This Dividend Growth Stock Appears 19% Undervalued

It’s a new year in the Valuation Zone. The bull market that started in March, 2009 has almost reached its 9th birthday. Seems hard to believe, doesn’t it?

Despite the rise in stock valuations overall, practically every month we are able to find a quality dividend growth company with a safe dividend and decent valuation. This month’s Valuation Zone stock is McKesson Corporation (MCK).

McKesson is a healthcare services provider.

Most of its sales come from the distribution of drugs, health, and beauty care products throughout North America.

It also manufactures automated dispensing systems and provides consulting and outsourcing services for retail pharmacies.

McKesson is a Dividend Contender with a 10-year streak of increasing its dividend.

Its dividend falls into the low-yield, medium-growth category. Its yield is only about 0.9%, but its 5-year dividend growth rate has been over 8% per year, and its increase in 2017 was 21%.

As always, before we take a look at McKesson’s valuation, we check to see if its dividend is safe. For most dividend growth investors, if the dividend isn’t safe, you probably wouldn’t be interested in it anyway.

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

I use Simply Safe Dividends to assess dividend safety. They use this scale.

Here is how Simply Safe Dividends scores McKesson:

Simply Safe Dividends’ score of 95 out of a possible 100 points suggests that McKesson’s dividend is very safe and extremely unlikely to be cut. The grade is in their highest safety ranking category.

I also use a second service, the Oxford Club’s Safety Net Pro. They use this scale to score dividend safety.

Here is their evaluation of McKesson:

They place McKesson in their 2d-highest category, indicating that the company has a safe dividend with a low risk of being cut.

Now that we have confidence in McKesson’s dividend safety, let’s value the stock.

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 current price-to-earnings (P/E) ratio to the historical average P/E ratio of the whole stock market. That historical average is 15.

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

By this first way of estimating valuation, McKesson is undervalued.

To calculate how much, we divide the stock’s actual P/E ratio of 13.0 (shown at the upper right) by the ratio of 15 that was used to draw the orange line.

We get 13 / 15 = 0.87, or 87%. This suggests that McKesson is 13% undervalued. As a potential buyer of the stock, that’s good news.

We can use the 0.87 ratio to calculate McKesson’s fair price. Just divide its current price by 0.87. That’s $161 / 0.87 or about $185 as a fair price. (I round prices off to the nearest dollar so as not to create a false sense of precision.)

Step 2: FASTGraphs Normalized Valuation

Next, 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 McKesson itself rather than by how the market has valued all stocks over many years.

This 2nd step makes McKesson appear to be even more undervalued. That’s because its 5-year historical P/E has averaged out to 15.9 (see the dark blue box in the right-hand panel), which is higher than the 15 that was used to draw the orange line in the first step.

McKesson’s current P/E is 13. Using the same equation as in the first step, the degree of undervaluation is 13 / 15.9 = 0.82, or 18% undervalued. We get a fair price of about $196.

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 DCF works, check out this excellent explanation at moneychimp.)

Under Morningstar’s 5-star system, 4 stars means that they also think that McKesson is undervalued. They calculate a fair price of $210.

Step 4: Current Yield vs. Historical Yield

The 4th and final valuation method is to 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.

McKesson’s’s current yield is 0.87%. According to Morningstar, its 5-year average yield is 0.6%. Thus McKesson’s yield is 45% more than its 5-year average.

For this valuation method, I cut off the difference at 20%, because this is an indirect method of assessing valuation. Other factors beside yield impact a stock’s valuation. Applying the 20% cutoff, McKesson is undervalued, and its fair price would be $201.

Valuation Summary
My overall valuation is an average of the 4 approaches just described.

The average of the 4 fair-price estimates is $198 compared to McKesson’s actual price of $161. That’s a 19% discount to fair value, making the stock clearly undervalued according to the methods that I use.

It appears that McKesson presents a good deal at this time, provided that you think highly of its quality, business model, and execution. Plus, of course, it has to fit into your portfolio and support your investing goals. Its low yield at <1% might disqualify it for many dividend growth investors.

Disclosure and Caution
The fact that a stock’s price is undervalued does not mean that anyone should just go out and buy it. A fuller analysis would be required.

Therefore, as always, this is not a recommendation to buy McKesson. 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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