Warren Buffett dropped some eternal wisdom on us all a while back, and it’s a quote that I try never to forget:
“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
Amen, Mr. Buffett.
How, ahem, wonderful would that be?
Well, that’s something I’m always aiming to do with my available investment capital.
But it’s not an easy task.
You first have to identify a wonderful business.
And then you have to identify a wonderful price. The market then has to give you a wonderful price on shares. And finally, you have to pull the trigger.
Well, I think the first step there is made easier when one focuses on high-quality dividend growth stocks.
I’m talking about stocks like those you’ll find on David Fish’s Dividend Champions, Contenders, and Challengers list, which is a compilation of more than 700 US-listed stocks with at least five consecutive years of dividend increases (but many stocks on his list have decades of dividend increases).
High-quality dividend growth stocks are such because there’s a longstanding track record of strong fundamentals, growing profit, and increasing dividends that one can clearly point to.
I certainly eat my own cooking – as you can see by checking out my real-life portfolio.
But what about that second step, where you have to identify a wonderful price?
This, too, is made easier when you use a system that’s designed to help ascertain the fair value of dividend growth stocks.
That’s why fellow contributor Dave Van Knapp’s dividend growth stock investing lesson on valuation is so, well, valuable.
This lesson breaks down the process of valuing just about any dividend growth stock out there, which allows one to estimate the intrinsic value of whatever high-quality dividend growth stock they identified in the first step.
Once you have a good idea of what a stock is worth, a wonderful price is then obviously as far below that value as possible.
Said another way, you want to buy a high-quality dividend growth stock when it’s significantly undervalued.
As Mr. Buffett noted, this confers huge benefits to the investor.
Namely, an undervalued dividend growth stock will offer a higher yield, greater long-term total return potential, and less risk.
This is all relative to what would be offered if the same stock were bought at fair value or higher.
Since price and yield are inversely correlated, a lower price on a stock will, all else equal, mean a higher yield.
This higher yield not only means more ongoing income in the investor’s pocket but also greater long-term total return prospects.
That’s because yield is a major component of total return.
The other major component, capital gain, is also given a nice boost by virtue of the additional upside that exists between the lower price paid and the higher intrinsic value of the stock.
If you estimate a stock’s worth $50 but pay $25, that’s $25 of additional upside that’s possible… on top of the long-term upside that’s likely to materialize as the business goes on to make more money, pay more dividends, and become more valuable (increasing its intrinsic value).
And this all works together to lower your risk.
You’re either spending less total money on the same amount of shares or you’re getting more shares for your money.
Either way, you’re introducing a margin of safety, whereby if something goes wrong and the intrinsic value of the company takes a hit, you’re still okay. The more undervalued a stock, the greater the margin of safety.
With all of that in mind, it’s then up to the market to provide the opportunity of a high-quality stock priced at a level far below what it might be worth.
Well, I think we might just have such an opportunity on our hands…
McKesson Corporation (MCK) is the largest distributor of pharmaceuticals in the United States, providing drugs, medical products, and related supplies to a variety of healthcare customers.
It’s no secret that the world is growing older, richer, and larger.
As that trend continues, access to and demand for high-quality medical care and treatments is only likely to increase.
This bodes well for the entire healthcare system, of which McKesson is a very large part of.
There are only a few major distributors in the entire country, so it’s essentially an industry that acts as an oligopoly. And McKesson is the biggest of them all.
But they don’t just pack a competitive punch.
Their dividend packs a nice punch, too.
They’ve been paying a dividend for decades. However, they have a tendency to keep the dividend static over longer periods of time.
Nonetheless, they started increasing their dividend rather aggressively almost a decade ago, which has served shareholders incredibly well.
The company has grown its dividend for nine consecutive years now.
And over the last five years, the dividend grown at a compound annual rate of 9.5%.
While that’s obviously well above the rate of inflation, it might actually seem a little disappointing in light of the fact that the stock only yields 0.83%.
However, there appears to have been an acceleration of dividend growth, with the most recent dividend increase coming in at over 16%.
