If you’re looking to build long-term wealth, high-quality stocks offer one of the easiest possible paths.
They feature low transaction costs, are highly liquid, and the long-term returns are the highest of all asset classes out there.
Plus, if you’re investing in stocks that regularly pay and raise dividends, like I do, you get a steady stream of cash flow that should outpace inflation.
Good stuff, right?
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You could invest in real estate, but the transaction costs are through the roof and it’s not particularly liquid.
Gold provides no cash flow.
Interest rates are historically low, so that limits your opportunity in fixed-income.
So you see why I have most of my wealth tied up in high-quality dividend growth stocks.
And if you’re looking for a good list of such stocks, David Fish’s Dividend Champions, Contenders, and Challengers document is a great place to start. He’s already done the hard work for you by compiling all US-listed stocks with at least five consecutive years of dividend raises.
However, while I regularly espouse the benefits of this strategy, I do not recommend to just buy stocks at any price. Valuation is extremely important in regards to buying stocks – even high-quality stocks – and it’s important to remember that price and value are not one and the same.
Merchandise of any type, including stocks, come with price tags attached. Sometimes these prices are reasonable. Other times they’re not. Once in a great while, you might get lucky and score a great deal on something.
For instance, we routinely see major electronics go on sale for Black Friday, right? You might see 50″ televisions being sold for $299 that day only. That’s a good value, especially when televisions of that size are routinely sold for $499. But if that same television goes up to $799 the next day it’s no longer a good value. The price changed, but the value and product didn’t.
It’s the same with stocks. Prices on stocks go up and down all the time, but the value doesn’t change that quickly. As such, it’s important to know the difference between price and value. If you’re looking for further reading on how to separate the two, David Van Knapp put together a solid piece on this site which discusses stock valuation.
Cheaper dividend growth stocks means the yield they offer are higher – yield and price are inversely correlated. Therefore, I’m always looking to buy stocks on sale.
I routinely scan my portfolio and watch list for stocks that are undervalued, and I’m going to share one of those potential opportunities with you today.
Chevron Corporation (CVX) is a global integrated oil and gas company, with interests in exploration, production, refining, marketing, and petrochemicals.
Oil prices may oscillate up and down based on global supply and demand, but Chevron has been consistently excellent at returning rising cash flow to shareholders via increasing dividends.
Check this out: They’ve increased their dividend for the last 27 consecutive years. That time frame encompasses a lot of oil price cycles, yet shareholders wouldn’t know a thing. They just keep getting more cash. I’m a shareholder in this company, so you can count me in as one that is giddy to receive more and more dividends from this company.
Over the last decade alone, CVX has increased its dividend by an annual rate of 10.6%.
Very, very solid.
And the stock yields a very healthy 3.74% right now, which is about twice what the broader market yields.
Meanwhile, that fairly large dividend is well-covered by earnings, with a payout ratio of just 40.8%.
I try to buy stocks with payout ratios of 50% or less, and that’s because if a company is sending out too much cash to shareholders in the form of dividends it becomes hard to continue growing the business. In Chevron’s case, they’re only sending out ~41% of profits to shareholders, while keeping the other ~59%, which allows them to grow. All that and a 3.74% yield!
Oil prices have been weak lately. In fact, Brent Crude fell below $90/bbl on October 9 for the first time in two years – from $106/bbol at the beginning of August. That can have a major effect on the prices of oil stocks, like Chevron. And that’s because higher oil prices results in more profitability. The greater the spread between the cost of drilling for oil and gas and the price of those resources on the open market, the better off an oil supermajor like Chevron is.
So Chevron’s stock is down some -8.39% over the last month alone. Compare that to the S&P 500 index’s -2.85% decline over the same time frame and you can sense where there might be an opportunity.
CVX is priced at $115.07 per share right now. But price alone doesn’t tell us the whole story. We have to find the stock’s value to know if that price is advantageous or not.
What’s CVX worth?
Well, I like to look at a company’s prior decade in terms of fundamental performance. This generally gives me a good idea on what kind of growth they’re experiencing.
And any company is ultimately worth the amount of cash flow it can return from now until infinity, discounted back to the present day.
So let’s take a look at Chevron’s growth over the last 10 years, which would allow us a reasonable estimate of growth going forward.
Revenue has increased from $150.865 billion in fiscal year 2004 (ends December 31) to $228.848 billion in FY 2013. That’s a compound annual growth rate of 4.74%. Not extremely impressive, but oil prices do oscillate quite a bit, as discussed above, which can have a material impact on Chevron’s results.
Earnings per share grew from $6.14 to $11.09 during this same time frame, which is a CAGR of 6.79%. That’s quite a bit better, as EPS growth has been bolstered by an aggressive share buyback program – Chevron reduced their share count by approximately 200 million during this 10-year stretch. Meanwhile, S&P Capital IQ predicts EPS will grow at a compound annual rate of just 2% over the next three years, hampered by tepid production growth, and supply/demand concerns.
Looking at Chevron’s balance sheet we see a fortress. The long-term debt/equity ratio was 0.13 as of the end of FY 2014, while interest payments are negligible.
Profitability appears solid. Net margin has averaged 9.23% over the last five years, while return on equity has averaged 18.02% over that time frame. These numbers compare well with major peers.
So what do all these numbers mean? How do we know we’re getting a good value?
Well, CVX shares are trading hands for a price-to-earnings ratio of 10.93. That means investors are willing to pay almost $11 for every $1 in profit that Chevron generates. Seems pretty reasonable, considering the broader market is around 18 and CVX’s five-year average P/E ratio stands at 10.3
I valued shares using a dividend discount model analysis with a 10% discount rate and a 6.5% long-term growth rate. I used this growth rate due to it being in line with CVX’s long-term earnings growth rate, but also well below its dividend growth rate over this time frame. So this would appear to be a rather conservative valuation. The DDM analysis gives me a fair value of $130.23.
The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide. The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth. It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today. I find it to be a fairly accurate way to value dividend growth stocks.
But I don’t blame you if you don’t want to take just my word for it. What about professional analysts? What do they value Chevron’s stock at?
Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system. 1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value. These stars are meant to coincide with predicted returns, as a stock that is substantially overvalued will likely lead to subpar returns.
Morningstar rates CVX as a 4-star stock, with a fair value estimate of $132.00.
I also like to compare my analysis to S&P Capital IQ, another professional analyst service. They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.
S&P Capital IQ rates CVX as a 4-star “buy” with a fair value calculation of $124.70.
It looks like all three of these fair value estimates are reasonably close to one another, which likely reduces the chances of one or more being completely incorrect. Averaging all three of these numbers together gives us a fair value on CVX of $128.98. That’s about 11% higher than today’s price, which means we might have a high-quality stock selling for less than what it’s really worth.
Bottom line: Chevron Corporation (CVX) is one of the world’s largest energy companies. It has almost unmatched scale and expertise in exploring for and producing petroleum, natural gas, and petrochemicals. They’ve increased their dividend for the last 27 consecutive years, and I see no reason that won’t continue for the foreseeable future. CVX’s yield is about twice what the broader market offers, while the stock appears to be a touch more than 10% undervalued. If you’re looking for a high-quality oil company in your portfolio, this could be your opportunity.
Jason Fieber, Dividend Mantra