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

It seems to be part of the human condition to naturally try to complicate things.

People like to take something simple, then try to make it more complex.

This comes up a lot in regard to investing.

There are countless funds out there, all kinds of options platforms, currency, real estate, gold, etc.

You name an idea. You can probably find it.

However, many of the world’s most successful investors have worked in an incredibly simple manner.

Warren Buffett is a great example.

He’s amassed a fortune worth billions of dollars (making his investors very wealthy along the way) by largely buying high-quality businesses and holding onto ownership for the long haul (either via shares or outright businesses).

In fact, Buffett often invests in businesses that pay growing dividends.

That’s essentially what I do, too.

And it’s worked pretty well, as can be evidenced by the real-life, real-money stock portfolio I control, which just so happens to generate five-figure passive dividend income for me.

Building a lot of wealth and passive income doesn’t have to be complicated. In fact, the simpler, the better (almost always).

Buying high-quality dividend growth stocks (like those you’ll find on David Fish’s Dividend Champions, Contenders, and Challengers list) at attractive valuations and holding for the long haul is a proven and almost foolproof investment strategy.

That said, one shouldn’t just pick a random dividend growth stock and buy at whatever price is currently available.

One must make sure they’re buying into a high-quality business they understand. You should only invest when a business is in your circle of competence.

It’s extremely important to look for durable competitive advantages and strong fundamentals. Growth, robust profitability, and a healthy balance sheet are just a few hallmarks of strong fundamentals.

And paying the right price is, of course, paramount.

But what is the right price?

Well, first it’s important to keep in mind that “price” tells you very little.

Price is only what you pay for something.

Price tells you what something costs.

That’s it.

But value is what you’re getting in return for what you pay.

Value tells you what something is worth.

Value gives context to price.

So whether you’re buying businesses or bread, paying less than value should always be the aim.

And the bigger the gap between price and value, the better.

This relationship is very apparent when it comes to dividend growth stocks. And the benefits conferred to the investor when paying below fair value are extremely rewarding.

An undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and less risk.

That’s relative to what the same stock would offer if it were fairly valued or overvalued.

The higher yield is generally available when undervaluation is present due to the dynamic between price and yield.

Price and yield are inversely correlated, meaning yield rises as price falls (assuming all else is equal).

So if a stock that’s worth $50 drops from $50 to $40, the yield will correspondingly rise.

That higher yield positively impacts total return, as yield is a major component of total return.

In addition, capital gain – the other component of total return – is also given a potential boost by virtue of the “upside” that exists between price and value, when undervaluation is present.

While the stock market might not necessarily be very good at appropriately pricing stocks over the short run, price and value often tend to more or less converge over the long haul.

Using that earlier example, if one is able to buy a stock that’s worth $50 for $40, there’s $10 worth of “upside” that exists, which is on top of whatever natural capital gain is available as the underlying business (and its stock) naturally becomes worth more (which should eventually be reflected in the price) as the company increases its profit.

This gap between price and value also serves to present the investor with a margin of safety, or “buffer”, against any adverse and unforeseen changes in the business.

Using the earlier example again, paying $40 for a stock deemed to be worth $50 provides a nice margin of safety, just in case the company does something wrong and becomes worth less as a result.

This naturally reduces one’s risk, as paying the full $50 (meaning paying fair value) doesn’t provide that same buffer.

As you can see, undervaluation is thus a very attractive trait that is always being pursued when it comes time to buy a high-quality dividend growth stock for the long haul.

But I won’t leave you readers there.

I’m going to reveal a high-quality dividend growth stock that appears to be undervalued right now.

CVS Health Corp. (CVS) is a pharmacy healthcare provider that operates one of the largest pharmacy retail chains in the US, with more than 9,700 locations across the US and the District of Columbia, Puerto Rico, and Brazil. It’s also one of the largest pharmacy benefit managers in the US, with nearly 90 million PBM plan members.

CVS is an absolute juggernaut in the pharmacy industry.

That size and scale is a competitive advantage, which means that people are usually never far away from accessing the drugs they need. Moreover, their PBM plan members are a built-in captive audience. And as the e-commerce push continues to develop (translating into product delivery), CVS is one of the most well-positioned businesses out there to take advantage.

Moreover, demographic trends serve as a tailwind for the company, as our aging population naturally means that demand for CVS’s core products and services should remain strong (and only increase) over time.

This continued and increasing demand bodes well for CVS’s dividend growth.

Indeed, the company has increased its dividend for 14 consecutive years.

And the dividend growth has been nothing less than tremendous: the ten-year dividend growth rate stands at 27%.

But even with all that dividend growth over the last decade, the stock’s payout ratio still sits at a pretty low level, meaning there’s still plenty of room for future dividend growth.

At just 41.4%, CVS could continue growing their dividend rather aggressively for the foreseeable future, even if EPS growth doesn’t necessarily keep up.

CaptureSaid another way, there’s room for payout ratio expansion.

Meanwhile, the stock yields 2.45% right now, which is actually pretty attractive when taking the dividend growth into account.

CVS is one of those rare stocks that offers solid, market-beating yield along with eye-popping dividend growth.

For perspective, and to back up my earlier point about the dynamic between undervaluation and yield, CVS’s five-year average yield is only 1.5%. So investors today are able to “lock in” a yield that’s almost 100 basis points higher than the recent historical average.

