Welcome to the Valuation Zone. Let’s look for a good dividend growth company that is selling at an attractive price.
This month’s stock is PPL Corporation (PPL).
PPL is an energy and utility holding company with subsidiaries that generate and market electricity in the northeastern and western USA and deliver electricity in Pennsylvania and the UK.
PPL is a high-yield stock with a current yield of 5.7%. Its most recent dividend increase, paid in April, was 3.8%.
As always, before we take a look at a Valuation Zone stock’s pricing, we’ll check to see if its dividend is safe.
Most dividend growth investors require a safe dividend before considering investing in a stock.
PPL’s Dividend Safety
For a complete discussion of dividend safety and reliability, see Dividend Growth Investing Lesson 17: Dividend Safety.
I use Simply Safe Dividends to assess dividend safety. They analyze cashflow, payout ratios, and several other metrics to arrive at an opinion about dividend safety. They summarize their results on this scale.
Here is how Simply Safe Dividends scores PPL:
Simply Safe Dividends’ score of 80 out of a possible 100 points places PPL right on the upper edge of their 2d-highest safety category. Thus, they believe that PPL’s dividend is safe and unlikely to be cut.
To value a stock, I attack the question from 4 directions and then average them out. For a complete discussion of how this works, please read Dividend Growth Investing Lesson 11: Valuation.
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.
That P/E = 15 reference for fair value is shown by the orange line on the following graph, while the black line is PPL’s actual price.
If the orange line represents fair value, then the price being under the orange line suggests undervaluation. As you can see, PPL’s price has been in a downtrend for almost a year, bringing it from overvalued (white area) to undervalued (green area).
To calculate the degree of undervaluation, we compare the P/E ratios of the two lines.
PPL’s current P/E is 12.6 (circled). That’s where the black line ends. The orange line was drawn with a P/E of 15. Make a ratio out of them, like this:
Formula for Measuring Valuation on FASTGraphs
Actual P/E divided by Reference P/E
12.6 / 15 = 0.84
The 0.84 translates to 84%. In other words, PPL’s P/E is 16% below the “fair” reference P/E of 15.
That means PPL’s price is 16% under its fair price. In other words, the valuation is attractive.
Here’s how to calculate PPL’s fair price: Divide its actual price by that same ratio:
Formula for Calculating Fair Price
Actual Price divided by Valuation Ratio from above
$28.65 / 0.84 = $34.11
I round prices off to the nearest dollar, because I don’t want to create a false sense of precision. Valuing stocks is part art, part math. Different valuation methods will produce different results.
So PPL’s fair price under this first method rounds off to $34.
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 PPL 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 similar picture, although the valuation gap is smaller. That’s because PPL’s 5-year historical P/E has averaged out to 13.7 (circled), which is less than the ratio of 15 that was used as a reference point in the first step.
We then use the same equations as in the first step.
The valuation ratio is 12.6 / 13.7 = 0.92.
The fair price is $29 / 0.92 = $32.
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. 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 PPL is undervalued.
This graph shows the last 5 years of Morningstar’s fair valuation estimates (red line) compared to PPL’s actual price (black marks).
As you can see, Morningstar’s Valuation Ratio is 0.82, and they calculate a fair price of $35.
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 are on sale.
This display from Simply Safe Dividends shows PPL’s yield over the past 5 years and its current yield (the green dot).
PPL’s yield has gone up over the past year as its price has fallen. PPL’s current yield of 5.7% is 29% more than its 5-year average of 4.4%. That suggests an undervaluation.
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% / 5.7% = 0.77
When using this method, I cut off the ratio at 0.8, because this is an indirect way to measure valuation.
The fair price is computed using the Valuation Ratio as in earlier steps. We get $29 / 0.8 = $36.
PPL’s Valuation Summary
Now we average the 4 approaches.
Notice that I colored the FASTGraphs Normalized valuation as yellow and called it “Fairly valued.” That’s because I regard any price within +/- 10% of fair value to be a fair price. I do this, again, in recognition of the reality that valuations are assessments, and it can be misleading to represent them as being more precise than they are.
The average of the 4 fair-price estimates is $34, compared to PPL’s actual price of about $29. That’s a 15% discount to fair value, suggesting a nice margin of safety for someone buying the stock now.
I have a dividend reinvestment in my Dividend Growth Portfolio coming up in May. If PPL remains attractively valued, I will strongly consider it for that reinvestment. I am inclined to add a new stock to the portfolio, and PPL is not in the portfolio now.
That said, I never suggest that anyone should take action based solely on one of my articles or to mimic what I own. A fuller analysis would be required.
Therefore, this is not a recommendation to buy PPL. Perform your own due diligence. Check the company’s dividend record, business model and quality, financial situation, and prospects for the future. Also consider whether it fits (or does not fit) your long-term investing goals.
— Dave Van Knapp