The US and China have come to terms on an initial trade deal.
Brexit is now all but guaranteed after a resounding victory for Boris Johnson.
And the US economy continues to roar, with no signs of a severe slowdown.
Unfortunately, near all-time highs, the broader US stock market is clearly aware of this reduced uncertainty.
Well, they do what they should have always been doing.
That is, buy high-quality stocks at attractive valuations and hold for the long term.
When I think of high-quality stocks, I immediately think of only one kind of stock.
I think of dividend growth stocks.
That’s because a business has to operate at a very high level in order to pay shareholders ever-rising cash dividends.
A lengthy track record of growing cash dividends ends up being a great initial litmus test of business quality, as you can see by looking at the Dividend Champions, Contenders, and Challengers list.
You can’t pay out growing dividends without producing the commensurate growing profit.
I rode the waves of dividend growth investing to a retirement in my early 30s, as I describe in my Early Retirement Blueprint.
My real-money early retirement dividend growth stock portfolio, the FIRE Fund, generates the five-figure passive dividend income I live off of.
Yes, the broader stock market is near all-time highs.
However, nothing has changed for the long-term dividend growth investor.
If anything, storm clouds are starting to disappear from the horizon.
Clear sailing might just give credence to some of the high valuations that exist among many areas of the stock market.
But high valuations aren’t everywhere.
There are still some wonderful businesses out there trading hands for attractive valuations.
Valuation, with or without elevated uncertainty, is of paramount importance to the investor.
An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.
This is relative to what the same stock might otherwise provide if it were fairly valued or overvalued.
Price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.
That higher yield correlates to greater long-term total return potential.
This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.
Prospective investment income is boosted by the higher yield.
But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.
And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.
These dynamics should reduce risk.
Undervaluation introduces a margin of safety.
This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value.
It’s protection against the possible downside.
Buying a high-quality dividend growth stock when it’s undervalued can lead to superior results over the long run.
The good news is, it’s not extremely difficult to spot and take advantage of undervaluation.
Lesson 11: Valuation, provided by fellow contributor Dave Van Knapp, is part of an overarching series of “lessons” on DGI.
This lesson specifically discusses and dissects valuation, providing a template that you can apply to most dividend growth stocks.
With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…
Chevron Corporation (CVX)
Chevron Corporation (CVX) is an integrated global energy company, with exploration, production, and refining operations across the world.
As the second-largest oil company in the United States, Chevron produces 2.9 million barrels of oil equivalent a day.
In addition to oil, the company has significant assets in natural gas and petrochemicals.
The company broke down FY 2018 earnings through two primary operating segments: Upstream, 90% of net income; and Downstream, 26%. All other accounted for -15%.
Furthermore, International comprised 69% of unconsolidated FY 2018 net income. United States comprised the other 31%.
Energy names have practically been left for dead by the stock market.
Many stocks in this space, including Chevron, have been flat (or worse) over the last five years.
The Energy sector is arguably the most glaring area to find value in the entire market.
That said, a lot of these stocks have looked cheap for a number of years now, yet they’ve gone nowhere.
But value is one of those things that you can’t deny over the long term.
Dividend Growth, Growth Rate, Payout Ratio and Yield
The cheaper a stock gets, and the more its earnings and dividends grow, the more of a coiled spring it becomes. At some point, that coiled spring is unleashed. The more it compresses, the more explosive the eventual move to the upside.
It works the same in the opposite sense, too. Stock bubbles can become much worse when overvaluation expands beyond rational limits. The bigger a bubble gets, the worse a bubble pop becomes.
One fantastic thing about undervaluation, though, is that it often leads to a higher yield.
So you get to collect more income while you wait for the price to catch up to value.
That’s playing out right now with Chevron’s stock.
It yields 4.02%.
That’s more than twice as high as the broader market.
It’s also slightly higher than the stock’s own five-year average.
That big yield is backed by one of the best dividend growth legacies in the entire industry.
Chevron has increased its dividend for 32 consecutive years.
And you’re looking at a 10-year dividend growth rate of 5.9%.
That’s inflation-beating dividend growth on top of a yield that’s two times the market’s.
With a payout ratio of 68.3%, in a period of low oil prices, the dividend appears about as secure as it ever has.
If oil prices improve, the dividend coverage would likely be even better.
Another thing that will improve the dividend coverage, of course, is increasing earnings and cash flow.
Revenue and Earnings Growth
I’ll now build out a growth trajectory for Chevron, which will later help us value the business and stock.
I’ll first show you what the Company has done over the last decade in terms of top-line and bottom-line growth.
Then I’ll compare that to a near-term professional forecast for earnings.
Blending the proven past with a future forecast in this manner should tell us a lot about where Chevron might be going with its earnings and dividend.
Chevron’s revenue declined slightly between FY 2009 and FY FY 2018, moving down from $168.320 billion to $158.902 billion.
This is obviously not what we want to see.
However, it’s tough to use arbitrary dates when looking at the top-line growth from a major oil company, because oil prices can vacillate somewhat significantly over even longer stretches of time. Moving things a few years forward or backward can produce very different results.
Looking at revenue growth from FY 2015 on, for instance, shows a totally different picture, as oil rebounded from extremely low levels.
Still, Chevron is able to do a lot with flat revenue.
Between buybacks and the ability to modulate project funding (right-sizing expenses to pricing and demand), the company has more control over the bottom line than it does revenue.
