s just like anything else in life. For instance, I’ve been seeing commercials and advertisements everywhere for massive sales on Black Friday and this holiday weekend – electronics and other home goods are being severely discounted from what they’re normally sold at.

It might be tough to intrinsically value a television set, but a 50″ TV being sold for $199 when it’s normally at least $500 every other day at every other store indicates to me that there’s some value there.

Likewise, I look for similar deals on dividend growth stocks – stocks featured on David Fish’s Dividend Champions, Contenders, and Challengers list. That’s a document that lists and tracks more than 500 US-listed stocks that have increased their respective dividends to shareholders for at least the last five consecutive years.

I look for cheap stocks because it allows a margin of safety in case something goes awry. In addition, a cheaper dividend growth stock means the yield is higher, which gives compounding a boost right from the beginning.

I may just have found a deal on one of these stocks. Might not be a Black Friday special, but a high-quality stock being sold for less than what it’s worth in a market that’s supposedly too expensive is probably a good deal in and of itself.

I’m not a shareholder of this particular company, and am actually invested in one of its biggest competitors. But that doesn’t mean I’m not interested in value and sharing that value with you readers.

Praxair, Inc. (PX) produces, distributes, and sells a variety of industrial gasses. Its products include oxygen, nitrogen, argon, hydrogen, carbon dioxide, helium, and specialty gasses.

You might not know of Praxair or what it does, but there’s no doubt there’s some quality here. Their dividend growth streak is a testament of that quality, as I’ll show you.

They’ve increased their quarterly dividend for the past 21 consecutive years, putting it in the company of a number of other blue-chip companies.

And the raises themselves have been rather generous; the company has increased the dividend by an annual rate of 9.9% over the last five years. If you’re looking to increase your income faster than the rate of inflation, you’ve come to the right place.

The stock only yields 2% here, which certainly leaves a bit to be desired. However, a payout ratio of just 41.3% leaves plenty of room for future generous dividend increases.

CaptureThe dividend metrics are obviously pretty impressive.

Yield’s a bit low, but the odds of PX increasing its dividend at an attractive rate for the foreseeable future are incredibly high.

We know it’s high in quality, but we want to buy it on sale. So let’s figure out how much a share of PX might be worth. And in order to have a reasonable idea of that, we need to know how fast the company is growing. So let’s take a look at the top line and bottom line growth over the last 10 years so that we might be able to extrapolate that out into the future.

Revenue grew from $6.594 billion in fiscal year 2004 to $11.925 billion at the end of FY 2013. That’s a compound annual growth rate of 6.80%.

The growth in profit has been even stronger. Earnings per share increased from $2.10 to $5.87 during this period, with is a CAGR of 12.10%. That’s rather impressive, in my view. Furthermore, it supports that generous dividend growth rate. Combining a modest payout ratio with substantial growth in profit means the dividend has plenty of room to expand.

S&P Capital IQ anticipates EPS will grow at a 10% compound annual rate for the next three years, which is roughly in line with their historical average.

The company’s balance sheet is leveraged, but not in a worrisome manner. The long-term debt/equity ratio is 1.21 as of the end of last fiscal year, while the interest coverage ratio is 15.92.

Profitability is very solid, and as good or better than peers. Net margin has averaged 14.18% over the last five years, while return on equity has averaged 27.06% over that time frame. These are very attractive numbers here.

I don’t think there’s really anything to not like here. Great growth, lengthy dividend growth streak, excellent profitability, and not overly leveraged.

Of course, high-quality stocks usually come with a big price tag. Is that the case here?

Shares in PX trade hands for a price-to-earnings ratio of 20.66. That’s a bit above the broader market, but it’s below PX’s five-year average P/E ratio of 21.2.

Judging by the P/E ratio, shares might be just a bit cheaper than normal right now. But let’s take it a step further.

I valued shares using a dividend discount model with a 10% discount and an 8% long-term growth rate. That growth rate appears fair considering the rate at which the business has grown over the last decade and what’s expected of them moving forward. In addition, the payout ratio is low enough to warrant substantial dividend growth for the foreseeable future. The DDM analysis gives me a fair value of $140.40 here.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide. The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth. It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

But don’t just take my word for it. Let’s see what some of the other opinions are regarding PX’s fair value to see if we can ascertain a reasonable idea of what we should pay for shares here.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system. 1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value. These stars are meant to coincide with predicted returns, as a stock that is substantially overvalued will likely lead to subpar returns.

Morningstar rates PX as a 3-star stock, with a fair value estimate of $134.00.

S&P Capital is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line. They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

S&P Capital IQ rates PX as a 4-star “buy”, with a fair value calculation of $135.60.

So I’m not terribly far off here. If you average all three of these numbers out, you’re looking at a valuation of $136.66 on shares. Since shares are currently trading for a price of $129.88, you’re getting a 5% discount off of shares in a very high-quality company. Maybe not a Black Friday special, but considering how expensive the stock market supposedly is, that’s not bad.

sc (1)Bottom line: Praxair, Inc. (PX) is a really high-quality company. Excellent fundamentals across the board, but this is one of those rare cases where you can buy into a high-quality firm for less than the fair price. Shares only yield 2% here; however, I suspect the dividend raises over the next 5-10 years will continue to be rather generous. This is a top-notch, global firm and getting a 5% discount in this market is an opportunity not to be taken lightly.

— Jason Fieber, Dividend Mantra

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