I’m constantly scanning David Fish’s Dividend Champions, Contenders, and Challengers document for potential opportunities.
What do I mean by “opportunities”?
Well, I’m talking about high-quality stocks that are selling for a discount to their intrinsic value.
[ad#Google Adsense 336×280-IA]Think about it.
In our everyday lives, aren’t we usually trying to buy something for less than it’s worth?
Trying to score a “deal”?
That’s exactly what I’m attempting to do with stocks on a regular basis as well.
I first do my best to determine a reasonable idea on what a stock is worth – its intrinsic value.
And if you’re looking for some help on how to do that, check out this resource that the venerable David Van Knapp put together.
Once I have a good idea on what a stock is worth, I try to buy it far enough below that number so as to receive a “margin of safety”, or a sizable gap between the price I pay and what the stock is worth, so that there’s some room for error.
Now, I focus on dividend growth stocks – stocks that regularly and reliably pay and increase dividend payments. And buying a cheaper dividend growth stock means the yield on that stock will be higher, since price and yield are inversely correlated.
So cheaper stocks come with higher yields, meaning the same dollar can buy more future dividend dollars. Nice!
As I mentioned at the outset, I’m constantly scanning for opportunities. Sometimes an opportunity comes in the form of a stock I already own, and sometimes not.
This is one of those times that it’s not.
So I’m going to share a dividend growth stock that I recently discovered that appears to be priced below its intrinsic value.
National Oilwell Varco, Inc. (NOV) designs, manufactures, and provides equipment and components used in oil and gas drilling for the upstream oil and gas industry. They also provide oilfield services and supply chain integration services.
NOV might not have the lengthy dividend growth track record that some of the other stocks I track possess, but some of the metrics are pretty impressive.
They’ve been increasing their dividend for the last six consecutive years. Not an incredible record by itself, but it gets better.
Over the last three years, they’ve increased their payout by an annual rate of 30.4%. Not too shabby, right?
The stock yields 2.57% here, which is fairly attractive.
And the payout ratio is moderately low, at just 30.1%.
So there’s plenty of room for sizable future dividend raises.
There’s a lot to like here with the dividend. They’re actively growing it at a robust rate and the yield is well-supported by a low payout ratio.
So let’s take a look at the underlying growth of the company to get a better picture of what’s going on.
Revenue grew from $2.318 billion in fiscal year 2004 to $22.767 billion in FY 2013. That’s a compound annual growth rate of 28.90%. That’s extremely impressive.
Earnings per share growth has been just as impressive, increasing from $0.64 to $5.44 during this time frame, which is a CAGR of 26.84%. Wow.
S&P Capital IQ predicts EPS will grow at a CAGR of 14% over the next three years, which is below what they’ve historically managed, but still quite vigorous.
Meanwhile, the balance sheet is extremely sturdy with low leverage. The long-term debt/equity ratio stood at 0.14 at the end of FY 2013, while the interest coverage ratio is 31.1. Great numbers here.
Profitability is solid. Net margin has averaged 12.30% over the last five years, while return on equity has averaged 11.29% over the same period. These figures are roughly in line with peers, though some competitors do sport slightly higher metrics.
The fundamentals look fairly incredible. I wish the net margin and ROE was a bit higher, but that’s probably nitpicking.
But while this appears to be a great stock, even great stocks aren’t worth paying too much for. I love to buy great stocks, but buying them “on sale” really makes my day.
So what’s the stock worth?
Well, NOV trades hands for a P/E ratio of 12.03. That’s below its five-year average of 14, and also below the broader market’s average of 18.
We might have a deal on our hands, but let’s actually put a number on shares here.
I valued shares using a dividend discount model analysis with a 10% discount rate and an 8% long-term growth rate. This rate is below NOV’s historical growth rate for earnings, and also below what the company has been growing its dividend at lately. Factoring in the substantial growth in profit with a low payout ratio and I think this growth rate is reasonable. The DDM analysis gives me a fair value of $99.36.
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 you might want some other opinions, so I’ll give them to you.
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 NOV as a 4-star stock, with a fair value estimate of $89.00.
S&P Capital is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line. 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 NOV as a 3-star “hold”, with a fair value calculation of $88.10.
So I’ll average these three numbers out, which should give us a reasonable estimate as to fair value. And that average is $92.15. That means shares could potentially be more than 25% undervalued here. Even if shares aren’t worth quite as much as the three numbers indicate, it would appear there’s some substantial value here.
Bottom line: National Oilwell Varco, Inc. (NOV) sports some of the most impressive fundamentals I’ve ever seen, and offers products and services stretching the gamut of drilling. If you believe energy consumption is going to increase globally over the next decade and beyond, this stock appears to offer substantial value. The yield beats the broader market, and it’s set to grow at a rather robust rate moving forward. This appears to be one of the better opportunities on the market right now, and certainly worthy of consideration here.
— Jason Fieber, Dividend Mantra