So the dividend metrics are pretty impressive here. And that’s not only in absolute terms, but it’s also true in relative terms (relative to the industry, the broader market, and the stock’s own recent historical averages).

But in order to determine a reasonable expectation for dividend growth moving forward, we must look at what kind of underlying growth the business is actually generating.

In that respect, we’ll look at what CVS has done in terms of top-line and bottom-line growth over the last decade, and then we’ll compare that to a near-term profit forecast. Combined, it should give us a pretty good idea as to what kind of growth the company is experiencing.

Moreover, this will help us greatly when it comes time to actually value the business (since growth information is imperative to valuation).

CVS has increased its revenue from $76.330 billion to $177.526 billion between fiscal years 2007 and 2016. That’s a compound annual growth rate of 9.83%.

During that same period, the company grew its earnings per share from $1.92 to $4.90. So we’re looking at a CAGR of 10.97%.

Double-digit bottom-line growth (and nearly so for revenue) is mighty impressive for a company of this size. Almost $180 billion in annual sales is huge, which makes it that much tougher to move the dial. But CVS has done incredibly well here.

The excess EPS growth can be fully explained by the share repurchasing activities of CVS, with the company reducing its outstanding share count by approximately 21% over this period.

Looking out over the next three years, CFRA (formerly S&P Capital IQ) anticipates that CVS will compound its EPS at an annual rate of 10%. That’s pretty much right in line with what CVS has done over the last decade.

CVS has tremendous opportunity in front of it, with its scale and PBM network being huge competitive advantages. Demographic trends only serve to reinforce their growth.

However, the continued shift to e-commerce could be a long-term headwind. While CVS has their own presence there, more sales online means less retail sales in stores. And the Retail/LTC business segment comprises a significant (approximately 40%) portion of the company’s overall sales.

In addition, ongoing uncertainty in our healthcare system only adds to the difficulty when it comes to forecasting what CVS might be able to do going forward.

But if CVS is able to continue compounding its EPS at a rate anywhere near 10% annually, that opens the door to plenty more dividend increases (and likely a much higher stock price).

The company’s balance sheet allows for flexibility in the face of uncertainty.

The long-term debt/equity ratio is 0.70, while the interest coverage ratio is just over 9. The company’s cash balance is about 13% the size of its long-term debt.

There’s been some moderate deterioration in the balance sheet over the last few years. While not a major concern – the balance sheet is certainly in line for the industry – further deterioration could become problematic as CVS continues to maneuver around changes in its business model.

Profitability is also in line, with CVS averaging net margin of 3.30% and return on equity of 12.55% over the last five years.

Margin is low, but that’s common for the industry. It’s especially important to consider that, as noted earlier, almost half of CVS’s business is essentially retailing.

Overall, CVS offers a lot to like.

Revenue and profit growth over the last decade has been very strong (especially after factoring in the size of the business), which has supported monstrous dividend growth.

With a moderate payout ratio and expectations for continued double-digit EPS compounding moving forward, dividend growth should remain robust for the foreseeable future.

Competitive advantages and demographic trends bode well for the business; however, the continued shift in the way people shop and buy prescriptions is a headwind.

That all said, the stock does appear to be undervalued here…

The P/E ratio is sitting at 16.57 right now, which compares quite favorably to the stock’s own five-year average P/E ratio of 20.0. Investors are also paying substantially less for the company’s cash flow relative to what they’ve typically paid, on average, over the last three years. And the yield, as pointed out earlier, is significantly higher than its own recent historical average.

So the discount looks pretty clear. But what might the stock be worth? How cheap might this stock be?

I valued shares using a dividend discount model analysis.

I factored in a 10% discount rate and a long-term dividend growth rate of 7.75%.

That growth rate is on the higher end of what I normally factor in; however, the demonstrated long-term dividend growth, forecast for growth moving forward, and moderate payout ratio all support that expectation.

Notably, this growth rate is a bit lower than what I used the last time I valued CVS, as the business has deteriorated ever so slightly since then.

CVS could actually grow its EPS much slower than anticipated, yet the dividend could easily grow at 7% to 8% for a very long period of time with no issue (due to where the payout ratio is).

The DDM analysis gives me a fair value of $95.78.

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.

My analysis and valuation concludes that CVS is at least moderately undervalued here, perhaps considerably so.

But I like to compare my conclusion with that of what professional analysis firms come up with, as this adds perspective, depth, and value to the piece.

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 $109.00.

CFRA (formerly 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.

CFRA rates CVS as a 3-star “HOLD”, with a fair value calculation of $108.80.

So we can see I came out the most conservative. I tend to err on the side of caution, and this provides even more upside surprise/downside protection. But averaging the three numbers out gives us a final valuation of $104.53, which would indicate the stock is potentially 30% undervalued right now.

CVS_chartBottom line: CVS Health Corp. (CVS) is a high-quality business that’s well-positioned to continue growing briskly, both because of and despite its size. While there are key long-term headwinds to consider, the valuation seems to more than factor these in. With the possibility of 30% upside on top of a yield that’s almost 100 basis points higher than its five-year average, this stock appears to be a very solid long-term dividend growth investment here.

— Jason Fieber

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