This High-Quality Dividend Grower Appears 7% Undervalued Right Now

Background

Defense companies are on everyone’s mind lately, what with the news from the Iran, Iraq, and the White House.

This month’s Valuation Zone stock is General Dynamics (GD).

GD is a global aerospace and defense enterprise.

General Dynamics was incorporated in 1952. From that date into the 1990s, GD provided tanks, rockets, missiles, submarines, warships, fighters, and electronics to all of the military services.

In the early 1990s, GD sold most of its portfolio, hanging on to just its military-vehicle and submarine businesses.

Then in the mid-1990s, GD began expanding again. It acquired Gulfstream Aerospace, combat-vehicle businesses, information technology companies, and additional shipyards.

Those form the foundation of GD today. Ranked by revenues, General Dynamics is the 5th-largest aerospace/defense company, just below Lockheed Martin (source).

Quality Snapshot and Dividend Record

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

General Dynamics is one grade short of perfection in this Quality Snapshot. On a 0-to-5-point scale for each metric, the company would score 24 out of 25 points. Only a small number of companies score that high.

General Dynamics’ dividend yield is 2.3%, which is lower than we normally write about in the Valuation Zone, although it is higher than the S&P 500’s yield, which is 1.8%. I call yields between 2% and 4% “mid-yield.”

GD’s mid-range yield is balanced by its fast dividend growth rate. Its 5-year dividend growth rate (through 2019) has been 10.5% per year. Last year’s raise was 9.7%.

For stocks with yields in the 2%-4% range, I call that “fast” dividend growth. So for classification purposes, GD is a mid-yield-fast-growth stock.

General Dynamics is also a reliable dividend growth stock. It has increased its dividend for 28 straight years, making it both a Dividend Champion and Dividend Aristocrat. The company increased its dividend straight through the last two recessions. Recessions are marked by the gray bands on this graph.

General Dynamics in the Valuation Zone

Now that we know that General Dynamics is a high-quality dividend-growth company, let’s see whether it presents a good investment opportunity from a valuation point of view.

To value a stock, I use four different valuation models, then take an average of the four fair prices. 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 P/E = 15 value is the used to draw the orange fair-price reference line on the following graph. I circled that value along with GD’s own P/E ratio.

The two P/Es are practically identical, which suggests that GD is fairly valued.

Formula for Measuring Valuation on FASTGraphs
Actual P/E divided by Reference P/E = Valuation Ratio
15.1 / 15 = 1.01

That valuation ratio suggests that GD is 1% overvalued.

Formula for Calculating Fair Price
Actual Price divided by Valuation Ratio = Fair Price
$180 / 1.01 = $178

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 GD’s own record.

In the following graph, General Dynamic’s 5-year average P/E ratio (circled) was used to draw the blue fair-value reference line. GD’s price is the black line, and its current P/E ratio is also circled.

This model presents a different picture, because GD’s long-term average P/E is higher than its current P/E. The balck price line is below the blue fair-value reference line.

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

Valuation ratio: 15.1 / 16.6 = 0.91, or 9% undervalued
Fair price: $180 / 0.91 = $198

This fair price is just inside the +/- 10% range that I call “fairly valued.”

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. The idea is that a stock’s fair price is equal to the net present value of all of the company’s future cash flows.

Here is Morningstar’s conclusion:

Morningstar also calculates General Dynamic’s price as a little (4%) undervalued. Their model suggests a fair price of $188 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, 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 your money.

General Dynamic’s current yield of 2.3% is 15% higher than its 5-year average of 2.0%.

[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
2.0% / 2.3% = 0.87

In other words, GD is 13% undervalued by this relative yield model. Using the same equation for fair price as in the other models, we get a fair price of $180 / 0.87 = $207.

General Dynamics’ Valuation Summary

Now we average the 4 approaches.

The average of the four models suggests a fair price for General Dynamics of $193, compared to its actual price of about $180.

Thus I conclude that GD is within the “fairly valued” range of +/- 10%, although its price does compute to being 7% undervalued.

Closing Thoughts

In my own investing, I will pay up to a 10% premium for a very high-quality company, because I am interested in owning high-quality companies, and you can’t often get them at a discount.

General Dynamics is a very high-quality company, as shown by its score of 24 out of 25 points on its Quality Snapshot. And by my calculations, its price is actually a little undervalued.

If you have room in your portfolio for a mid-yield-fast-growth dividend company, GD is certainly worth a look.

Here are recent write-ups on General Dynamics that you can use for further research.

General Dynamics is a holding in Jason Fieber’s FIRE Fund that he uses in early retirement.

This is not a recommendation to buy General Dynamics. 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 how well it fits (or does not fit) your long-term investing goals.

— Dave Van Knapp

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