This Dividend Growth Stock Yields 5.8% and Appears 14% Undervalued Right Now

Welcome back to the Valuation Zone. Let’s find a well-valued dividend growth stock.
I have owned Philip Morris (PM) in my Dividend Growth Portfolio since 2013. At the current time, it is paying a 5.8% yield – quite a bit higher than its 5-year average.

The reason for the high yield is an extended price drop that has been happening since mid-2017, shown by the blue dot on the following graph. The 5-year span of the graph roughly matches the time that I have owned PM.

Despite the price action, PM has delivered dividends quarterly, increasing every year, since it was spun off from Altria (MO) in 2008. Earlier this year, PM raised its dividend by 6.5%. Its next payment, expected in October, hasn’t been announced yet.

[Source: Simply Safe Dividends]

According to Simply Safe Dividends, PM’s dividend is safe:

Let’s see if PM is well valued.

Philip Morris’s Valuation

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 PM’s actual price.

By this method, PM is a little overvalued. That’s because its current P/E ratio of 15.9 (circled) is a bit above the market’s historical P/E average of 15. Therefore its price (black line) is a bit over the orange fair-value reference line.

To calculate the degree of overvaluation, we make a ratio out of the two P/Es.

Formula for Measuring Valuation on FASTGraphs
Actual P/E divided by Reference P/E
15.9 / 15 = 1.06

That translates to PM being 6% overvalued. I call anything within +/- 10% of fair price “fairly valued.”
Here’s how to calculate PM’s 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
\$79 / 1.06 = \$75

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 utilizing data on how the market has historically valued PM 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 paints a different picture. PM looks undervalued, because the stock has historically carried a higher P/E ratio – 18.2 – than the 15 that was used in the first step to draw the fair-value line.

As in the first step, we make a ratio out of the P/Es to assess the degree of undervaluation. The valuation ratio is 15.9 / 18.2 = 0.87.

PM appears 13% undervalued under this 2nd method. The fair price calculation is \$79 / 0.87 = \$91.

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 for future projections, 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.) Here is Morningstar’s conclusion:

On Morningstar’s 5-star system, 5 stars means that they think that PM is way undervalued.

As you can see, Morningstar calculates a fair price of \$102. They consider PM to be 23% 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 PM’s yield over the past 5 years (the horizontal line at 4.4%) and its current yield (the green dot at 5.8%).

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
4.4% / 5.8% = 0.76

That would suggest 24% undervaluation, but when using this 4th valuation step, I cut off undervaluation at 20% to be conservative. Therefore I round the 0.76 to 0.8.

The fair price is computed using the (adjusted) valuation ratio the same way as in earlier steps. We get \$79 / 0.8 = \$99.

Philip Morris’s Valuation Summary

Now we average the 4 approaches.

The average of the 4 fair-price estimates is \$92, compared to PM’s actual price of about \$79. That’s a 14% discount to fair value, suggesting that there is a margin of safety for someone buying the stock now.

Closing Thoughts

With its high yield, good dividend safety, and 14% undervaluation, I think that PM is an attractive stock for dividend growth investors right now.

That said, this is not a recommendation to buy Philip Morris. Perform your own due diligence. Check the company’s complete dividend record, business model, quality, financial situation, and prospects for the future, as well as its effect on your portfolio’s diversification.

Some people may have ethical objections to investing in tobacco companies. And as always, consider whether PM fits (or does not fit) your long-term investing goals.

— Dave Van Knapp

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