As the broader stock market climbs higher and higher, it might seem like it’s impossible to find undervalued, high-quality stocks.
But that’s not necessarily true.
First, it’s important to keep in mind that the stock market is nothing more than a market full of stocks.
Works just like any other market in the sense that it offers a central location to buy and sell merchandise.
[ad#Google Adsense 336×280-IA]And just like any other market full of merchandise, some can be expensive and some is cheap.
But how do you know if a stock is cheap or expensive?
Well, you have to be able to separate price and value first – price is what you’re paying for something, whereas value is what something is actually worth.
The two aren’t necessarily one and the same very often at all.
Once that concept is clear, you go about determining the approximate fair value of a stock, which is something that Dave Van Knapp’s lesson on stock valuation aims to help with.
Why is this important?
Simply put, so that you get a good deal and avoid overpaying.
A stock that pays a $1.00 dividend and priced at $30.00 yields 3.33%. But if you were able to buy that same stock at $25.00, your yield shoots up to 4%. That spread of 67 basis points in yield can have a dramatic difference in your long-term returns, while also reducing risk.
And let’s assume that stock is only worth $25. By paying $30 you’re not only reducing your income via a lower yield, but you’re also increasing the odds that the market will at some point realize that the stock is expensive and reprice it accordingly.
This is why I attempt to add high-quality dividend growth stocks to my portfolio only when they’re fairly priced or better. It’s a strategy that has helped me build a portfolio from zero into almost $200,000 in five years on a modest salary.
Now, if the stock market is nothing more than a market full of stocks, then I like to use David Fish’s Dividend Champions, Contenders, and Challengers list as my “shopping list”.
It contains information on every single US-listed stock – all 690 of them – that has increased its respective dividend for at least the last five consecutive years.
And when looking at that list, I recently came across one stock in particular that exudes not only quality, but also appears to be potentially significantly undervalued.
Let’s take a look!
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 to the upstream O&G industry.
Now, NOV hasn’t been particularly popular lately due to the dramatic fall in the price of crude – the stock is down 20% over the last six months.
But would you rather buy high-quality merchandise after it’s been marked down 20% or after the price has already shot up?
Now, NOV doesn’t have the lengthy dividend growth streak I typically like to see, but at six consecutive years and counting, they are doing right by shareholders.
What’s much more impressive than their dividend growth streak, however, is the dividend growth rate. Over just the last five years, the dividend has increased by an annual rate of 78.2%.
That’s not sustainable over the long term, but it’s still indicative of management’s view on rewarding shareholders with increasing cash dividends.
And with a payout ratio of just 32.3% (even with all that dividend growth), there’s still plenty of room to continue expanding the dividend.
Meanwhile, the stock yields a very attractive 3.33% right now.
That dividend growth can’t materialize out of thin air, so we’ll take a look at what kind of growth the company has managed over the last decade.
This will also help us with valuing the company.
Revenue is up from $4.645 billion in fiscal year 2005 to $21.440 billion in FY 2014. That’s a compound annual growth rate of 18.52%. Extremely impressive, but keep in mind that NOV has acquired a number of businesses during this period.
Earnings per share increased from $0.91 to $5.82 over this stretch, which is a CAGR of 22.90%. Really phenomenal.
S&P Capital IQ is calling for no EPS growth over the next three years, citing continued lack of demand for NOV’s products due to weak oil pricing. However, keep in mind that many of NOV’s products wear, even with wells that are already in use.
One area of strength for NOV which can help them prosper through this time of uncertainty in the energy markets is their balance sheet. Sporting a long-term debt/equity ratio of just 0.15 and a interest coverage ratio of over 34, and you can see that this firm is on excellent financial footing.
In addition, their profitability is really solid. They’ve averaged net margin of 12.28% and return on equity of 11.40% over the last five years, which compares well across the industry.
So we can see that the fundamentals across the board are pretty spectacular. Huge growth, great balance sheet, and a dividend that’s very attractive here. Oil is volatile, but the odds seem pretty good that the world will continue to need more energy over the next 10 or 20 years, and NOV provides the tools necessary to extract energy products.
But is the stock a good deal right now?
The P/E ratio on NOV is 9.71, which is incredibly low. This is because the market expects soft or no growth over the next year or so. Nonetheless, compare that to the five-year average P/E ratio of 14.1.
If the stock is cheap, how cheap? What’s it worth?
I valued shares using a dividend discount model analysis with a 10% discount rate and a 7% long-term growth rate. That growth rate is lower than what I used the last time I looked at NOV, to account for the possibility of lower returns moving forward due to the current energy market. However, that rate is still well below NOV’s long-term growth rate across the top and bottom lines, as well as the dividend. The DDM analysis gives me a fair value of $65.63.
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.
So we could potentially be looking at a vastly undervalued stock here, but my opinion isn’t the only one in town. Let’s check out what some of the analysts think about NOV right now.
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.
Morningstar rates NOV as a 4-star stock, with a fair value estimate of $66.00.
S&P Capital IQ 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 12-month target price of $60.00.
So it looks like there’s a pretty narrow range there. If we average out the three numbers, which gives us a final consensus to work with, we get $63.88. That’s 16% below the $55.28 shares are trading hands for right now.
Bottom line: National Oilwell Varco, Inc. (NOV) offers a combination of a very attractive yield, incredible growth, and very strong fundamentals across the board. There’s certainly volatility right now due to the energy markets, but those who are patient are paid to wait with a yield of 3.33% and potential 16% upside on top of it. Long-term investors who are okay with volatility should strongly consider this stock right now.
— Jason Fieber, Dividend Mantra