Undervalued Dividend Growth Stock of the Week: CVS Health Corp. (CVS)

As investors, we’re faced with a multitude of opportunities at any given moment.

There are literally thousands of publicly traded stocks available – and that’s just one asset class.

How does one go about filtering all of these options down to the best choices?

Well, I propose one may want to focus on high-quality dividend growth stocks like those you’ll find on David Fish’s Dividend Champions, Contenders, and Challengers list.

Mr. Fish’s list is an invaluable compilation of all US-listed stocks that have increased their dividends for at least the last five consecutive years. Many of them have paid and increased dividends for decades.

Why would an investor want to focus on these stocks?

Easy.

A long-term track record of dividend growth is one of the best “litmus tests” out there for quality.

Moreover, growing dividend income is one of the most passive forms of income available to an investor.

Think about it for a second. Dividends are paid in cash from cash.

If a business isn’t generating the growing cash flow necessary to cash those growing dividend checks, dividends don’t get paid.

Now just imagine what kind of business you have to be running to pay increasing dividends to investors for years – or decades – on end.

Try to run an unprofitable and low-quality business for a lengthy period of time while simultaneously paying out increasing dividends to shareholders and you’ll run into major problems.

In addition, the growing dividend income itself is mighty attractive when you realize that this is completely passive income. And it’s not just income but growing income, likely growing at a rate in excess of inflation, meaning one’s purchasing power is increasing over time.

These are just a couple reasons why I personally invest my hard-earned cash into high-quality dividend growth stocks.

In fact, I’m so confident in this strategy that I’m literally betting my freedom on it – I’m counting on my portfolio to be able to generate enough growing dividend income for me to live off of by 40 years old, rendering me financially independent decades before most people.

But while Mr. Fish’s list filters the thousands of publicly traded stocks into a few hundred or so high-quality stocks that pay growing income, there’s more to it than that.

Just like you’d walk into a market and expect to find merchandise that ranges from cheap to expensive, the stock market is similar. And Mr. Fish’s list being a microcosm of the entire stock market, there are dividend growth stocks that range from cheap to expensive at any given time.

The good news is that we have a guiding star when it comes to knowing which stocks are cheap and which are expensive.

That guiding star is the ability to reasonably value stocks.

It sounds harder than it really is. In fact, there are a number of methodologies that exist that are designed to help an investor ascertain an acceptable estimate of a stock’s intrinsic value.

For instance, one such methodology exists right here on the site for you readers – and it’s designed specifically for the high-quality dividend growth stocks that we’re talking about. Put together by fellow contributor Dave Van Knapp, it’s definitely worthy of your attention.

Once you know what a stock is likely worth, you know what you should pay.

After all, price and value are not one and the same.

Price is how much you’re paying; value is what something is actually worth.

And what should you pay?

As far below fair value as possible.

The reason you want to pay less should be obvious. Every dollar less you spend on a stock is one more dollar in your pocket.

But it goes much further than that.

When you pay less for a dividend growth stock, you lock in more income, more income growth, more potential long-term total return, and less risk.

Awesome, right?

All else equal, a lower price equals a higher yield. A dividend is a fixed payment that isn’t affected by a stock’s fluctuating price. So unless a dividend is somehow altered or cut, a lower price means the yield will be higher. Thus, paying less means you lock in more income now.

I’ll show you how that works.

If a stock is worth $50 and pays a $1.00 dividend per year, that’s a 2% yield at $50. Investing $1,000 will snag you 20 shares good for $20 in annual dividend income (until the company increases its dividend).

But let’s say you’re patient and avoid the stock at $50, knowing that there’s no margin of safety. The stock falls to $40, at which point you see the stock is roughly 25% undervalued and buy it.

That same $1,000 you were going to invest now buys 25 shares. That’s five extra shares just for waiting until the stock was undervalued and priced lower. Furthermore, you now lock in a yield of 2.5% (that’s 50 basis points higher) and $25 in annual dividend income.

