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

So far in 2016, we have examined the valuations of 14 highly rated dividend growth stocks:

Company Ticker Yield Price / Fair Value Link to article
Cardinal Health CAH 2.2% 1.0   – fairly valued August 3, 2016
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 1.10 indicates that the stock was overvalued. In other words, its actual price was higher than the range that I calculated as its fair value range. That is a cautionary note when you are considering buying a stock.

On the other hand, a value of 1.09 or below indicates that the stock was fairly valued or undervalued.

That means that you could have purchased it at a price that was only slightly above, equal to, or below its fair value.

For a review of how valuation is determined and what it means, please see Dividend Growth Investing Lesson 11: Valuation.

This time, we stay in the healthcare field, moving on to a well-known retailer: CVS, which is the largest pharmacy healthcare provider in the USA.

CVS Health Corp. (CVS) has increased its dividend for 13 straight years. Its most recent increase was in February, when it raised its dividend by 21% from 2015’s level.

CVS’s dividend safety is A-rated by Safety Net Pro.

CaptureCaptureNow let’s see whether CVS is selling at a fair price. The 4-step process that we follow is described in the DGI Lesson on Valuation that I linked to earlier.

Step 1: FASTGraphs Default Valuation

In the fhe first step, we compare the stock’s current price to FASTGraphs’ default estimate of its fair value. FASTGraphs is a unique tool that allows you to look at price and valuation on the same graph.

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

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

How much? That’s easy to calculate. Simply divide CVS’s actual P/E ratio of 17.4 (shown in the upper-right corner) by the ratio of 15 used to compute the orange line.

So we have 17.4 / 15.0 = 1.16. In other words, CVS is trading about 16% over its fair value by this method of appraisal.

That would suggest that its fair price is about $84 compared to its actual recent price of about $97.

Step 2: FASTGraphs Normalized Valuation

In the second step, we compare CVS’s current P/E ratio to its own long-term average P/E ratio. In other words, instead of judging CVS’s fair valuation by how the market has valued all stocks over many years, we judge it by how the market historically has valued CVS itself.

CaptureThis changes the picture. We see that over the past 10 years, the market has valued CVS at a higher level than the whole market: 16.9 (see the blue box in the right panel).

Using 16.9 as the benchmark P/E ratio, CVS is trading at a fair value. Specifically, using the same calculation as in the first step, we get 17.4 / 16.9 = 1.03. In other words, the stock is trading at just 3% above its fair value price using this method.

I consider anything within plus or minus 10% as within the fair value range. The fair value price computes to $94.

Step 3: Morningstar Star Rating

The next step is to see what Morningstar has to say. Morningstar uses a discounted cash flow (DCF) approach that is different from the approach based on P/E ratios Morningstarn 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.

CaptureOn Morningstar’s 5-star grading scale, 3 stars means that Morningstar believes that CVS is fairly valued. They have computed a fair value price of $104, which is about 7% more than CVS’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, CVS’s yield is practically as high as it has ever been. According to Morningstar, CVS’s current yield is 31% above its average yield over the past 5 years. That is a very favorable comparison, suggesting that CVS is far undervalued.

However, to be conservative, I cut off the ratio at 20%. Using that, I calculate a fair price of $121.

Averaging the 4 Valuation Steps

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

CaptureBy my reckoning, CVS is fairly valued at the present time. Its current price of about $97 is 7% under my calculation of its fair price of $101. As stated earlier, I consider anything within 10% of fair value to be in the fair-value range.

As always, this is not a recommendation to buy CVS. This valuation analysis omits evaluation of the company’s quality, business model, likely future earnings, and ability to withstand competition. Also, the company’s yield of 1.7% may fall below your required minimum.

So always perform your own due diligence. 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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