Welcome back to the Valuation Zone. Once a month, we look for a well-valued dividend growth stock.
I have a little story to tell. Last October, I wrote up JM Smucker Co. (SJM) as my Dividend Growth Stock of the Month. In addition to being a strong company, I thought that the stock was 19% undervalued.
I liked Smucker so much that when I had some cash to invest in my Dividend Growth Portfolio, I bought 15 shares of the stock. That was on November 1, 2017.
Not only that, the company has paid 3 quarterly dividends, adding another 2.2% return.
Therefore, Smucker’s total return in about 7 months was 11.7% – not counting any value I’ve received from reinvesting those dividends.
Let’s just focus on the price return piece (9.5%) and ignore the dividends for a moment.
In Dividend Growth Investing Lesson 11, on valuation, I made the point that if all you know is a stock’s price, you know nothing about its valuation.
Smucker over the last 7 months is a perfect illustration of that principle. What do we know about its price? That it has gone up 9.5% since last November 1.
If Smucker’s price is now 9.5% higher than it was when I bought it, one might think, “It couldn’t possibly be well-valued now.”
One would be wrong. Smucker’s price, while up 9.5% in 7 months, is still well valued. Let’s demonstrate that.
To see how I value a stock, please read Dividend Growth Investing Lesson 11: Valuation. In a nutshell, I assess the stock in 4 different ways, then average the results out.
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.
The P/E = 15 reference for fair value is shown by the orange line on the following graph, while the black line is Starbucks’ actual price.
By this first method, Smucker is a little undervalued. That’s because its current actual P/E ratio of 14.0 (circled) is a bit under the market’s historical P/E average of 15. Its price (black line) is a bit under the orange fair-value reference line.
To calculate the degree of undervaluation, we make a ratio out of the two P/Es.
Formula for Measuring Valuation on FASTGraphs
Actual P/E divided by Reference P/E
14.0 / 15 = 0.93
That translates to Smucker being 7% undervalued.
Here’s how to calculate Starbucks’ fair price under this first method: Divide its actual price by that same valuation ratio:
Formula for Calculating Fair Price
Actual Price divided by Valuation Ratio from above
$113 / 0.93 = $122
I round prices off to the nearest dollar so as not to create a false sense of precision. Valuing stocks is part art, part math.
Under this step, Smucker is selling for $9 less per share than what we think its fair price is.
I call anything within +/- 10% of fair price “fairly valued.” Again, valuation is part art, so I don’t want to make it sound more precise than it actually is.
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 Smucker itself rather than by how the market has valued all stocks.
I use the stock’s 5-year average P/E ratio (circled) for this step.
This 2nd step makes Smucker look more undervalued, because Smucker has historically carried a higher P/E ratio than the 15 that was used in the first step. Its 5-year average is 18 (circled).
As in the first step, we make a ratio out of the P/Es to assess the degree of undervaluation.
The valuation ratio is 14.0 / 18 = 0.78. The stock appears 22% undervalued.
The fair price calculation is $113 / 0.78 = $145. Smucker is selling for $32 less than our calculation of its fair value using this second step.
Step 3: Morningstar Star Rating
The next step is to see how Morningstar values the stock.
Morningstar takes a different approach to valuation. They ignore P/E ratios.
Instead, they use a discounted cash flow (DCF) model. Using conservative estimates as inputs, 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 Smucker is undervalued.
Morningstar spells out their fair value and degree of undervaluation.
As you can see, Morningstar calculates a fair price of $129. They consider Smucker to be 13% undervalued.
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 as if the dividends, and the stock itself, are on sale.
This display from Simply Safe Dividends shows Smucker’s yield over the past 5 years and its current yield (the green dot).
To calculate the degree of undervaluation, we form a ratio of the yields:
Formula for Measuring Valuation by Comparing Yields
Historical Yield divided by Current Yield
2.3% / 3.0% = 0.77
When using this 4th valuation step, I cut off undervaluation ratios at 0.8. That’s because I consider yield comparisons to be an indirct way of measuring valuation, so I want to be conservative. Therefore I round the 0.79 to 0.8.
That’s not much difference in this instance, but sometimes it is a significant adjustment.
The fair price is computed using the (adjusted) valuation ratio the same way as in earlier steps. We get $113 / 0.8 = $141.
By the way, Simply Safe Dividends rates the safety of Smucker’s dividend at a near-perfect score of 97 out of 100 points.
Smucker’s Valuation Summary
Now we average the 4 approaches.
The average of the 4 fair-price estimates is $133, compared to Smucker’s actual price of about $113. That’s a 15% discount to fair value, suggesting that there is a margin of safety for someone buying the stock now.
In my Dividend Growth Portfolio, I have a dividend reinvestment coming up later this month. I will consider adding to my position in Smucker when that time comes, along with a few other candidates.
The short list will include other stocks that I have recently evaluated favorably such as Dominion Energy (D), which would be a new addition to the portfolio; Procter & Gamble (PG), which would add to an existing position; Medtronic (MDT), which would be a new position; and PPL (PPL), which would be new.
My colleague Mike Nadel has placed Dominion into Daily Trade Alert’s Income Builder Portfolio. His most recent report on that portfolio can be found here. And Procter & Gamble and Medtronic are featured in Daily Trade Alert’s “9 Best Stocks to Own Right Now” special report for August.
In any event, this is not a recommendation to buy Smucker or any of the other stocks listed. Perform your own due diligence. Check the company’s dividend record, business model, quality, financial situation, and prospects for the future, as well as its effect on your portfolio’s diversification.
And as always, consider whether it fits (or does not fit) your long-term investing goals.
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