Undervalued Dividend Growth Stock of the Week: CVS Health Corp. (CVS)

January 8, 2017
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Note from Daily Trade Alert: CVS Health Corp. (CVS) is one of the 29 stocks selected for Dave Van Knapp’s new dividend growth “ETF”. The “ETF” just launched and is now open to the public. Investors can own all 29 stocks at once for a trading fee of just $9.95. Click here to learn more.

I spend hours per day reading about how life, work, and happiness all intertwine.

But some of what I read is pretty disheartening.

A vast majority of our population is pretty unhappy at work.

These are people that are doing jobs that detract from their personal happiness.

Well, I know how that feels.

I spent about eight years in the auto industry, and it was my general disdain for the job that led me to aggressively save and invest so that I could get out.

And boy, did I ever get out.

I was able to essentially retire in my early 30s.

But the amazing thing is that it’s possible for almost anyone to do this!

What I did was save a high percentage of my income. And then I invested the excess capital in high-quality dividend growth stocks.

A dividend growth stock is a stock that has a lengthy track record of paying increasing dividends, with these dividend payments generally growing at least on an annual basis.

One of the most robust resources for finding stocks that reliably pay increasing dividends is David Fish’s Dividend Champions, Contenders, and Challengers list – an incredible collection of pertinent information on more than 700 US-listed stocks, all of which have paid increasing dividends for at least five consecutive years.

I largely used Mr. Fish’s seminal work to start my research, which helped me build out the real-life dividend growth stock portfolio that currently supports my early retirement lifestyle.

But it’s important to realize that you can’t just throw a dart at any name on Mr. Fish’s list and then buy that stock at any price.

You must first perform a full quantitative and qualitative analysis on any prospective investment.

After all, these are real businesses we’re talking about here. Stocks just represent a sliver of equity. But these are oftentimes massive operations with many moving parts. Just buying stocks randomly is not a recipe for success.

As such, you want to look at growth, debt, profitability, brand names, patents, R&D, competitive advantages, etc.

But perhaps just as important as the business analysis is the valuation of a stock.

I mean, you wouldn’t just pay any price for anything else in your life, would you?

You wouldn’t pay $20 for a gallon of milk, right?

Businesses, like pretty much anything else in this world, have value to them.

Price is simply what you’re paying for something, but value is what something is worth.

Without knowing the latter, it’s impossible to know whether or not the former is appropriate.

And so we must set about valuing a dividend growth stock before we buy it.

A great resource to help with this process is Dave Van Knapp’s valuation lesson, which is part of an overarching series of dividend growth investing lessons that my fellow contributor put together for prospective investors.

However, just knowing the value of a stock isn’t even good enough.

We want to ascertain a good estimate of a stock’s intrinsic value.

But we then want to only buy high-quality dividend growth stocks when they appear to be undervalued.

That means first doing the analysis in order to eliminate low-quality stocks. And then one has to estimate the value of a stock. Finally, one should only pull the trigger when the stock is priced well below what it’s deemed to be worth.

This is the formula I’ve followed over the years, and it’s served me very well.

The reason you want to buy a dividend growth stock when it’s undervalued is due to the advantages that are conferred to the investor when undervaluation is present.

An undervalued dividend growth stock should offer higher yield, better long-term total return prospects, and less risk.

This is all relative to what would be offered if the same stock were fairly valued or overvalued.

See, price and yield are inversely correlated.

All else equal, a lower price will equal a higher yield.

That higher yield means not only more income in an investor’s pocket both now and possibly for the life of the investment, it also means greater long-term prospects due to the fact that yield is a major component of total return.

The other component, which is capital gain, is also given a boost via the upside that exists between the lower price paid and the higher intrinsic value of the stock.

If that value is realized by the market, that upside turns into a capital gain.

This all has a way of reducing one’s risk as well.

Paying less for each share of a business means you’re laying out less of your capital. You’re putting less of your money on the line for each sliver of that business.

That introduces a margin of safety. So just in case the company does something wrong, or isn’t worth as much as you thought, you’re not necessarily “upside down” on your investment.

With all this in mind, I’m always on the hunt for a high-quality dividend growth stock that appears to be undervalued.

Well, I think we might have one on our hands…

CVS Health Corp. (CVS) is a pharmacy healthcare provider that operates one of the largest pharmacy retail chains in the US. It’s also one of the largest pharmacy benefit managers in the country with over 70 million PBM plan members.

CVS is a massive player in their space.

You almost cannot go a day without seeing a CVS store or directly dealing with the business.

And with over 75 million baby boomers in this country, the demographics continue to favor pharmacy benefit mangers like CVS, as millions of people will continue to need these pharmacy services on an ongoing basis.

As people continue to age, the demand for access to high-quality medication is only likely to grow. This bodes well for CVS and other businesses like it.

It also bodes well for CVS’s shareholders, as CVS continues to share a large chunk of its growing profit with shareholders – in the form of a growing dividend.

In fact, CVS has increased its dividend for 14 consecutive years.

