This A-Rated Dividend Growth Stock is 20% Undervalued

This is the second in a series of articles on the valuations of selected dividend growth stocks. In the first article, we concluded that Realty Income (O) was not well valued. In fact, it looked 22% overvalued as of a couple of weeks ago.

This time we look at another REIT (real estate investment trust), Ventas (VTR).

[ad#Google Adsense 336×280-IA]Ventas owns a portfolio of seniors’ housing and healthcare operations in the United States, Canada and the UK.

For this series, I will be looking at stocks that are A-rated and B-rated for dividend safety.

The safety ratings are from Wealthy Retirement’s Safety Net Pro service.

I explained their system in this article.

Ventas gets an A from Safety Net Pro for dividend safety.

That means that under their analysis, its dividend is extremely safe and unlikely to be cut.

CaptureMy 4-step valuation process is described in Dividend Growth Investing Lesson 11: Valuation. Let’s see how Ventas stacks up in terms of valuation. Its current price is about $55.

The question to answer: Is that a good price for this stock?

Step 1: FASTGraphs Default. The first step is to compare the stock’s current price to FASTGraphs’ default estimate of its fair value.

Because Ventas is a REIT, the best measure of its profits is funds from operations (FFO). The default estimate of fair value is based on a price-to-FFO ratio of 15, shown by the orange line on the following graph.

CaptureFrom the graph, we can see that VTR is trading below its fair value under this method of appraisal.

In fact the stock is trading at a 17% discount to fair value when measured this way. That implies a fair value of about $66 for Ventas.

Step 2: FASTGraphs Normalized. The second valuation step is to compare VTR’s price to its long-term average P/FFO ratio. Some stocks are “perpetually” overvalued or undervalued by the market. This second step adjusts for that.

I used VTR’s 10-year P/FFO average, since this takes the 2007-08 real estate meltdown into account. VTR’s average P/FFO ratio during that time has been 16.2, shown by the blue line on the following graph.

CaptureAt a current P/FFO ratio of 12.4, this method also suggests that Ventas is undervalued. The fair price suggested by this method would be the stock’s current price multiplied by (16.2 / 12.4), or about $71. The company’s actual current price is about 23% below that.

Step 3: Morningstar Star Rating.
Morningstar uses a comprehensive net present value (NPV) technique for valuation. Many investors consider this approach to be superior to using P/E or P/FFO ratios as we just did with FASTGraphs.

In its NPV approach, Morningstar makes a projection of all the company’s future profits. The sum of all those profits is discounted back to the present to reflect the time value of money. The resulting net present value of all future earnings is considered to be the fair price for the stock today.

CaptureMorningstar believes that Ventas is way undervalued. It has computed a fair value of $83, which is about 51% higher than the actual current price.

The 5-star rating is the highest that Morningstar gives under its rating scale.

Step 4: Current Yield vs. Historical Yield.
Finally, we compare the stock’s current yield to its historical yield. It is better to be near the top of that range than the bottom.

CaptureThe chart shows us that, except for the spike in 2009 (during the Great Recession), VTR’s dividend yield has spent most of the time over the past 10 years in the 4.5% – 6.5% range.

It is in that range now, so I would rate Ventas as fairly valued by this method.

Valuation Summary:
Using the 4 approaches just described, our valuation summary for VTR looks like this:

CaptureMy conclusion is that Ventas is undervalued at the present time. In other words, if after due diligence you like the company and it is a good fit for your portfolio, now is a good time to buy it.

I am personally interested in this result, because I will be reinvesting dividends later this month in my Dividend Growth Portfolio. Ventas is on my candidate list. My own due diligence suggests that it is a good quality company, and its 5.8% yield is certainly attractive.

So I may add some more to a position that I already have. Stay tuned.

— Dave Van Knapp