This Dividend Growth Stock Looks 15% Undervalued

It’s time for our monthly foray into the Valuation Zone. The Zone is a forest where we look for specific trees: Good, solid dividend growth companies that are also selling at a fair price, or better yet, selling at a bargain price.

This month’s stock is Omnicom Group (OMC). Omnicom is a global leader in marketing communications. They have an inter-connected global network of leading marketing communications companies that do creative work for some of the world’s most iconic and successful brands.

Omnicom offers a comprehensive menu of marketing solutions, including brand advertising, customer relationship management (CRM), media planning and buying, and public relations services.

Omnicom is a Dividend Challenger with a 9-year streak of increasing its dividend. Omnicom’s dividend falls into the medium-yield, fast-growth category.

The company currently yields 3.3% and sports a 5-year dividend growth rate of over 14%.

Its most recent increase was 9.1% in January.

As always, before we take a look at Omnicom’s valuation, we’ll 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.

Omnicom’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 analyze cashflow, payout ratios, and several other metrics to arrive at an opinion about dividend safety. They summarize their results on this scale.

Here is how Simply Safe Dividends scores Omnicom:

Simply Safe Dividends’ score of 86 out of a possible 100 points places Omnicom in their highest safety category. They believe that Omnicom’s dividend is very safe and extremely unlikely to be cut.

I also use a second service, the Oxford Club’s Safety Net Pro. Unfortunately, Omnicom is not in their database.

Now 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 how this works, 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 Omnicom’s actual price.

By this first way of estimating valuation, Omnicom is a bit undervalued. Its price line is a little below the orange reference line.

It is simple to calculate the degree of undervaluation. We divide the stock’s actual P/E ratio of 14.2 (circled in red) by the ratio of 15 that was used to draw the orange line.

We get 14.2 / 15 = 0.95, or 95%. This suggests that Omnicom is 5% undervalued.

If we divided Omnicom’s currrent price by that ratio, we get the stock’s fair price. That’s $73 / 0.95 or about $77 for 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

The next step is to compare the stock’s current P/E ratio to its own long-term average P/E ratio. This lets us judge fair value by recognizing how the market has historically valued Omnicom itself rather than by how the market has valued all stocks. I use the stock’s 5-year average valuation ratio for this step.

This 2nd step makes Omnicom appear to be more undervalued than the first step. That’s because its 5-year historical P/E has averaged out to 16.9, which is higher than the 15 that was used as a reference point in the first step.

Omnicom’s current P/E is 14.2. Using the same equation as in the first step, the degree of undervaluation is 14.2 / 16.9 = 0.84, or 16% undervalued. We get a fair price of about $89.

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 think that Omnicom is undervalued. They calculate a fair price of $85.

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.

Omnicom’s current yield is 3.3%. According to Morningstar, its 5-year average yield is 2.6%. Thus Omnicom’s yield is 27% higher 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, Omnicom is undervalued, and its fair price would be $91.

Valuation Summary
Now we average the 4 approaches.

The average of the 4 fair-price estimates is $86 compared to Omnicom’s actual price of $73. That’s a 15% discount to fair value, making the stock clearly undervalued according to the methods that I use.

It appears that Omnicom 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 yield of 3.3% is attractive.

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 Omnicom. 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

This Stock Could Be Like Buying Amazon in 1997 [sponsor]
A little-known Canadian company just went public and it's already made people rich, including one lucky insider -- a ski-bum with strong coding skills -- who made $782 million with his stake in the company. But that's not why investors are buying shares hand over fist right now. The real reason is that they think this stock will make them rich, too. Click here to learn how you can profit.