This Stock Has Top-Rated Dividend Safety and is Fairly Valued Right Now

So far in 2016, we have examined the valuations of 16 dividend growth stocks whose dividends are highly rated for safety.

Here is a list of the stocks we have covered, including links to the articles:

Company Ticker Yield Price / Fair Value Link to article
Omega Healthcare OHI 6.5% 0.86 – undervalued August 18, 2016
CVS Health CVS 1.8% 0.93 – fairly valued August 12, 2016
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

Of the 16 stocks so far, 7 were undervalued at the time of their articles, 7 were fairly valued, and 2 were overvalued.

[ad#Google Adsense 336×280-IA]This kind of distribution is fairly typical when you research to find companies to invest in.

One hears these days that “everything is overvalued,” but that is not true.

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

I am pleased to announce that henceforth, I will be using a second dividend safety evaluation in my valuation articles.

In addition to the dividend safety grades from Safety Net Pro, I am adding the system from Simply Safe Dividends.

Both systems analyze the probable safety of each company’s dividend, and both use a 5-step scoring scale to express the degree of safety. For Safety Net Pro, the scoring scale looks like this:

Simply Safe Dividends delivers a numerical score of 0-100, which is then divided into 5 grading categories as follows:

captureFor a more complete discussion of each system’s approach, please see my newly updated Dividend Growth Investing Lesson 17: Dividend Safety.

For the company to value this time, I have selected The Travelers Companies (TRV), the well-known insurance giant.

Travelers has increased its dividend for 12 straight years, yields about 2.3%, and most recently increased its dividend nearly 10% in June.

Travelers’ dividend safety is top-rated by both rating services:

Safety Net Pro:

captureSimply Safe Dividends:

captureBoth scores indicate an extremely low risk of a dividend cut. It is reassuring when 2 ratings services come to the same conclusion about a subject as important as dividend safety.

Now let’s see whether Travelers is selling at a fair price. The 4-step process that we follow is described in DGI Lesson 11 on Valuation that I linked to earlier.

Step 1: FASTGraphs Default Valuation

In the 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 TRV’s actual price.

captureYou can see that TRV is trading well below the orange fair-value line.

How much? To calculate, simply divide TRV’s actual P/E ratio of 12.0 (shown in the upper-right corner) by the ratio of 15.0 used to compute the orange line.

So we have 12.0 / 15.0 = 0.80. In other words, TRV is trading about 20% under its fair value by this method of appraisal.

That would suggest that its fair price is about $148 compared to its actual recent price of about $118.

Step 2: FASTGraphs Normalized Valuation

In the second step, we compare TRV’s current P/E ratio to its own long-term average P/E ratio. In other words, instead of judging TRV’s fair valuation by how the market has valued all stocks over many years, we judge it by how the market historically has valued TRV itself.captureThis presents a completely different picture. We see that over the past 10 years, the market has valued TRV at a considerably lower level than the whole market: 9.8 (see the blue box in the right panel).

In a pop-up box on FASTGraphs, we can see the progression over the past 10 years of TRV’s valuation:

captureWhat you can see here is that TRV’s average valuation has generally been around a P/E of 10, but the 10-year average of 9.8 presents a difficult comparison.

Nevertheless, I normally use the 10-year average as the benchmark, because that time frame includes the Great Recession (2008-2009) as well as more “normal” years.

By the 10-year average P/E ratio of 9.8, TRV is overvalued. Specifically, using the same calculation as in the first step, we get 11.5/9.8=1.17. In other words, the stock is trading at 17% above its fair value price using this method.

The fair value price computes to $97.

Step 3: Morningstar Star Rating

The next step is to see what Morningstar has to say.

Morningstar uses a discounted cash flow (DCF) approach to valuation that is different from the approach based on P/E ratios. 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.

captureOn Morningstar’s 5-star grading scale, 3 stars means that Morningstar believes that TRV is fairly valued. They have computed a fair value price of $117.

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.

Per Morningstar, TRV’s 5-year average yield is 2.3%, or just about what it is right now.
So by this measure, TRV is fairly valued at its current price.

Averaging the 4 Valuation Steps

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

captureBy my reckoning, TRV is fairly valued at the present time. The slight discount to the calculated fair value price of $120 is too small to be of importance.

As always, this is not a recommendation about buying, holding, or selling TRV. Its 2.3% yield is less than many dividend growth investors seek, but its dividend safety appears rock-solid. This valuation analysis omits evaluation of the company’s quality, business model, likely future earnings, and ability to withstand competition.

So always perform your own due diligence. Check out the company’s quality, financial position, and business prospects. Also consider whether it fits (or does not fit) into your portfolio in terms of diversification and especially whether it might help you meet your long-term investing goals.

— Dave Van Knapp