This High-Yield Dividend Growth Stock Appears 27% Undervalued

Later this month, I will be making a dividend reinvestment in my Dividend Growth Portfolio. Rather than add a new stock, I am inclined to increase the size of one of the positions already in the portfolio.

The healthcare REIT Omega Healthcare Investors (OHI) is one of the candidates. It currently accounts for about 4% of the value of my 20-stock portfolio.

One of the factors in deciding whether to buy more of OHI is its valuation. So the time is right to see whether it is selling at an attractive price. Let’s take a look.

Dividend Safety

I always kick off these valuation articles by confirming the company’s dividend safety. I only want to invest in companies whose dividends are safe.

For a more complete discussion of dividend safety and reliability, see Dividend Growth Investing Lesson 17: Dividend Safety.

I use two services to assess dividend safety. The first is Simply Safe Dividends. They use the following scale to score dividend safety:

Here is how Simply Safe Dividends scores Omega Healthcare Investors:

CaptureAs you can see, Simply Safe Dividends gives OHI 74 out of a possible 100 points for dividend safety, suggesting that the dividend is safe and unlikely to be cut.

The second service I use is Safety Net Pro. They use the following scale to score dividend safety:

CaptureSafety Net Pro gives OHI an even better safety grade:

CaptureWith that reassurance on Omega’s dividend safety, let’s proceed to our valuation steps and see how the company’s stock stacks up in terms of fair price.

Valuation Steps

For a complete discussion of how I value stocks, please read Dividend Growth Investing Lesson 11: Valuation. I employ 4 methods and then average them out.

Step 1: FASTGraphs Default Valuation

In the the first step, we check the stock’s current price against FASTGraphs’ basic estimate of its fair value.
What is a basic estimate? FASTGraphs compares the stock’s actual price-to-earnings (P/E) ratio to the historical average P/E ratio of the whole stock market, which is 15.

That fair-value reference is shown by the orange line on the following graph, while the black line is OHI’s actual price.

CaptureAs you can see, the black price line is well below the orange fair-price line. By the way, that orange line is marked with little F’s. That indicates that I have used FFO (funds from operations) to measure Omega’s profits. That is standard practice for real-estate investment trusts (REITs).

[ad#Google Adsense 336×280-IA]So this first step suggests that Omega Healthcare is far undervalued.

How much? That is easy to calculate.

We divide the stock’s actual P/FFO ratio of 9.4 (shown at the upper right) by the ratio of 15 that was used to draw the orange line.

We get 9.4 / 15 = 0.63.

In other words, OHI’s actual price is 63% of its fair price as computed by this first method of valuation.

It is undervalued by 37%.

We can calculate OHI’s fair price by dividing its current price by the ratio 0.63. That’s $32.16 / 0.63 or about $51. Note that I round fair-value estimates off to the nearest dollar to avoid creating a false sense of precision. Valuations are estimates, not scientific calculations.

Step 2: FASTGraphs Normalized Valuation

In the second step, we compare Omega’s current P/E ratio to its own long-term average P/E ratio. By doing this, we judge fair value by recognizing how the market has historically valued OHI itself rather than by how the market has valued all stocks over many years.

CaptureThis narrows the gap, but OHI still looks undervalued. That’s because OHI’s average valuation looking back 10 years has been P/FFO = 12.3 (see the dark blue box in the right panel). That’s less than the 15 used in the first step, but still more than OHI’s actual P/FFO of 9.4 right now.

How much is the undervaluation? We use the same equation as before: 9.4 / 12.3 = 0.76, or 76%. So this suggests that Omega Healthcare Investors is 24% undervalued.

The fair price using this valuation method is $42.

Step 3: Morningstar Star Rating

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

Morningstar ignores P/FFO ratios. Instead, they use a discounted cash flow (DCF) model. They discount all of the stock’s projected future cash flows back to the present to arrive at a fair value estimate. (If you would like to learn more about how this works, check out this excellent explanation at moneychimp.)

Unfortunately, Omega is not one of the stocks that Morningstar rates. So we do not have the benefit of their valuation or fair price estimate for this stock.

Step 4: Current Yield vs. Historical Yield

Finally, as a 4th valuation method, we compare the stock’s current yield to its historical yield. If a stock is yielding more than its historical average, that suggests that it is a better value than usual.

Omega’s current yield is 7.8%. According to Morningstar, its 5-year average yield is 6.5%. Thus under this method, Omega’s yield is 20% higher than its 5-year average, suggesting that its stock price is 20% beneath its fair value.

Doing the math, we get a fair price estimate of $32.16 / 0.8 = $40.

Valuation Summary

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

CaptureThe average of the 3 fair-value prices is $44 compared to OHI’s actual price of about $32. That’s a 27% discount to fair value, which I call Far Undervalued.

Omega is a Dividend Contender, with a 15-year streak of consecutive dividend increases. The company pays quarterly and also normally increases its dividend a little with each distribution rather than once per year.

So far this year, OHI has announced two payments, and each was a slight increase from the prior payment. The first payment (in February) was a 1.6% increase. The next payment will be on May 15, and it again represents a 1.6% increase over February’s payment. (The ex-dividend date for the June payment has already passed.)

Disclosure and Caution

I own OHI already, as discussed earlier. Also, the fact that the stock’s valuation is favorable does not mean that I will select it for my dividend reinvestment later this month. I am checking out several candidates.

As always, this is not a recommendation to buy Omega Healthcare Investors. Always perform your own due diligence. Check out the company’s dividend record, quality, financial position, business model, and prospects for the future. Also consider whether it fits (or does not fit) your long-term investing goals.

— Dave Van Knapp