We’re all after cheap stocks, right?
After all, who doesn’t want to buy $1.00 for $0.80?
Buying an undervalued stock can do just that for you. If you’re able to reasonably estimate a stock’s value at $100 and it’s priced at $80, you can effectively pay 80 cents on the dollar.
Price and value are very different.
Everything in this world that’s for sale has a price tag of some sort attached to it.
But price just tells you what that item is being sold for.
Value, on the other hand, tells you what that particular item is worth.
Being able to tell the difference is an important skill to develop if you’re interested in buying individual stocks.
If that’s a skill you lack, you may want to check out this informational piece put together by David Van Knapp.
The reason you’d want to buy a buck for eighty cents should be clear.
Not only are you buying an asset for less than it’s worth, meaning you stand to profit, but stocks that pay dividends will have a higher yield attached to them at a lower price.
So a $100 stock paying a $3.00 annual dividend has a yield of 3%. But if you can buy that stock at $80, you’d be receiving a yield of 3.75%. You just received a yield 75 basis points higher simply for paying less than you should have. That’s more income which can compound for as long as you own the stock. Pretty nice, right?
This is exactly why I’m always on the lookout for undervalued stocks to add to my personal portfolio.
Any my favorite place to look for potentially undervalued high-quality stocks is David Fish’s Dividend Champions, Contenders, and Challengers list, which is a document that tracks more than 600 US-listed stocks with at least five consecutive years of dividend increases.
I was recently perusing the CCC list for a potential stock that’s both high in quality and undervalued. I not only came across one, but I’m going to share it with you readers today!
Caterpillar Inc. (CAT) manufactures construction and mining equipment, diesel and natural gas engines, industrial gas turbines, and diesel-electric locomotives.
Caterpillar is truly a global company, currently the world’s largest manufacturer of earthmoving equipment. They’re incredibly well-known, as their bright yellow machines can be easily spotted at major construction projects across the world. But these qualities don’t mean that we should just pay any price for the stock.
So let’s take a look at their track record as far as rewarding shareholders with increasing dividend payouts. That tells us a lot about a company. It’s great to hear about how profits are increasing, but it’s much nicer to see it with cash in hand!
The company has increased its dividend for the past 21 consecutive years. More than two decades of pay raises to shareholders speaks for itself.
Over the last decade alone, they’ve grown the dividend at an annual rate of 12.8%. When’s the last time you received a 12.8% raise at work? How about that kind of pay raise for a decade straight?
The stock currently yields a pretty attractive 3.24% right now.
And the dividend is well-covered with a moderate payout ratio of just 45.3%.
We have a yield well above the broader market’s average, with a dividend that is easily affordable for the company and growing. Not much to really dislike here.
We’ll next see what kind of growth the company has managed over the last decade, which will help us determine what shares are worth.
So how much money does a global manufacturer of construction and mining equipment make? Let’s find out!
Revenue grew from $30.251 billion in fiscal year 2004 to $55.656 billion in FY 2013. That’s a compound annual growth rate of 7.01% over the last 10 fiscal years, which is pretty solid.
Meanwhile, earnings per share increased from $2.88 to $5.75 during this period, which is a CAGR of 7.99%. Again, very solid growth here. Combine 8% earnings growth with a yield above 3% and you can see where solid long-term total returns will likely materialize.
S&P Capital IQ is calling for EPS to compound at a 7% annual rate over the next three years, which is par the course for CAT.
Caterpillar operates a capital-intensive business, but they actually sport a fairly conservative balance sheet. The long-term debt/equity ratio is just 0.38, while the interest coverage ratio is 13.59. Pretty attractive numbers, in my view, for a business like this.
Profitability is robust and compares well with peers. Net margin has averaged 6.55% over the last five years, and has actually been improving as of late. Return on equity averaged 27.68% over that time frame.
There’s a lot of good stuff here. You’ve got a worldwide brand, solid growth, robust profitability, and a great track record of increasing dividends. When you find stocks that are fairly high in quality like this, you’ll also oftentimes find that they’re expensive. And that’s because everyone wants to own it.
Is that the case right now?
The stock is on the market for a P/E ratio of 13.99 right now. That compares well to both the broader market as well as CAT’s own five-year average of 15.2. So we might have a deal on our hands.
But what is each share worth? What should we pay?
I valued shares using a dividend discount model analysis with a 10% discount rate and a 7% long-term growth rate. That rate is below CAT’s growth in both EPS and its dividend over the last decade. Factor in a moderate payout ratio that should allow the dividend to grow at least in line with earnings per share and I think this model is reasonable. The DDM analysis gives me a fair value of $99.87 on shares.
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.
It would seem that CAT is on the market for a pretty sizable discount, but perhaps you want a second opinion. I’ll do you one better and give you a second and a third opinion.
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 CAT as a 3-star stock, with a fair value estimate of $98.00.
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 CAT as a 4-star “buy”, with a fair value calculation of $109.30.
It looks like I was right in line there with my analysis. This stock does appear to be potentially substantially undervalued, no matter how you slice it. If we average out the three numbers to come to some kind of consensus, we get a fair value of $102.39. That means shares in CAT could be as much as 16% undervalued right now.
Bottom line: Caterpillar Inc. (CAT) is the world’s largest manufacturer of earthmoving equipment, and as long as construction is necessary across the world, the products that CAT builds will likely be necessary. The company sports solid fundamentals across the board, with great growth, even though it’s a cyclical business.
21 consecutive years of dividend increases is an impressive track record and the company appears poised to continue handing out dividend raises for the foreseeable future. The stock appears attractively valued here with a sizable margin of safety. If you’re constructing your portfolio with high-quality dividend growth stocks in mind, CAT should be considered here.
— Jason Fieber, Dividend Mantra