This A-Rated Dividend Growth Stock Is Fairly Valued Right Now

So far in 2016, we have examined the valuations of 13 highly rated dividend growth stocks.

Here is a list of the previous stocks and their valuations at the time of publication.

Company Ticker Yield Price / Fair Value Link to article
Target TGT 3.2% 0.93 – fairly valued July 25, 2016
Wells Fargo WFC 3.3% 0.81 – undervalued July 13, 2016
Eaton ETN 3.9% 0.87 – undervalued June 27, 2016
AT&T T 5.0% 1.04 – fairly valued May 25, 2016
Boeing BA 3.3% 0.90 – undervalued May 13, 2016
Archer-Daniels ADM 3.0% 0.97 – fairly valued April 26, 2016
Clorox CLX 2.4% 1.36 – overvalued April 19, 2016
Cummins CMI 3.6% 0.86 – undervalued March 29, 2016
Amgen AMGN 2.7% 0.86 – undervalued March 21, 2016
Lowe’s LOW 1.6% 0.96 – fairly valued March 9, 2016
United Parcel Service UPS 3.2% 0.99 – fairly valued February 26, 2016
Ventas VTR 5.9% 0.80 – undervalued February 5, 2016
Realty Income O 4.4% 1.22 – overvalued January 26, 2016

In the Price / Fair Value column, a value above 1.00 indicates that the stock was overvalued. In other words, its actual price was higher than what I calculated as its fair value. That is a cautionary note when you are considering buying a stock.

On the other hand, a value of 1.00 or below indicates that the stock was fairly valued or undervalued. That means that you could have purchased it at a price that was even with, or below, its fair value.

Depending on the degree of undervaluation, that is an encouraging sign if you are considering a new purchase or adding to a stake that you already own.

The older the article, the more important it is that you update the valuation before considering a new purchase.

Valuations can change quickly, especially during and after earnings are announced each quarter.

We are in the Q2 earnings season right now, and companies are reporting daily.

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 portfolio. I am in the process of adding Boeing to my public Dividend Growth Portfolio.

Next up: The stock for this article is Cardinal Health (CAH). Cardinal Health is one of the leading wholesale distributors of pharmaceuticals, medical and surgical supplies, and related products. It sells to a broad range of health care customers.

The company increased its dividend in July for the 20th consecutive year. That makes it a Dividend Contender.

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

CaptureLet’s use my 4-step process to see how well valued Cardinal Health 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 the long-term price-to-earnings (P/E) ratio of the whole market, which is 15. This fair value estimate is shown by the orange line on the following graph, while the black line is CAH’s actual price.

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

Let’s put a number on it. We divide CAH’s actual P/E ratio of 15.8 (shown in the upper-right corner) by the ratio of 15 used to compute the orange line.

So we have 15.8 / 15.0 = 1.05. In other words, CAH is trading about 5% over its fair value by this method of appraisal. That would suggest that its fair price is about $80 compared to its actual recent price of $83.60.

Step 2: FASTGraphs Normalized Valuation

In the second step, we compare CAH’s current P/E ratio to its own long-term average P/E ratio. In other words, we judge fair valuation by how the market has valued CAH over many years rather than how the market has valued stocks across the board.

CaptureWhat we find for Cardinal Health is that its 10-year average P/E of 16.0 is just above the value of 15 used in the first step.

But its current P/E of 15.8 is just below the blue fair-value line of 16.0. Numerically, 15.8 / 16.0 = 0.99. The stock is trading at 1% below its fair value price using this method.

The fair value price computes to $85.

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, they are not “sell side” analysts, and they are not trying to sell me anything except accurate information. There are no conflicts of interest.

Second, Morningstar uses a comprehensive discounted cash flow (DCF) approach that is different from the approach based on P/E ratios used in the first two steps. Morningstar discounts all of the stock’s future cash flows back to the present to arrive at a fair value estimate.
When this technique is done right, many investors consider it to be the finest way to value a stock.

Here is how Morningstar describes its approach:

Morningstar analysts estimate a company’s future financial performance using a detailed discounted cash-flow model that factors in projections for the company’s income statement, balance sheet, and cash-flow statement….

The Morningstar Rating for stocks system identifies stocks trading at a discount or premium to our estimate of their fair values. Generally speaking, stocks trading at large discounts to our analysts’ fair value estimates will receive higher (4 or 5) star ratings, and stocks trading at large premiums to their fair value estimates will receive lower (1 or 2) star ratings. Stocks that are trading very close to our analysts’ fair value estimates will receive 3-star ratings….

Ratings are updated daily and can therefore change daily. They can change because of a move in the stock’s price, a change in the analyst’s estimate of the stock’s fair value, a change in the analyst’s assessment of a company’s business risk, or a combination of any of these factors.

CaptureOn Morningstar’s 5-star grading scale, 3 stars means that Morningstar believes that CAH is fairly valued. They have computed a fair value price of $79, which is about 6% less than CAH’s actual price.

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, CAH’s yield is near the highest that it has ever been. According to Morningstar, CAH’s current yield is 11% above its average yield over the past 5 years. That is a favorable comparison, suggesting that CAH is undervalued.

Using that 11% value suggests that Cardinal Health’s fair price is $93.

Averaging the 4 Valuation Steps

Using the 4 approaches just described, our valuation for CAH comes out like this.

CaptureI conclude that Cardinal Health is fairly valued at the present time. Its current price of about $84 is right at my calculation of its fair price.

Note that this is not a recommendation for you to buy Cardinal Health. This valuation analysis omits any evaluation of the company’s quality, business model, likely future earnings, or ability to withstand competition.

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.

— Dave Van Knapp

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