Irrational exuberance.
Revered professor and economist Robert J. Shiller used this phrase to describe one of the biggest stock market bubbles ever.
Publishing a book using that phrase at its title during the height of the dot-com bubble in 2000 was almost prophetic.
But even in that big bubble, there were still cheap stocks to be found.
And I’d argue the same situation exists today, 20 years later.
Indeed, we’ve seen a lot of tech stocks reach exuberant valuations this year.
Yet in the midst of these explosive increases in valuations across tech, there are many other stocks that have been almost left for dead.
Avoiding irrational exuberance as an investor has allowed me to steadily increase my wealth and passive income, year after year.
In fact, I went from below broke at age 27 to financially free at 33.
As I lay out in my Early Retirement Blueprint, I used the investment strategy of dividend growth investing to accomplish that feat.
This strategy advocates investing in world-class enterprises that pay reliable and rising dividends.
The Dividend Champions, Contenders, and Challengers list contains hundreds of examples.
That strategy helped me to build the FIRE Fund, which is a real-money stock portfolio that produces enough five-figure passive dividend income for me to live off of.
I have avoided bubbles.
I have also avoided bubble bursts.
By sticking to great businesses trading at attractive prices, I’ve slept well at night.
Valuation always matters.
It can have a massive impact on your investment results. And your sleep.
Price is what you pay. But value is what you get.
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.
Avoiding irrational exuberance by investing in high-quality businesses selling for rational valuations can allow you to avoid bubble bursts and build sustainable wealth and passive income.
The good news is, estimating intrinsic value isn’t all that difficult.
Fellow contributor Dave Van Knapp put together Lesson 11: Valuation, which has made it easier than ever.
Part of a series of 20 “lessons” on dividend growth investing, Lesson 11 provides a valuation template that can be applied to just about any dividend growth stock out there.
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…
Altria Group Inc. (MO)
Altria Group Inc. (MO) is one of the world’s largest tobacco companies. It is the largest cigarette manufacturer in the United States.
Founded in 1822, Altria is now a $70 billion (by market cap) tobacco giant employing more than 7,000 people.
The company operates across the following subsidiaries: Philip Morris USA, U.S. Smokeless Tobacco, John Middleton, Ste. Michelle Wine Estates, Nu Mark, Nat Sherman, and Philip Morris Capital.
Altria holds a ~10% interest in Anheuser-Busch InBev (BUD). They also own 45% of Cronos Group Inc. (CRON). And they have a 35% stake in private e-cigarette maker Juul Labs, Inc.
US tobacco sales produce most of Altria’s revenue. This is despite some moderate diversification.
FY 2019 revenue breaks down across the following product categories: Smokeable Products, 88%; Smokeless Products, 9%; Wine, 3%; and All Other, less than 1%.
Altria might mostly do one thing. But they do that one thing really, really well.
The company’s flagship US cigarette brand of Marlboro has a ~43% share of the market.
In total, Altria controls just over 50% of the US cigarette market, making them the largest domestic player. They have no international cigarette sales.
To give you an idea of how important Marlboro is to the company, this single brand accounted for 87% of the company’s total cigarette unit sales in 2019.
But even with control of the best cigarette brand, we can’t ignore the elephant in the room.
The obvious issue here is the secular decline of the cigarette market.
There are simply less smokers today than there were 20 years ago. And it’s very likely there will be even less smokers 20 years from now.
But if there’s one market with secular decline you’d want to be in, it’s probably this one. With entrenched brands, limited competition, inelastic pricing properties, and the addictive nature of the products, it’s a cash cow.
That said, Altria sees the writing on the wall. And they’ve made recent moves into cannabis and e-cigarettes to help “future-proof” the business.
These moves have been disappointing, however, with Altria incurring major write-downs regarding its investments in both Cronos and Juul.
Fortunately, these disappointments come with a silver lining.
That silver lining is a steep drop in Altria’s valuation, which has pushed up the stock’s yield to stratospheric levels.
Dividend Growth, Growth Rate, Payout Ratio and Yield
To that point, the stock now yields 9.03%.
That’s more than five times higher than the S&P 500’s yield.
