The stock market is an interesting and funny place.
You’ve got these thousands of stocks out there available to buy. But the prices are constantly fluctuating all of the time, whenever the market is “open for business”.
How do you make sense of it all?
Well, I say you focus on value.
But value tells you what you’re actually getting in exchange for that money.
Value tells you what something is worth.
That’s why it’s far more important to focus on value rather than price.
If you determine a stock is reasonably worth $100, then you should pay that price or less. Not more.
It’s fairly concrete, which is an interesting juxtaposition against the constantly changing prices of stocks.
Why should you pay fair value or less?
Well, how about additional long-term total returns, a higher yield, and less risk?
If a stock that’s worth $100 pays a $3.00 annual dividend, that’s a 3% yield.
But if it’s priced at $120, that yield drops to 2.5%.
Conversely, priced at $80, that stock yields 3.75%.
So overpaying by $20 means you’re getting a yield that’s 125 basis points lower than if you were to score a $20 deal on that same stock.
And that makes a huge difference over the long run.
Paying less than fair value also lowers risk.
If you’re at all wrong on your $100 valuation, paying $120 gives you no margin of safety. You’ve got no wiggle room. Not only did you potentially waste $20 right off the bat (assuming the stock is worth $100), but if your calculations were off and the stock is worth less, you wasted even more money.
And that means if the market recognizes that and reprices that stock, you just risked a lot of money for no reason at all.
That’s why I’m always looking for good deals on high-quality stocks, which has helped me build the six-figure portfolio I now enjoy.
That portfolio is filled with stocks you’ll find on David Fish’s Dividend Champions, Contenders, and Challengers list.
That list contains the names of and relevant information on more than 700 US-listed stocks that have all increased their dividends for at least the last five consecutive years.
I focus on these “dividend growth stocks” because they filter out the junk. You can’t viably increase dividends for years and years on end without the increasing profit to support those higher payouts. Growing dividends are the “proof in the pudding”.
Now, what if you’re unsure where to start when it comes to valuing stocks? What if you’re prone to let pricing dictate what you pay?
Well, I’d check out Dave Van Knapp’s guide to valuing dividend growth stocks, which is a great start for anyone who’s unfamiliar with stock valuation.
In the name of finding high-quality stocks that are also currently undervalued, I recently stumbled upon one that seems to exude quality while simultaneously appears significantly undervalued.
Could be an incredible opportunity here…
National Oilwell Varco, Inc. (NOV) designs, manufactures, and provides equipment and components used in oil and gas drilling for the upstream oil and gas industry. They also provide oilfield services to the upstream O&G industry.
Perhaps not a household name, but I really think this stock should be on your radar.
They have a history dating back to the late 1800s, so they’ve been through a number of boom and busts over their years.
And the recent “bust” has had an outsized effect on NOV’s stock price – it’s down over 46% over the last 52 weeks.
But you know what’s not down?
National Oilwell Varco’s dividend.
They’ve increased their dividend for the past six consecutive years. Not the lengthiest track record around, but that’s mostly because they weren’t a dividend payer at all until 2010.
But what they lack in length, they make up for in terms of the growth rate: The five-year dividend growth rate stands at 78.2%.
Now, I don’t expect that high of a rate to continue indefinitely, or even at all moving forward.
But you can see the potential here, and you can also see that management is committed to rewarding shareholders with a growing dividend.
The payout ratio, as a result of that high growth rate, has obviously expanded some. But it’s still a rather low 35.5%, which affords the firm some flexibility when earnings start to slow dramatically as a result of lower oil prices and reduced demand for a number of their products and services.
However, what’s really crazy is the fact that the low payout ratio and high growth rate also comes attached to a yield of 4.10%.
It’s not very often at all you’ll find a stock yielding over 4% with a dividend growth rate that high along with a moderate payout ratio. It’s almost unheard of.
But let’s take a look at the underlying growth of the firm, which will give us some idea as to how sustainable the dividend and dividend growth might be. It’ll also provide us with the information necessary to value the business.