This means that Chevron can produce a ton of profit in most pricing environments, even if revenue isn’t growing.
Earnings per share advanced from $5.24 to $7.74 over this same 10-year stretch, illustrating my point.
That’s a compound annual growth rate of 4.43%.
This is a pretty respectable result. It’s been a challenging period for the likes of Chevron, yet they still moved profit in the right direction.
Looking forward, CFRA is predicting that Chevron will compound its EPS at an annual rate of 4% over the next three years.
They’re basically expecting a continuation of the status quo. A repeat of the last decade in terms of EPS growth.
CFRA cites a boosting of production by 3.5% per year through 2021, quality global assets, significant exposure to the Permian Basin, and cash harvesting from the successful execution of the Gorgon and Wheatstone LNG projects in Australia.
A call for increasing production roughly matches what Chevron has recently been doing. As the world consumes more energy, the products that Chevron produces will remain in demand for years to come.
The five-year reserve replacement ratio is over 100%, further supporting this growth projection.
I will note that it’s always difficult to forecast earnings growth of any company.
But it’s particularly challenging to forecast earnings growth for an oil supermajor. Chevron’s energy products are commodities. And prices fluctuate regularly, which can have major impacts on revenue.
As I noted earlier, though, Chevron is able to keep a more steady hand on earnings over the long haul, smoothing out these fluctuations somewhat.
And that’s why you’ve seen such a consistent dividend growth story here, too.
Taking all of this into consideration, I think the dividend growth is set for a continuation of the status quo.
That is, the long-term dividend growth rate of ~6% looks like a fairly reasonable base of expectation for future dividend raises over the foreseeable future. The most recent dividend increase of 6.2%, which was announced in January, is evidence of that.
Moving over to the balance sheet, Chevron maintains a rock-solid financial position.
The long-term debt/equity ratio is 0.19, while the interest coverage ratio is over 28.
In addition, cash on hand adds up to almost 1/3 of long-term debt.
This is a fortress balance sheet.
Profitability is competitive for the industry.
Chevron has averaged annual net margin of 5.77% and annual return on equity of 6.27% over the last five years.
These numbers are good, although they do trail nearest competitor Exxon Mobil Corporation (XOM).
Overall, Chevron offers long-term investors a lot to like.
Chevron’s scale, expertise, and global asset base are huge competitive advantages. They protect the company and give it a great opportunity to succeed over the long run.
But there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
Chevron has a lot of exposure to capital-intensive projects that are exposed to volatility in the pricing of energy products.
There is also a “black swan” risk in terms of major oil spills. These can be environmentally damaging and extremely costly to clean up, if they occur.
Oil supermajors also face more geopolitical risk than the average American multinational company. Their asset base is global. Hostile governments can intermittently interfere with operations.
There is also the risk of obsolescence. The world is demanding cleaner energy products. This threatens products like oil and natural gas.
Stock Price Valuation
With those risks known, I still think this stock looks like a great long-term investment.
At the right valuation, it could be an extraordinary investment.
Well, with a stock price that’s been flat over the last five years, the valuation now looks very attractive…
The P/E ratio is 17.0 right now.
That compares favorably to the broader market, and it’s also markedly below the stock’s own five-year average P/E ratio of 29.7.
Of course, a P/E ratio isn’t always an accurate measure of value on an oil stock due to variable earnings. But most other basic valuation metrics indicate a lot of value here.
For example, the P/CF ratio is 7.3. Compare that to the three-year average P/CF ratio of 11.8.
Even stripping away earnings, and digging right into cash flow, shows a disconnect on the present valuation.
And the yield, as noted earlier, is slightly higher than its own recent historical average.
So the stock does look cheap. But how cheap might it be? What would a reasonable estimate of intrinsic value look like?
I valued shares using a dividend discount model analysis.
I factored in a 10% discount rate and a long-term dividend growth rate of 6%.
That projected DGR is right in line with Chevron’s proven long-term DGR.
I’m essentially expecting Chevron to continue growing the company and dividend as they’ve been doing.
The prices of energy products aren’t currently elevated, compared to long-term averages. And some of Chevron’s big investments, like the Australian LNG projects, are starting to come online and provide significant cash flow. So I think the company is positioned to possibly do better than this expectation.
Furthermore, Chevron is due for a dividend increase very soon.
On the other hand, energy is ever-volatile and ever-changing. I’d rather err on the side of caution here.
The DDM analysis gives me a fair value of $126.14.
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.
In my view, this is a high-quality dividend growth stock that’s slightly cheap in an otherwise expensive market.
But we’ll now compare that valuation with where two professional stock analysis firms have come out at.
This adds balance, depth, and perspective to our conclusion.
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 CVX as a 4-star stock, with a fair value estimate of $136.00.
CFRA 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.
CFRA rates CVX as a 4-star “BUY”, with a 12-month target price of $133.00.
I came out the lowest. Not a surprise. I was being cautious. Averaging the three numbers out gives us a final valuation of $131.71, which would indicate the stock is possibly 11% undervalued.
Bottom line: Chevron Corporation (CVX) is a high-quality energy company with vertical integration, massive scale, and fantastic global assets. With a 4% yield, a well-covered dividend, more than 30 consecutive years of dividend raises, inflation-beating dividend growth, and the potential that shares are 11% undervalued, dividend growth investors should consider buying this stock to power their portfolios.
Note from DTA: How safe is CVX’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 85. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, CVX’s dividend appears Very Safe with a extremely unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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