This Dividend Growth Stock Now Appears 13% Undervalued

Valuation: Eaton Corporation

The Brexit panic on Friday, June 24, caused widespread declines in many – not all – stock prices. Those price declines improved valuations all over the market. But of course Brexit also introduced fear that prices could have further to fall.

Basically Brexit introduced massive uncertainty, and the market never likes uncertainty. Judging from the news over the weekend, it could take months for the UK to exit the European Union.

It could take years for politicians and markets to sort out all of the economic dislocations that Brexit will cause.

Nevertheless, some investors may see this as a good time to buy certain stocks.

If you are supposed to “be greedy when others are fearful,” now is an opportunity.

Many are fearful.

So we are going to continue to value stocks one at a time, using our usual methods.

You may wish to take counsel on whether to invest in stocks at this time. Many gurus are advising investors to hold onto cash at the moment.

Eaton (ETN) is a global technology leader in power management solutions. They make products that make electrical, hydraulic, and mechanical power operate more efficiently, reliably, safely and sustainably.

As an industrial company, Eaton fell harder than the average stock on Friday, losing 7.6% compared to the market’s general loss of about 3% to 4%.

Eaton is a Dividend Challenger, having raised its dividend for 7 straight years. It has already increased its dividend 3.6% this year, back in March. It pays quarterly; the next payout should be in August.

Eaton is an Irish company that trades in the US as ADRs (American Depositary Receipts). Ordinarily there are no issues related with that, it trades just like any other stock. With Brexit, of course, you may wish to look extra hard at an Irish company when you do your due diligence. It may be under more pressure than US-based companies.

Eaton is A-rated for dividend safety by Safety Net Pro.

CaptureLet’s use my 4-step process to see whether Eaton is fairly valued.

Step 1: FASTGraphs Default Valuation

First we compare Eaton’s current price to FASTGraphs’ standard estimate of its fair value.

FASTGraphs’ standard is based on a price-to-earnings (P/E) ratio of 15. That is the long-term historical average for the whole stock market.

This fair value is shown by the orange line on the following graph, which shows Eaton’s earnings per share multiplied by 15 to arrive at fair price.

The black line is ETN’s actual price. The thin lines are 10% increments above and below the orange fair-value line.

CaptureBy this first method, you can see that Eaton is trading at a discount to fair value. The black price line is below the orange fair-value line.

Let’s put a number on how much the discount is.

To do that, we simply make a ratio between ETN’s actual P/E ratio at its current price and the value 15 used for the orange line. Eaton’s actual P/E ratio is shown in the upper right: 13.5. So the ratio is 13.5 / 15 = 0.90.

So the conclusion from this first approach is that ETN is 10% undervalued at its current price. That suggests a fair price of about $64. Here is that calculation: $58.03 / 0.90 = $64.48. I drop the cents and just round to the nearest whole dollar.

That 10%-below-fair-value mark is just at the point of undervaluation in my book. My dividing line between the fair value range and undervaluation is 10%. Valuation is as much art as science (because it involves estimates about the future), so it is best to think of fair valuation as a range rather than as an exact price.

That is also why I round my fair value prices off to the nearest dollar. Carrying them out to exact dollars-and-cents is false precision, in my opinion.

Step 2: FASTGraphs Normalized Valuation

Next, we use Eaton’s long-term average P/E ratio to define “fair value.” This takes into account the fact that many stocks typically trade at valuations above or below the P/E of 15 that we used in the first step.

A stock’s long-term average P/E ratio reflects the sentiment that investors typically have about the company and its stock. Higher long-term P/E ratios suggest more confidence in the company, particulalrly its ability to sustain growth. Lower P/E ratios suggest more uncertainty.

I usually select the 10-year average P/E to represent “normal.” That ensures that I am including the Great Recession of 2007-2009 in the calculation as well as more conventional years.

The normalized fair value estimate is shown by the blue line in the following graph.

CaptureExcept for color, this is the same graph. As it turns out, the market over the past 10 years has valued Eaton the same as the P/E ratio of 15 that we used in the first step.

So the conclusion is the same: Eaton is 10% undervalued and has a fair price of $64.

Step 3: Morningstar Star Rating

Now we try another approach. Morningstar uses a comprehensive net present value (NPV) technique for valuation. This 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.

CaptureMorningstar registers another vote for undervaluation. On its 5-star system, 4 stars = undervalued.

Morningstar calculates a fair price of $67, just a few bucks more than we got in our first two steps. That suggests that Eaton is 13% undervalued.

I have been watching this stock for a few days as I prepared this article, and it was Friday’s price drop that brought Eaton to 4 stars. The day before, it had been 3 stars on Morningstar. That’s a great example of how valuations can change as prices fluctuate.

Step 4: Current Yield vs. Historical Yield

A review of a stock’s historical dividend yield gives us a fourth way to estimate fair value. A higher current yield compared to the stock’s historical average suggests better valuation, because dividend yield is higher when price is lower, all else equal.

This display from Morningstar shows Eaton’s current yield compared to its 5-year average yield (see the last line).

CaptureEaton’s current yield of 3.9% is 26% more than its average 5-year yield of 3.1%.

Because I consider this 4th method to be the least precise, I cut off undervaluation indications at 20%. Using the 20% ratio suggests a fair value price of $73.

Valuation Summary

Now we put the 4 steps together and average them out.

CaptureI conclude that Eaton is about 13% undervalued at the present time. Its post-Brexit price of about $58 is around 13% less than its fair value price of $67.

I would consider Eaton at its current price, but I would not criticize anyone who held out from buying any stock while seeking more clarity about the long term effects of Brexit. Stock prices are likely to be quite volatile for the next few days.

As always, do not use this article as a recommendation to buy Eaton. Do your own due diligence into the company, its dividend practices, the macro situation caused by Brexit, and the stock’s fit for your portfolio.

— Dave Van Knapp

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