This High-Quality Dividend Growth Stock Looks 13% Undervalued

The Valuation Zone is where we look for good dividend growth companies that are selling at an attractive price.

This month’s stock is Pfizer (PFE). Pfizer is a high-quality pharmaceutical company. By “high-quality,” I mean things like this:

• Value Line Safety rank of 1 (highest)
• Value Line Financial Strength grade of A++ (highest)
• Morningstar Economic Moat rating of Wide (highest)
• S&P Credit Rating of AA (high investment grade)

Pfizer is a Dividend Challenger with an 8-year streak of increasing its dividend. Pfizer’s dividend yield is 3.9%, and its most recent increase, earlier this year, was 6.3%

As always, before we take a look at Pfizer’s valuation, we’ll check to see if its dividend is safe. Most dividend growth investors require a safe dividend before considering investing in a stock.

Pfizer’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 Pfizer:

Simply Safe Dividends’ score of 86 out of a possible 100 points places Pfizer into their highest safety category. They believe that Verizon’s dividend is very safe.

Pfizer’s Valuation

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 Pfizer’s actual price.

By this method, Pfizer is undervalued, because its price line is below the orange reference fair-value line.

Here’s how to calculate the degree of undervaluation: Compare the P/E ratios.

Pfizer’s current P/E is 12.9 (circled). The orange line was drawn with a P/E of 15. Make a ratio out of them, like this:

Actual P/E divided by Reference P/E
12.9 / 15 = 0.86

The 0.86 translates to 86%. In other words, Pfizer’s P/E is 14% below the “fair” reference P/E of 15. That means Pfizer’s price is 14% under its fair price. For a new buyer, that’s attractive.

Here’s how to calculate Pfizer’s fair price: Divide its actual price by that same ratio:

Actual price / 0.86
$35.17 /6 = $40.90

I round price amounts off to the nearest dollar, because I don’t want to create a false sense of precision. Valuing stocks is part art, part math. Different valuation methods will produce different results. So Pfizer’s fair price rounds off to $41.

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 utilizing data on how the market has historically valued Pfizer itself rather than by how the market has valued all stocks. I use the stock’s 5-year average P/E ratio for this step.

This 2nd step paints a similar picture, although the gap is smaller. That’s because Pfizer’s 5-year historical P/E has averaged out to 13.7 (circled), which is less than the ratio of 15 that was used as a reference point in the first step.

Using the same equations as in the first step, the degree of undervaluation is 12.9 / 13.7 = 0.94, or 6% undervalued. We get a fair price of about $37.

Step 3: Morningstar Star Rating

The next step is to see how Morningstar values the stock. Morningstar takes a different approach to valuation, and it is useful to utilize diverse methods of assessment.

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 Pfizer is undervalued.

This graph shows the last 5 years of Morningstar’s fair valuation estimates (red line) compared to Pfizer’s actual price (black marks).

As you can see, they recently raised their fair value estimate. They calculate a fair price of $43.50. Pfizer’s actual price is in the blue “undervalued” area of the chart, about 19% below the fair value estimate.

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, because you are “paying less” for the stock’s dividends. It’s a sign the dividends are on sale.

This display from Simply Safe Dividends shows Pfizer’s yield over the past 5 years and its current yield (the green dot).

The company’s current yield of 3.9% is above the 5-year average of 3.5%. That suggests an undervaluation. The degree of undervaluation is 3.5 / 3.9 = 0.90, or 10% undervalued.

Using the same equation as in prior steps, the 10% undervaluation suggests a fair price of $35 / 0.90 = $39.

Valuation Summary

Now we average the 4 approaches.

The average of the 4 fair-price estimates is $40, compared to Pfizer’s actual price of $35. That’s a 13% discount to fair value, suggesting a nice margin of safety for someone buying the stock now.

Closing Thoughts

I do not own Pfizer. However, such a high-quality company selling at a decent discount makes it an attractive opportunity, in my opinion.

I have a dividend reinvestment in my Dividend Growth Portfolio coming up in May. If Pfizer remains attractively valued, I will strongly consider it for that reinvestment.

That said, I never suggest that anyone should take action based solely on one of my articles. A fuller analysis would be required.

Therefore, this is not a recommendation to buy Pfizer. Perform your own due diligence. Check the company’s dividend record, business model and quality, financial situation, 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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