If that’s not impressive in and of itself, consider that the company has increased its dividend at an annual rate of 27% over the last decade.

Yes. You read that right. 27%.

While that’s unlikely to continue indefinitely, the company certainly has the wherewithal and willingness to continue handing out raises that are very strong.

captureIndeed, the most recent increase, which was announced just weeks ago, came in at over 17%.

And with a payout ratio of just 42.6%, I believe there’s plenty more where that came from.

On top of the massive dividend growth, investors are looking at a rather appealing yield of 2.5% right now.

That yield is, first off, quite a bit higher than the broader market.

But more importantly, the stock’s yield is 100 basis points higher than its own five-year average.

Remember what I noted about undervaluation and higher yield? Well, here you go.

Now, in order to really get an idea of what kind of dividend growth to expect moving forward, we must take a look at what CVS has managed in terms of underlying earnings growth.

A company can’t continue to increase dividends for very long if it’s not generating the increasing cash flow necessary to support that behavior.

So we’ll take a look at what CVS’s revenue and profit growth over the last decade looks like.

We’ll then compare that to a near-term forecast for profit growth moving forward.

Together, this should give us a pretty good idea as to what to expect.

CVS’s revenue has increased from $43.814 billion to $153.290 billion from fiscal years 2006 to 2015. That’s a compound annual growth rate of 14.93%.

Meanwhile, the company grew its EPS from $1.60 to $4.63 over this same stretch, which is a CAGR of 12.53%.

Double-digit dividend growth supported by double-digit underlying earnings growth? Check.

Really impressive stuff here.

Now, I usually see stronger EPS growth than revenue growth for most of the businesses I invest in. And that’s due to some combination of margin expansion and/or share buybacks.

However, CVS registered the opposite.

This is due to CVS’s 2007 acquisition of Caremark Rx, which catapulted CVS into a major PBM (as opposed to mostly just a retailer). This was an all-stock deal, however, which led to some dilution. The company has been aggressively retiring shares ever since.

Nonetheless, CVS has performed extremely well over the last decade.

Looking forward, S&P Capital IQ believes that CVS will compound its EPS at an annual rate of 10% over the next three years.

While lower than what the company has registered over the last 10 years, that would still be impressive growth, in my view. With substantial ongoing share repurchases and recent accretive moves, like the $12.7 billion purchase of Omnicare, this could prove to be conservative. However, being recently pushed out of the Tricare network was a hit to the company. Keep in mind, though, that contracts in this space change somewhat regularly.

Fundamentally, the rest of the business is extremely sound.

The balance sheet sports a long-term debt/equity ratio of 0.71. And the interest coverage ratio is moderate, at just over 11.

Profitability is quite competitive, with CVS averaging net margin of 3.36% and return on equity of 11.53% over the last five years.

All in all, I see a lot to like.

PBM’s like CVS are perfectly positioned to take advantage of increasing demand for high-quality medical care. And their retail end, which is massive, serves as an additional opportunity for sales across the board.

Of course, risks like changes to our healthcare system and threats to brick & mortar retail should be considered.

The business is attractive, in my opinion. But the current valuation makes it even more attractive.

The stock is down about 16% over the last six months, leading to what appears to be a very strong opportunity…

We can see that the stock is trading hands for a P/E ratio of 17.06 right now. That’s a significant discount to the five-year average P/E ratio for this stock, which is 20. Furthermore, the yield, as noted above, is 100 basis points over its own five-year average.

So the stock does appear to be cheap based on recent historical averages. But how cheap? What’s a good estimate of its intrinsic value?

I valued shares using dividend discount model analysis. I factored in a 10% discount rate. And I assumed a long-term dividend growth rate of 8%. That growth rate is well below CVS’s demonstrated long-term EPS and dividend growth rate. It’s also well below the forecast for near-term EPS growth. With a modest payout ratio, there’s a lot of room for error here. The DDM analysis gives me a fair value of $108.00.

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 stock appears to be substantially undervalued to me. But I always like to compare my perspective to that of professional analysts just to make sure I’m not way off. It looks like I’m pretty much on target here, though.

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 CVS as a 4-star stock, with a fair value estimate of $104.00.

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 CVS as a 3-star “HOLD”, with a fair value calculation of $98.20.

So there’s a pretty clear consensus here. CVS is a high-quality dividend growth stock that looks to worth far more than it’s currently being priced at. If you average these three valuations out, you get $103.40. That would indicate the stock is potentially 30% undervalued right now.

cvs_chartBottom line: CVS Health Corp. (CVS) is a fantastic company that operates one of the largest pharmacy retail and pharmacy benefit manager networks in the country. With demand for access to high-quality medication only likely to grow, they’re poised to take advantage of a long-term tailwind. I recently used the recent weakness in the stock to add to my position, as I think the current undervaluation offers 30% upside on top of a higher-than-average yield for the stock. I think long-term dividend growth investors should take a good look at this stock here.

– Jason Fieber

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