This Dividend Growth Stock is Potentially 22% Undervalued

About a year ago, I valued CVS Health (CVS), finding it to be fairly valued.

Since then, CVS’s price has gone pretty much sideways after a 2-month slide. Its yield has mirrored the price moves, going higher as the price went lower, as shown in this 1-year chart.

CVS raised its dividend almost 18% in January. The company is a Dividend Challenger with an increase streak of 14 straight years.

Let’s see whether CVS’s price lethargy over the past year has improved its valuation.

Dividend Safety

I like to 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 this scale to score dividend safety:

Here is how Simply Safe Dividends scores CVS:

Simply Safe Dividends’ score of 97 out of a possible 100 points for dividend safety suggests that CVS’s dividend is very safe and extremely unlikely to be cut.

Safety Net Pro gives CVS a similar grade. They use the following scale to score dividend safety:

Here is how Safety Net Pro scores CVS:

Now let’s see how the company’s stock stacks up in terms of fair price.

Valuation Steps

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

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.

For its 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 CVS’s actual price.

The black price line is below the orange fair-price line. That suggests that CVS is undervalued.

We can calculate the degree of undervaluation.

We simply divide the stock’s actual P/E ratio of 13.3 (shown at the upper right) by the ratio of 15 that was used to draw the orange line.

We get 13.3 / 15.0 = 0.89.

Translating that to 89%, this step suggests that CVS is 11% undervalued.

We can calculate CVS’s fair price in dollars by dividing its current price by 0.89.

That’s $77.97 / 0.89 or about $88. (I round fair-value estimates off to the nearest dollar to avoid creating a false sense of precision.)

Step 2: FASTGraphs Normalized Valuation

In the second step, we compare the stock’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 CVS itself rather than by how the market has valued all stocks over many years.

This step also suggests that CVS is undervalued. The degree is computed the same way: CVS’s average valuation going back 10 years has been P/E = 17.0 (see the dark blue box in the right panel). So the degree of undervaluation is 13.3 / 17.7 = 0.75, or 25% undervalued. In my book, that is very undervalued.

Using the same equation as in the first step, we get a fair value price of $77.97 / 0.75 = about $104.

Step 3: Morningstar Star Rating

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

Morningstar ignores P/E 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.)

Morningstar’s ratings scale goes from 1 to 5 stars. Morningstar states that 3-star stocks should offer a “fair return” (one that adequately compensates for the riskiness of the stock). 5-star stocks are very undervalued, while 1- and 2-star stocks have lower expected returns going forward from their current price, because they are overvalued.

Morningstar’s 4 stars indicates that they too consider CVS to be undervalued. They think that CVS is 28% undervalued, leading to a fair price estimate of $109 per share.

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.

CVS’s current yield is 2.6%. According to Morningstar, its 5-year average yield is 1.5%. Thus CVS’s yield is 53% higher than its 5-year average.

That is a huge gap, created by a combination of rapid dividend increases with the stock’s languishing price. This 10-year chart shows how CVS’s price grew about as fast as its dividend until mid-2014. After that, its price shot up until mid-2016, then came back down and stagnated this year. Meanwhile its dividend kept going up, creating the rapid rise in the stock’s yield that we saw earlier.

In applying this 4th method of valuation, I cut off valuation gaps at 20%, because this valuation method is inherently indirect.

Doing the math using a 20% undervaluation estimate, we get a fair price estimate of about $97.

Valuation Summary

So using the 4 approaches just described, our valuation for CVS comes out like this.

The average of the 4 fair-value estimates is $100 compared to CVS’s actual price of about $78. That’s a 22% discount to fair value, which I call “very undervalued.”

Disclosure and Caution

I do not own CVS. The fact that the stock’s valuation is favorable does not mean that I would select it for my own portfolio. A fuller analysis would be required. I suspect that CVS’s apparent undervaluation is partly caused by the current political uncertainty around healthcare insurance, among other factors.

As always, this is not a recommendation to buy CVS. 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

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