Undervalued Dividend Growth Stock of the Week: Monsanto (MON)

December 28, 2014
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yield-stockphotoThere are some that believe the stock market – and all stocks within the market – is fairly valued at all times.

That would infer that every stock is priced exactly as it should be, every day. If this were true, then price and value would be one and the same at all times.

However, many investors, including Warren Buffett, believe that stocks are often mispriced – meaning a stock’s price and its intrinsic value are rarely aligned perfectly.

And this makes sense. After all, you have billions of investors and traders out there competing against one another for stocks, alongside computers armed with complicated algorithms.

Mix all of that into one pot and how can stocks possibly be fairly priced at all times?

It’s just like any other market or store out there.

You often see sales run at your local department store.

So on Saturday, a designer shirt may be $100. But if the store decides to run a sale on Monday to get some traffic into the store during the week and reprices that shirt to $80, does that mean the value of the shirt changed?

No.

The price changed, but the shirt is still the same shirt. But whereas most consumers are happy to purchase a shirt on sale like that, it’s quite the opposite in the stock market – people hate to see the price of stocks go down, even though anyone accumulating stocks should be cheering when this happens.

Just like the stock market, the store in this example is pricing merchandise at a level that it thinks can be had. If you think you can get $100 for something, you’re going to price it at $100. But if nobody is biting, then perhaps the price needs to be changed.

However, there’s no magic formula that all stocks abide by to make sure they’re priced exactly in line with their respective intrinsic value. And that provides a huge opportunity to those out there willing to take the time to analyze and properly value stocks. In pursuit of this, a valuation tool is provided to you courtesy of David Van Knapp, which you will probably find helpful.

I often use David Fish’s Dividend Champions, Contenders, and Challengers document as a sort of “shopping list”, where I look for great stocks to add to my portfolio.

The reason I stick to Mr. Fish’s document is because he’s already done all the hard work for me, condensing the thousands of US-listed stocks into a manageable list of just under 600 stocks, all of which have increased their dividends for at least the last five consecutive years. That’s a fantastic resource for any dividend growth investors out there.

There’s one stock on this list that appears to be a glaring opportunity, where the current price appears to be below its inherent value.

And I’m going to share that name with you today!

Monsanto Company (MON) provides agricultural products such as seeds, biotechnology trait products, and herbicides to farmers.

Monsanto may not be a household name, but this is a company with a market cap near $60 billion.

Also perhaps not as widely known is their generous dividend policy.

MON has increased the dividend payout to shareholders for over a decade now - 14 consecutive years and counting.

And I think you’ll agree that the word generous is apt when you consider that the dividend has increased at an annual rate of 20.1% over the last decade.

The stock only yields 1.62% here, which is perhaps a bit low for some investors.

But factor in that growth, as well as a payout ratio of just 38.2%, and the lower yield is somewhat justified.

So while Monsanto may not be as well-known as some other more popular dividend growth stocks, the healthy and growing dividend indicates that it should.

CaptureBut a dividend can only grow if the underlying company is growing, right?

After all, stocks are simply pieces of ownership in real companies.

And the dividend is funded from a company’s cash flow. So let’s take a look at the business and its growth over the last decade.

Revenue was $6.294 billion in fiscal year 2005. The top line increased to $15.855 billion in FY 2014. That’s a compound annual growth rate of 10.81%. Impressive.

Earnings per share grew from $0.47 to $5.22 during this time frame. That’s a mind-boggling 30.67% CAGR. That huge growth in profit explains the growth in the dividend over the last decade.

S&P Capital IQ anticipates EPS will compound at a 15% rate over the next three years, which certainly seems achievable based on MON’s track record.

The company maintains a pretty solid balance sheet. The long-term debt/equity ratio is 0.96, while the interest coverage ratio is 16.43.

Other fundamentals, like profitability metrics, are also sound. Net margin averaged 14.6% over the last five years, while return on equity has averaged 18.03% over that time frame.

We’ve got a potential winner here. The company has been able to grow at an astounding rate over the last decade, and is expected to keep up a rather aggressive rate for the foreseeable future. Meanwhile, the dividend is well-covered and growing at a substantial rate alongside earnings. And the company’s position in the global agriculture market means it should continue to do well, as demand for food rises in kind with a growing worldwide population which places a burden on increasing crop yields.

But a great stock isn’t worth paying any price for. Pay too much for even the best stock and you could realize subpar returns as the the price comes back into line with its intrinsic value. However, buying a high-quality stock below its intrinsic value means you not only have the company’s growth to propel returns, but you also have a chance to realize additional returns when the market realizes the price should rise to match the value.

So is MON a good deal here?

Well, the stock trades hands for a P/E ratio of 23.6. That my seem expensive at first glance, but it actually compares favorably to MON’s five-year average of 26.6.

So that tells us that shares usually trade for a higher premium, but what is the stock actually worth?

I valued shares using a two-stage dividend discount model analysis with a 10% discount rate and a 15% growth rate for years 1-10 along with a 7% terminal growth rate. That appears fair due to growth predicted for the firm as well as the low payout ratio. The DDM analysis gives me a fair value of $134.27.

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.

So it appears that my analysis concludes that MON is undervalued here. But I’m certainly not the only opinion in the world. Let’s find out what some professional analysts think of Monsanto and its stock 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.

Morningstar rates MON as a 3-star stock, with a fair value estimate of $130.00.

S&P Capital IQ 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 MON as a 4-star “buy”, with a fair value calculation of $135.40.

The three valuations are actually in a pretty tight range here. We’ll average them out to give us one final, firm number to work off of. The average of all three is $133.22, indicating that shares in MON are potentially 10% undervalued right now.

scBottom line: Monsanto Company (MON) has grown tremendously over the last 10 years, and there appears to be nothing on the horizon to slow them down. The company has raised the dividend generously for well over a decade, while a low payout ratio combined with a fast-growing bottom line likely means shareholders will continue to reap these rewards for a long time to come. If you’re looking for a high-quality stock that is potentially undervalued in an overheated market, consider MON here.

– Jason Fieber, Dividend Mantra

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