This A-Rated Dividend Growth Stock is Available at 4% Below Its Fair Value

This is the 8th article in a new series for 2016 that examines highly rated dividend growth stocks and reports on their valuations.

Before we get started with the next stock, here for your convenience is a list of the previous stocks and what their valuations were at the time of publication.

In the Price / Fair Value column, a value above 1.00 indicates that the stock was overvalued. That is a cautionary note.

On the other hand, a value of 1.00 or below indicates that the stock was fairly valued or undervalued. Depending on the degree, that is an encouraging sign if you are considering a new purchase or adding to a stake that you already own.

Company Ticker Yield Price / Fair Value Link to article
Clorox CLX 2.40% 1.36 – overvalued April 19, 2016
Cummins CMI 3.60% 0.86 – undervalued March 29, 2016
Amgen AMGN 2.70% 0.86 – undervalued March 21, 2016
Lowe’s LOW 1.60% 0.96 – fairly valued March 9, 2016
United Parcel Service UPS 3.20% 0.99 – fairly valued February 26, 2016
Ventas VTR 5.90% 0.80 – undervalued February 5, 2016
Realty Income O 4.40% 1.22 – overvalued January 26, 2016

The older the article, the more important that you update the valuation before considering a new purchase. Valuations can change quickly, especially after earnings are announced each quarter. (We are in Q1 earnings season right now. Companies are reporting daily.)

Not only can valuations change quickly, earning reports and other news may radically change your perceptions of the quality of a company, the safety of its dividend, and the sustainability of its business model.

Bottom line: Do your own due diligence before buying anything.

By the way, I eat my own cooking.

Since the articles listed above were published, I have trimmed my holding of overvalued Realty Income, added to my stake in undervalued Ventas, and purchased the undervalued company Cummins in my wife’s and my dividend growth portfolios.

The stock for this article is Archer Daniels Midland (ADM).

ADM is a company in the agriculture industry that has raised its dividend for 41 straight years, making it a Dividend Champion.

It just raised its dividend 7.1% in March. It currently yields 3.1%.

ADM is A-rated for dividend safety by Safety Net Pro. Under their cash-flow-based method of analyzing dividend safety, ADM’s dividend is considered to be extremely safe.

CaptureLet’s use my 4-step process to see how well valued Archer Daniels Midland is.

Step 1: FASTGraphs Default Valuation

In the first step, we compare the stock’s current price to FASTGraphs’ default estimate of its fair value.

That default estimate is based on a price-to-earnings (P/E) ratio of 15, which is the long-term historical average for the whole stock market. This fair value is shown by the orange line on the following graph, while the black line is ADM’s actual price.

CaptureYou can see that the stock is trading just a bit above the orange-line fair value.

Let’s put a more precise number on it. To do this, we divide ADM’s actual P/E ratio of 15.5 by the fair value ratio of 15 used in the graph.

So we have 15.5 / 15.0 = 1.03. In other words, ADM is trading about 3% over its fair value when we use this method of appraisal. That would suggest that its fair price is $38.47, compared to its actual recent price of $39.62.

Because valuation is inherently imprecise – it is a method of appraisal – I always round my fair prices to the nearest dollar. So I would say that ADM’s fair price under this first step is $38.

Step 2: FASTGraphs Normalized Valuation

In the second step, we compare ADM’s current P/E ratio to its long-term average P/E ratio.

This lets us adjust for the fact that many stocks typically trade at valuations above or below the default P/E ratio that we used in the first step.

It turns out that ADM is interesting in this regard, because its P/E ratio has varied significantly over the past 20+ years.

CaptureYou can see that ADM’s “normal” P/E ratio is hard to describe. In 2001, it had a value of around 25. More recently, it has been under 15. Overall, over the past 15 years, it has been in a downward trend with lots of volatility.

That raises the question of what time period to choose for “normal” in reviewing ADM’s average valuation. Usually I use 10 years, because that includes the Great Recession period from late 2007 to mid-2009.

I have decided to do that here, to be conservative. FASTGraphs allows me to go as far back as 18 years, and if I used all 18 years, ADM’s average valuation would be 18.9, as shown here:

CaptureHowever, that would make ADM appear to be quite a bit undervalued, when we know that its average P/E ratio has been trending downward. So to be conservative, I will use 10 years, because that seems more relevant to the way that the market has more recently been valuing ADM.

CaptureUsing 10 years for the look-back period, the average P/E ratio is just 13.8. So under this second approach, ADM’s valuation is 15.5 / 13.8 = 12% overvalued. Its fair price computes to about $35.

This step is a good illustration why valuation is inherently imprecise. You can see how much the conclusion is influenced by the choice of the look-back period. At 18 years, ADM would appear to be 18% undervalued. At 10 years, it appears to be 12% overvalued.

When faced with a choice like this, I prefer to go the conservative route.

Step 3: Morningstar Star Rating

I like to use Morningstar valuations for two reasons. First, they are an independent source. They do not have a brokerage, and they are not trying to sell me anything except information. There are no conflicts of interest.

Second, Morningstar uses a comprehensive net present value (NPV) technique for valuation. It involves discounting all of the stock’s future cash flows back to the present. When this technique is done right, many investors consider it to be the finest way to value a stock.

CaptureOn Morningstar’s 5-star grading scale, 3 stars means that Morningstar believes that ADM is fairly valued. They have computed a fair value price of $43, which is about 9% above ADM’s actual price.

I usually use a 10% band above and below the fair value price to call something fairly valued, and Morningstar is doing the same thing. Their numerical calculation is that ADM is 9% undervalued, but their use of 3 stars indicates that they think that ADM is in the fairly valued range.

Step 4: Current Yield vs. Historical Yield

Finally, we compare the stock’s current yield to its historical yield. The higher the stock’s current yield is compared to its historical average, the better value it represents.

CaptureAs you can see, ADM’s yield has never been higher. According to Morningstar, ADM’s current yield is 26% above its average yield over the past 5 years. That is a favorable comparison, suggesting that ADM is undervalued.

On this 4th step, I usually use a cutoff of 20% as the most I will consider a stock to be undervalued or overvalued. Using that 20% cutoff, I reckon that ADM is 20% undervalued, and that its fair price is therefore $48.

Valuation Summary

Using the 4 approaches just described, our valuation for ADM comes out like this. There is more variation here than we often see.

CaptureI conclude that ADM is fairly valued at the present time. Its current price of about $40 is around 4% less than its fair value price of $41.

Considering ADM’s 41-year history of dividend growth and its recent strong dividend increase, this looks like an attractive entry point to me.

I do not own ADM now, but I intend to study it in more depth. I will be making a dividend reinvestment next month into my Dividend Growth Portfolio, and ADM looks like a strong candidate. Its presence in the agricultural business would add an interesting element of diversification to the portfolio.

Note that this is not a recommendation for you to buy ADM. Always perform your own due diligence on every potential stock purchase. Check out the company’s quality, financial position, and business prospects. Also consider whether it fits into your portfolio and how it might help meet your long-term investing goals.

Those are all things that I intend to do before my dividend reinvestment in May. I have several candidates to consider.

— Dave Van Knapp

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