This Dividend Growth Stock Appears 12% Undervalued

Background

This month’s Valuation Zone stock is Pfizer (PFE), the global pharmaceutical and consumer-health company based in New York City. Pfizer’s history stretches back more than 150 years.

Ranked by market capitalization, Pfizer is the 5th-largest pharmaceutical company in the world (source).

Quality Snapshot and Dividend Safety

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

Pfizer is one grade short of perfection in this snapshot.

On a 0-to-5-point scale for each metric, the company would score 24 out of 25 points.

Not many companies in the world can match that.

Pfizer’s dividend yield is 3.8%.

It has raised its dividend each year since 2010.

Pfizer’s dividend increases since then have all been in the 6% to 8% range.

Its most recent increase, in March 2019, was just under 6%.

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

Pfizer is in the process of becoming smaller. It plans to spin off and combine its off-patent pharmaceuticals business (called Upjohn) with Mylan (MYL), which is a global generic and specialty-medicines company domiciled in The Netherlands.

The transactions will create a new company, not yet named. The transactions are expected to be completed in mid-2020. Pfizer will become synonymous with what is now its core bio-pharma business.

The following slide is from a Pfizer investor presentation.

Under current plans, Pfizer shareholders will receive 0.12 shares of the new company for each share of Pfizer that they own. Management has stated that, following the closing of the transaction, “the combined dividend dollar amount received by shareholders…will equate to Pfizer’s dividend amount in effect immediately prior to closing.”

In other words, Pfizer’s current dividend will probably be reduced, but the shares in the new company that shareholders receive will pay a dividend that makes up for the reduction.

Pfizer’s Valuation

To value a stock, I use four different valuation models, then average out the fair prices derived from each model. For more details on my approach, see Dividend Growth Investing Lesson 11: Valuation.

Model 1: FASTGraphs Default Valuation

The first model checks the stock’s current price against FASTGraphs’ basic estimate of its fair value.

FASTGraphs uses the historical average P/E ratio of the whole stock market (which is P/E = 15) to represent a fair valuation. That is the used to draw the orange fair-price reference line on the following graph, as shown by the yellow highlight.

The black line is Pfizer’s actual price. Since the black line is below the orange line, it suggests that that Pfizer is undervalued. The end of the black line reflects the company’s current P/E ratio, which is 12.9 (circled).

We calculate the degree of undervaluation by making a ratio out of the two P/Es.

Formula for Measuring Valuation on FASTGraphs
Actual P/E divided by Reference P/E = Valuation Ratio
12.9 / 15 = 0.86

That valuation ratio suggests that Pfizer is 14% undervalued.

Formula for Calculating Fair Price
Actual Price divided by Valuation Ratio = Fair Price
$38 / 0.86 = $44

Model 2: FASTGraphs Normalized Valuation

FASTGraphs offers another fair-value reference line. This one is based on the stock’s own long-term valuation rather than the market as a whole. That is, this model “normalizes” the valuation to Pfizer’s own record.

In the following graph, Pfizer’s actual 5-year average P/E ratio (highlighted) was used to draw the blue fair-value reference line. Pfizer’s price again is the black line

Pfizer’s 5-year average P/E ratio is 14.0. The formulas for the valuation ratio and fair price are the same as in the first step. Applying them, we get:

Valuation ratio: 12.9 / 14.0 = 0.92, or 8% undervalued
Fair price: $38 / 0.92 = $41

Model 3: Morningstar’s Valuation

Morningstar takes a different approach to valuation. They ignore 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.

Here is Morningstar’s conclusion:

Under Morningstar’s system, four stars means that they think that the stock is undervalued. The following detail shows the degree:

Morningstar’s calculation is that Pfizer is 17% undervalued, and that its fair price is $46 per share.

Model 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.

That is because, with a well-valued stock, you can buy more shares with your money, no matter how much you invest. Because dividends are paid per share, you will get more shares, and therefore more dividends, for that money.

Pfizer’s price has dropped 13% over the past 12 months, which, combined with Pfizer’s dividend increase early in 2019, has raised the company’s yield.

Formula for Yield
Yield % = Annual Dividend / Price

The net effect is that Pfizer’s current yield of 3.8% is 6% higher than its 5-year average of 3.6%.

[Source: Simply Safe Dividends]

That suggests 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
3.6% / 3.8% = 0.95

In words, Pfizer is 5% undervalued by the relative yield model. Using the same equation for fair price as in the other models, we get a fair price of $38 / 0.95 = $40.

Pfizer’s Valuation Summary

Now we average the 4 approaches.

You will note that, in the above chart, I label Models #2 and #4 as “fairly valued,” even though the data indicates 8% and 5% undervaluation, respectively. That is because I recognize that valuation is an assessment rather than a physical measurement. Therefore, I call any price within 10% of fair value to be “fairly valued.”

The average of the four methods suggests a fair price for Pfizer of $43, compared to its actual price of about $38.

Thus I conclude that Pfizer is 12% undervalued at the present time, according to the average of the four models.

Closing Thoughts

Pfizer is an extremely high-quality company. Its attractive yield (3.8%), high degree of dividend safety, and 12% undervaluation makes it an attractive dividend growth investment.

The proposed spinoff of Upjohn and merger with Mylan introduces a degree of uncertainty into Pfizer at the current time. As noted earlier, the transaction is not expected to alter the combined dividend payout of the new company + Pfizer. That said, a potential investor may wish to research how attractive the proposed new company will be to own, because a Pfizer shareholder will become a shareholder in it when the transactions are completed.

Pfizer is a component of Jason Fieber’s FIRE Fund early-retirement portfolio. Here are recent articles on Pfizer that you can use for further research.

This is not a recommendation to buy Pfizer. As always, perform your own due diligence. Check the company’s complete dividend record, business model, financial situation, and prospects for the future. Also consider whether it fits (or does not fit) your long-term investing goals.

— Dave Van Knapp

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