This Dividend Growth Stock Yields 3.5% and Appears 18% Undervalued

Welcome back to the Valuation Zone.

This month, we’ve got a well-valued dividend growth stock: Principal Financial Group (PFG).

PFG, founded in 1879, provides retirement, asset management, and insurance products and services to businesses, individuals, and institutional clients. Here are some fast facts about the company:

• 3.5% yield
• Good dividend safety grade of 79 (out of 100) from Simply Safe Dividends
• 10-year streak of increasing its dividend; the streak was re-started after a cut in 2009 during the financial crisis
• 5-year dividend growth rate of almost 20% per year, although this year’s increase was just 1.9%
• Good investment grade (A-) credit rating from S&P

Now let’s see why PFG is well valued.

Principal Financial Group’s Valuation

To see how I value a stock, please read Dividend Growth Investing Lesson 11: Valuation. In a nutshell, I assess valuation 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’ most 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 fair value reference line is shown in orange line on the following graph, while the black line is PFG’s actual price.

PFG’s actual price is below the orange line, so by this method, PFG is undervalued.

That’s because its P/E ratio of 10.9 (circled) is well below the market’s historical P/E average of 15 that is used to draw the orange line.

Here’s how to calculate the degree of undervaluation: We make a ratio out of the two P/Es.

Formula for Measuring Valuation on FASTGraphs
Actual P/E divided by Reference P/E
10.9 / 15 = 0.73

That translates to PFG being 27% undervalued. I call anything >20% undervalued “way undervalued.”

Here’s how to calculate PFG’s fair price: Divide its actual price by the valuation ratio that we just calculated:

Formula for Calculating Fair Price
Actual Price divided by Valuation Ratio
$60 / 0.73 = $82

I round prices off to the nearest dollar so as not to create a false sense of precision.

Step 2: FASTGraphs Normalized Valuation

In this step, we “normalize” the comparison to make it specific to the stock’s own long-term P/E ratio rather than the market’s historical average.

We do this by comparing PFG’s current valuation to its own historical valuation. I use the stock’s 5-year average P/E ratio (circled) for this step.

This 2nd step portrays PFG as undervalued again, but less so than in the first step.

That’s because PFG’s 5-year average P/E ratio is 12.2 (circled) rather 15 as was used in the first step.

That has the effect of moving the fair-value reference line down, closer to PFG’s actual price.

As in the first step, we create a valuation ratio from the P/Es.

The calculation is 10.9 / 12.2 = 0.89.

So PFG appears 11% undervalued under this 2nd method. The fair price calculation is $60 / 0.89 = $67.

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 estimated 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, 4 stars means that they think that PFG is undervalued.

As you can see, Morningstar calculates a fair price of $70. They consider PFG to be 15% 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.

What causes the ratio of a stock’s current yield to its historical yield to be high?

There are two reasons:

• The stock price has fallen while the dividend has stayed even or gone up.
• The dividend has increased without a corresponding increase in the stock’s price.

Yield, as you know, is the ratio of dividend to price, so either of the above factors will cause the yield ratio to rise.

Both factors are at play with PFG, as shown on this 5-year chart of PFG’s price and dividend:

You can see that PFG’s dividend (orange line) has risen steadily, while its price (blue line) has been volatile. In 2018, PFG’s price has mostly fallen, leading to its relatively high yield now.

[Source: Simply Safe Dividends]

PFG’s current yield is 3.5% compared to its 5-year average of 2.9%. In other words, PFG’s dividend dollars are “on sale.”

To calculate the degree of discount, we form a ratio of the yields:

Formula for Measuring Valuation by Comparing Yields
Historical Yield divided by Current Yield
2.9% / 3.5% = 0.83

That would suggest 17% undervaluation, and a fair price of $60 / 0.83 = $72.

Principal Financial Group’s Valuation Summary

Now we average the 4 approaches.

The average of the 4 fair-price estimates is $73, compared to PFG’s actual price of about $60. That’s an 18% discount to fair value, suggesting that there is a margin of safety for someone buying the stock now.

Closing Thoughts

With its 3.5% yield, good dividend safety, and 18% undervaluation, I think that PFG is an attractive stock for dividend growth investors to consider right now.

That said, this is not a recommendation to buy PFG. In particular, this year’s low 1.9% dividend increase would need to be investigated. So as always, 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. And as always, consider whether PFG fits (or does not fit) your long-term investing goals.

— Dave Van Knapp

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