On top of all that, your dividend income will likely grow much faster through the power of exponential growth off of a higher base.

If that stock grows its dividend by 7% per year over the next decade, your aggregate income will be much higher when starting with 25 shares at a higher yield versus 20 shares at a lower yield.

As such, your potential long-term total return is much higher as well. Yield is, of course, one component to total return, and you locked in a yield of 50 basis points higher when buying the undervalued stock.

Moreover, the other component – capital gain – is more likely to accelerate when you bought at $40 versus $50. Not only do you have the company’s earnings power driving the stock higher over the long run but you also have the gap that could be closed between $40 and $50 as the market realizes the mispricing that took place.

All of that and you risked less money on a per-share basis. By focusing on undervalued dividend growth stocks, you gain numerous financial benefits when attempting to introduce a margin of safety.

This is why I’m always hunting for undervalued dividend growth stocks that are high quality – stocks on Mr. Fish’s list that appear to be priced less than they’re worth.

Well, I see a prominent dividend growth stock that looks undervalued right now…

CVS Health Corp. (CVS) is a pharmacy healthcare provider that operates one of the largest pharmacy retail chains in the US. It’s also one of the largest pharmacy benefit managers in the country with over 70 million PBM plan members.

The appeal of investing in one of the world’s largest pharmacies should be intuitive.

The business model has been around for centuries, and there doesn’t appear to be any reason why pharmacies won’t be around for centuries more. People can become sick at any time, but old age exacerbates this. Our demographics here in the US basically ensures increasing demand for pharmacy benefit managers like CVS.

st cvsFortunately, CVS shares the wealth with shareholders.

They’ve increased their dividend for 13 consecutive years now.

Not the lengthiest track record around. But the company makes up for much of that with the rate at which they’ve increased their dividend.

Over the last decade, the dividend has been increased at an annual rate of 25.4%.

While astounding, it’s even more amazing when one considers that the dividend growth isn’t materially slowing down. The most recent dividend increase, announced just over a month ago, was 21.4%.

With a payout ratio of 38.2%, there’s still a lot of room left to increase the dividend at a rather aggressive rate for the foreseeable future, even absent significant profit growth.

That means the company is retaining more than 60 cents of every dollar it takes in, sending the other 38 cents or so back to shareholders via that dividend. So that’s a really nice mix that even allows for a few bumps in the road.

The only real drawback here in terms of the dividend is the yield.

With a yield of just 1.79% here, there is something to be desired for investors looking for current income.

Of course, that massive dividend growth more than makes up for that, in my opinion. Moreover, that yield is about 50 basis points higher (notice a parallel to the example earlier?) than the five-year average yield of 1.3% for this stock

This stock is a dividend growth monster. It’s the perfect stock to offset and complement higher-yield stocks that might offer more current income at the expense of dividend growth. With inflation in the low single digits, CVS is poised to offer outstanding total return and plenty of increasing purchasing power over time.

With a fairly low payout ratio even in the face of such a high dividend growth rate, one might expect underlying profit growth and fundamentals to be outstanding.

Well, you would be right.

I like to look at the prior decade’s performance for any company, which tends to give a longer-term picture of the business, smoothing out short-term headwinds and economic cycles.

Both the top line and bottom line should be considered, though it’s really the bottom-line growth that drives dividend growth and so much more.

From fiscal years 2005 to 2014, revenue increased from $37.006 billion to $139.367 billion. That’s a mighty impressive compound annual growth rate of 15.87%.

I rarely come across such incredible top-line growth when it comes to large and somewhat mature companies. What happened here is that CVS almost serially acquires smaller, bolt-on companies, leading to that growth we see above. On the flip side, CVS routinely issues shares to pay for some of these acquisitions.

Earnings per share growth is an even better gauge of true growth since it takes that additional equity into consideration.