With a payout ratio of 12.6%, there’s still plenty of room for further acceleration.
In fact, that’s one of the lowest payout ratios I’ve ever come across for a company with almost a decade of dividend increases already under its belt.
But this only tells us one very small part of the story.
We’ll next see what kind of underlying top-line and bottom-line growth McKesson has managed over the last decade, which should help us paint not only a picture of the broader business but also its growth trajectory, which will help us later value the business.
In addition, we’ll take a look at a forecast for near-term growth, as we don’t invest in where a company’s been, but where it’s going.
The company’s revenue is up from $92.977 billion to $190.884 billion from fiscal years 2007 to 2016. That’s a compound annual growth rate of 8.32%.
That’s mighty impressive, in my view. Not only is it a fine growth rate for revenue in general, but we’re looking at a company that grew that fast starting from what was already a base of almost $100 billion!
Meanwhile, McKesson increased its earnings per share from $2.99 to $9.70 over this period, which is a CAGR of 13.97%.
Again, really impressive growth here, especially considering the size of the company.
Looking out over the next three years, S&P Capital IQ believes that McKesson will compound its EPS by an annual rate of 6%.
This about half the growth that McKesson has generated over the last decade, so we’re looking at a steep drop here.
S&P Capital IQ believes price competition will be a headwind moving forward. As is, it’s business model with very thin margins. However, that isn’t anything new.
Other than those thin margins, there’s a lot to like with the fundamentals.
The balance sheet is solid for the industry, with a long-term debt/equity ratio of 0.73 and an interest coverage ratio that’s just over 10.
Profitability, as foreshadowed, leaves something be desired in absolute terms. But relative to the industry, we’re looking at pretty strong stuff here.
Over the last five years, McKesson has averaged net margin of 1.08% and return on equity of 21.04%.
So there’s definitely a high-quality business here.
However, the stock itself is down more than 30% YTD, with a good chunk of that coming after its Q2 earnings release that missed expectations.
A goodwill impairment hurt GAAP results, but adjusted earnings per share came in at down just 7% YOY. A 7% reduction in net income per share doesn’t seem to warrant a 30% drop in the value of the company.
But is it a wonderful business at a wonderful price?
The P/E ratio for the stock is sitting at 15.13 right now. Consider that the five-year average P/E ratio for this stock is 23.0. Furthermore, investors are paying about 5.5 times cash flow, whereas the average average over the last five years is 15 times. Clearly a major disconnect here.
What, then, might the fair value be? Just how wonderful is the price?
I valued shares using a two-stage dividend discount model analysis due to the low yield. I assumed a 10% discount rate. For the first 10 years, I factored in a dividend growth rate of 20%. The terminal dividend growth rate I used is 8%. This is arguably aggressive, but the payout ratio is extremely low. Even modest underlying EPS growth could support this kind of dividend growth for years to come. The DDM analysis gives me a fair value of $163.02.
The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.
The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.
It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.
I find it to be a fairly accurate way to value dividend growth stocks.
The valuation I came up with indicates that this indeed might just be a wonderful business at a wonderful price. But it gets more interesting. Some professional analysis firms that have taken a swing at this stock’s valuation think it’s worth even more than I do.
Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system. 1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.
Morningstar rates MCK as a 5-star stock, with a fair value estimate of $200.00.
S&P Capital IQ is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line. They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.
S&P Capital IQ rates MCK as a 3-star “HOLD”, with a fair value calculation of $216.30.
Averaging these three valuations out gives us a final number of $193.11. That would indicate the stock is potentially 43% undervalued right now. A wonderful business at a wonderful price. The last step is pulling the trigger. That’s up to you.
Bottom line: McKesson Corporation (MCK) is the largest player in what’s apparently an oligopoly. In addition, this industry appears to have a long-term tailwind working in its favor due to healthcare trends. This looks like a wonderful business at a wonderful price, with 43% upside. In a market that remains doggedly elevated off of historical levels, a high-quality stock that’s this undervalued is rare. This is a great long-term investment opportunity to consider right now.
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