We’ll see what they’ve managed over the last decade, which smooths out cycles.
Revenue was $4.645 billion in fiscal year 2005. That grew to $21.440 billion in FY 2014. That’s a compound annual growth rate of 18.52%.
Rather significant top-line growth here, but keep in mind that NOV has been a serial acquirer over this time frame. That growth will likely slow quite a bit both as attractive acquisitions become fewer in number and the full weight of the weakness in the O&G industry takes its toll on the company.
Meanwhile, earnings per share increased from $0.91 to $5.82 over the last 10 years, which is a CAGR of 22.90%.
Eye-popping numbers here, but there are clouds on the horizon. That massive slide in the stock price didn’t occur out of thin air: S&P Capital IQ predicts -12% compound annual growth in EPS over the next three years due to the soft market for offshore drilling and reduced demand for components.
However, the company’s backlog of approximately $12 billion will cushion some of that softness and buoy results for most of 2015.
One other high-quality aspect of the company that provides a cushion is the balance sheet. They have a long-term debt/equity ratio of 0.15 and an interest coverage ratio over 34. That means earnings before interest and taxes cover interest expenses more than 34 times over.
So they can actually afford to expand the balance sheet a bit without running into trouble. That also means they can take on an attractive acquisition at cheap prices, if an opportunity were to present itself.
Profitability is robust. Over the last five years, NOV has averaged net margin of 12.28% and return on equity of 11.40%. These numbers compare well to the industry and most peers.
The fundamentals here about as good as you’ll find. Growth over the last 10 years (which includes a major drop in oil prices in 2009) has been nothing short of astounding.
However, orders have dried up and NOV is largely drawing off of its backlog now. While that should allow for a smoothing effect over the next year, orders will have to pick up later this year or in 2016 to keep earnings from falling out.
But, as a shareholder, I take comfort in knowing that NOV has “been there, done that”. They’ve been through these boom-and-bust cycles for over a century. I see no reason why this time is any different. Meanwhile, the $3 billion buyback program announced by the company in September 2014 couldn’t have been more timely; the company is buying back shares at very compelling long-term prices.
In fact, I think the valuation is so compelling that I recently bought more shares myself.
Shares are trading hands right now for a price-to-earnings ratio of 8.67. That’s less than half that of the broader market. Notably, it’s also trading below its book value. That’s happened very rarely over the last decade. Even if EPS drops by 50%, the valuation wouldn’t be much higher than five-year average, and that’s probably looking at a trough.
Seems like a pretty solid opportunity. How solid? What’s the stock worth?
I valued shares using a dividend discount model analysis with a 10% discount rate and a 7% long-term dividend growth rate. That growth rate factors in underlying per-share profit growth that’s about three times that high over the last decade, as well as a moderate payout ratio. It’s difficult to forecast where things are going with the prevailing weakness right now, but I think NOV is a long-term winner. The DDM analysis gives me a fair value of $65.63.
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.
My perspective concludes that it’s reasonable to assume that NOV is very cheap here. But what do some of the professional analysts that follow and value this stock think?
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 NOV as a 5-star stock, with a fair value estimate of $66.00.
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 NOV as a 3-star “hold”, with a 12-month target price of $58.00.
Well, I’m definitely not alone here. No matter how you slice it, NOV appears to be an incredible deal. Averaging out these three numbers so as to come to one final conclusive fair value gives us $63.21. That means that this stock is potentially 42% undervalued right now.
Bottom line: National Oilwell Varco Inc. (NOV) is a high-quality company with an incredible track record over many boom and busts, but is definitely facing a softening market for its products and demands right now. Nonetheless, the market is pricing this stock as if its growth is permanently and significantly hampered.
That appears unlikely, meaning you’re getting a stock that is historically cheap with a 4% yield and the potential for 42% upside. I’d strongly consider this stock if you’re a long-term investor and can stomach the volatility.
– Jason Fieber, Dividend Mantra
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