This Dividend Growth Stock Appears 17% Undervalued Right Now

Background

The Toronto-Dominion Bank (TD) is headquartered in Toronto, Canada. It has more than 85,000 employees around the world. TD offers a full range of financial products and services to over 26 million customers worldwide through three business lines:

• Canadian Retail, which includes trust, business banking, auto finance, wealth management, investing, and insurance services
• U.S. Retail, which offers similar services in the USA
• Wholesale Banking, which includes TD Securities

TD ranks among the world’s leading online financial services firms, with more than 13 million active online and mobile customers.

TD was formed in 1955 through the amalgamation of The Bank of Toronto (chartered in 1855), and The Dominion Bank (chartered in 1869).

Quality Snapshot and Dividend Safety

I derive Quality Snapshots from the following sources, which I have come to trust and respect over the years:

• Safety and Financial Strength grades from Value Line
S&P’s Credit rating
Morningstar’s Moat rating, and
Simply Safe Dividends’ Dividend Safety grade.

TD is a very high-quality company. It gets green scores across the board, including three scores in the highest grading level.

On a 0-to-5-point scale for each metric, TD would score 23 out of 25 points. That’s really good.

Regarding dividends, TD yields 4.1%.

It does not register as a Dividend Champion because of exchange rates, but in Canadian dollars, TD has increased its dividend for 8 straight years and has been paying dividends regularly going back to 1969.

It did freeze its dividend over 10 consecutive payments during the financial crisis (2008-10).

TD’s dividend increases are generally in the 10% range, making TD a high-yield, fast-growth stock.

Its dividend is very reliable, with the caveat that exchange rates may make its increases and payout amounts look a little jittery to American investors after they are converted to U.S. dollars.

In Canadian dollars, its dividend increase in March, 2019, was 11.7%.

The following graphic from Simply Safe Dividends sums up TD’s dividend growth record.

TD’s Valuation

To value a stock, I use four different methods, then average them out. For more details on my approach, see Dividend Growth Investing Lesson 11: Valuation.

Step 1: FASTGraphs Default Valuation

In the the first step, I check the stock’s current price against FASTGraphs’ basic estimate of its fair value.

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 orange line on this graph represents a fair-price reference line, computed at a P/E ratio of 15. The black line is TD’s actual price.

Since the black line is below the orange line, it suggests that that TD is undervalued. The end of the black line reflects the company’s current P/E ratio, which is 10.7 (circled).

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

Formula for Measuring Valuation on FASTGraphs
Actual P/E divided by Reference P/E = Valuation Ratio
10.7 / 15 = 0.71

That valuation ratio suggests that TD is 29% undervalued.

The FASTGraph is calculated in Canadian dollars. The stock’s actual price in U.S. dollars is about $55. To calculate its fair price, divide its actual price by the valuation ratio:

Formula for Calculating Fair Price
Actual Price divided by Valuation Ratio = Fair Price
$55 / 0.71 = $78

Valuations are assessments, not physical traits, so we want several points of view. We’ll get more from the following steps.

Step 2: FASTGraphs Normalized Valuation

In this step, we “normalize” the fair-value reference line to reflect the stock’s own long-term valuation rather than the market as a whole.

I use the stock’s 5-year average P/E ratio (circled) for this step. The fair-price reference line is in blue on this graph.

This method suggests that TD’s price is closer to its fair value than the first step. TD’s 5-year average P/E ratio (circled) is 12.5, which is lower than the 15 used in the first step, and also closer to TD’s actual current P/E ratio.

The formulas for the valuation ratio and fair price are the same as in the first step. Applying them, we get:

Valuation ratio: 10.7 / 12.5 = 0.86, or 14% undervalued
Fair price: $55 / 0.86 = $64

Step 3: Morningstar’s Valuation

The next step is to consult Morningstar’s valuation of the stock.

Morningstar ignores P/E and other valuation ratios.

Instead, they use a discounted cash flow (DCF) model. Using conservative 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:

Morningstar gives TD three stars, which means fairly valued. Looking at the details, their actual calculation is that TD is 9% undervalued, but that’s within their fair-value band.

Morningstar calculates a fair price of $61 per share.

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.

With a well-valued stock, you can buy more shares with your money. Because dividends are paid per share, you will get more dividends for that money.

TD’s dividend yield has increased recently because its dividend has gone up while its price has remained flat since the beginning of 2018.

Thus, TD’s current yield is higher than its 5-year average.


TD’s current yield of 4.1% is 11% higher than its 5-year average yield of 3.7%. That suggests that the stock is undervalued.

To calculate the degree of discount, I again form a valuation ratio, this time by comparing the yields:

Formula for Measuring Valuation by Comparing Yields
5-Year Average Yield divided by Current Yield = Valuation Ratio
3.7% / 4.1% = 0.90

That would suggest 10% undervaluation. I consider anything within +/- 10% of fair price to be fairly valued, but we do get a fair price that is 11% higher than TD’s recent closing price.

Using 0.90 as our valuation ratio, we get a fair price of $55 / 0.90 = $61.

TD’s Valuation Summary

Now we average the 4 approaches.

The average of the four methods suggests a fair price for Toronto-Dominion of $66, compared to its actual price of about $55.

That makes TD 17% undervalued at the present time, according to my estimation methods.

Closing Thoughts

With its good yield, very high quality rankings, and 17% undervaluation, I think that Toronto-Dominion is a very attractive dividend growth investment.

I have a dividend reinvestment coming up in my Dividend Growth Portfolio in October or November, and if the valuation holds up, TD will be on my shopping list. I have had my eye on the Canadian banks for a long time, and this might be a good chance to get involved with one of them.

Here is an excellent article discussing TD in detail on Daily Trade Alert:

This High-Yield Stock Has Paid Dividends Since 1857 (Brian Bollinger, April 2017)

TD is also a component of Jason Fieber’s FIRE Fund early-retirement portfolio.

For a complete analysis of another one of the Canadian “Big Five” banks, see this article of mine from May about Canadian Imperial Bank of Commerce.

This is not a recommendation to buy Toronto-Dominion. As always, perform your own due diligence. Check the company’s complete dividend record, business model, financial situation, and prospects for the future, as well as its effect on your portfolio’s diversification. And always be sure to consider how and whether any asset fits (or does not fit) your long-term investing goals.

— Dave Van Knapp

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