The company grew its EPS from $1.45 to $3.96 over this period, which is a CAGR of 11.86%.

So that’s slightly less impressive but still very, very solid.

Nonetheless, EPS growth hasn’t kept up with dividend growth over the last decade, which means future dividend growth will likely be a bit less than what we’ve seen in the past. As mentioned, the low payout ratio affords CVS some wiggle room here, but I wouldn’t expect 20%+ annual dividend increases indefinitely.

For perspective, S&P Capital IQ anticipates that CVS will be able to compound its EPS at an annual rate of 14% over the next three years. Recent acquisitions, including the purchase of Target Corporation’s (TGT) pharmacies, should be notably accretive. This near-term forecast, if it comes to pass, would mean CVS’s business is accelerating from what’s an already impressive rate of growth.

The rest of this business is also really high quality.

Their balance sheet is a good example of this.

Sitting on a long-term debt/equity ratio of 0.31 and an interest coverage ratio over 13, the company is in excellent financial health.

What’s really great about the balance sheet is that it’s not only solid in absolute and relative terms but it’s also really flexible even in light of all the acquisitions that CVS has taken on over the last decade. So we see that some of that equity has been used appropriately, leading to plenty of EPS growth and a very healthy balance sheet when all is said and done.

Profitability is also robust and relatively competitive.

Over the last five years, CVS has averaged net margin of 3.39% and return on equity of 10.63%.

The margins are low but compare well to the industry. One has to consider the retail exposure here.

All in all, this is a very appealing business model. Competition is somewhat limited, with just a few major players out there. With more than a billion adjusted claims processed last fiscal year, CVS has economies of scale that few can match.

The demographics play into CVS’s favor. With an aging population here in the US, that tilts toward the likelihood of increased demand for pharmaceuticals. In addition, recent changes in US healthcare policy means more people are covered than before, leading to a larger pool of potential customers.

Their acquisitions have helped fuel really impressive growth, and their penchant for increasing the dividend does not appear to be deterred at all.

With all of this in mind, one might expect to pay a premium for shares. Interestingly, I’d argue that no premium at all exists. In fact, we might have a good deal on our hands...

The P/E ratio of 21.31 on this stock might appear to be a bit expensive. That’s roughly in line with the broader market, and certainly not cheap in absolute terms. However, paying slightly more than 20 times earnings for a company growing well into the double digits strikes me as fairly intelligent. In addition, the yield is somewhat significantly higher than usual right now.

What’s the likely intrinsic value on the stock then?

I valued shares using a two-stage dividend discount model analysis due to the low yield. My discount rate is 10%. I then assumed a dividend growth rate of 15% for the first ten years and a terminal growth rate of 7%. I think these assumptions are actually rather conservative when looking at the payout ratio and forecast for near-term EPS growth. The DDM analysis gives me a fair value of $116.46.

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.

I believe this stock is actually worth a premium, yet doesn’t really trade for one. Quite the opposite, actually. This stock appears to be solidly undervalued right now, leading to potentially all of the benefits outlined earlier. But am I alone in this 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 CVS as a 3-star stock, with a fair value estimate of $104.00.

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 CVS as a 5-star “strong buy”, with a fair value calculation of $116.50.

Boy, I came up with a valuation almost exactly the same as the latter firm, right down to the penny. But I like to actually average out these three valuation perspectives so as to come up with a firm, final number. This blends all of these opinions together, leading to, hopefully, a more accurate overall picture. That averaged fair value is $112.32, which would indicate this stock is potentially 18% undervalued.

cvsBottom line: CVS Health Corp. (CVS) is a high-quality pharmacy and benefits manager, and one of the largest in the world. Numerous long-term tailwinds bode well for the firm and its shareholders, and massive dividend growth is unlikely to let up much over the foreseeable future. With a yield significantly higher than the recent historical average and the possibility for 18% upside, I see this stock as a very strong long-term investment at the current price.

— Jason Fieber

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