It’s also more than 430 basis points higher than the stock’s own five-year average yield.
This yield is so high that the stock can provide for an appealing total return proposition with no growth at all.
I mean, we’re talking about almost a 10% annual clip on just the dividend alone. That’s near the long-term average annual return of the US stock market.
I would go so far as to say that the market is pricing in a dividend cut of some kind.
But that doesn’t seem to line up well with the reality of the company’s finances.
In fact, Altria increased the dividend in July by over 2%.
They’re not cutting the dividend. They’re raising it.
This increase made Altria good for 51 consecutive years of dividend increases.
And even after that raise, the payout ratio is 78.4%, based on adjusted TTM EPS.
Management targets a payout ratio of 80% of adjusted earnings per share. They’re right in line.
Moreover, free cash flow easily covers the dividend.
Recent dividend raises have slowed from the 10-year dividend growth rate of 9.7%, but I don’t see a cut on the horizon.
Revenue and Earnings Growth
And it really is the horizon that investors care most about.
We invest in tomorrow’s results, not yesteryear’s stats.
Thus, I’ll now build out a forward-looking growth trajectory for Altria, which will later help us estimate intrinsic value.
This trajectory will first rely on what the business has done in terms of top-line and bottom-line growth over the last decade.
I’ll then compare that to a near-term professional prognostication for profit growth.
Combining the proven past with a future forecast in this way should tell us a lot about where the business might be going.
Altria increased its revenue from $16.892 billion in FY 2010 to $19.796 billion in FY 2019.
That’s a compound annual growth rate of 1.78%.
Meanwhile, earnings per share expanded from $1.87 to $4.22 (adjusted) over this period, which is a CAGR of 9.46%.
Admittedly, I did use adjusted EPS for FY 2019. That’s because of the write-downs I noted earlier. This is to more accurately reflect earnings power and growth.
A combination of margin expansion and buybacks helped to drive this excess bottom-line growth.
For perspective on the latter, the outstanding share count is down by about 10% over the last decade.
Looking forward, CFRA believes Altria will compound its EPS at an annual rate of 5% over the next three years.
They cite margin expansion from cost cuts, more modest volume declines, and more consumption per smoker as near-term tailwinds.
Furthermore, Altria has unique pricing power properties as the largest player in a fairly fixed market with addictive products.
This is all somewhat offset by the more long-term nature of the market’s dynamics. It’s in secular decline.
That secular decline isn’t as dramatic as you might think, though. It’s worthwhile to point out that Altria most recently reported reported a 1.4% YOY shipment volume decrease for the first nine months of the year for Smokeable Products. That’s an improvement relative to expectations.
One wildcard here is how e-cigarettes play out. Altria’s write-downs on Juul have put it in the spot where it’s almost all upside from here.
And there’s also the exclusive licensing agreement they have with Philip Morris International Inc. (PM) to commercialize IQOS in the US.
In my view, a 5% growth rate is pretty conservative compared to Altria’s long-term results.
But even that would be more than enough to put together a very attractive total return picture here, when you consider the yield is over 9%.
If they can simply maintain the dividend and hand out low-single-digit dividend raises for the next decade or two, I think that’s more than enough to make this stock an appealing long-term idea. That’s particularly true for income-oriented investors.
Financial Position
Moving over to the balance sheet, this is the weakest part of the business.
The balance sheet has long been just okay to me. It was a leveraged cash cow.
But there’s been a recent balance sheet deterioration because of the aforementioned strategic investments.
The long-term debt/equity ratio, at 4.35, is very high.
But that’s more because of low common equity than an extremely high debt load. Low common equity is due to a lot of treasury stock from buybacks.
On the other hand, the interest coverage ratio for last fiscal year came in at under 2, which is alarming.
However, in my view, Altria’s recent results are skewed and inaccurate. They’ve maintained at least a high-single-digit interest coverage ratio over the last decade, and I see this number improving once they move past some turbulence.
Profitability, unlike the balance sheet, is robust. Their main product benefits from incredibly high margins.
Over the last five years, factoring out the most recent FY, the firm has averaged annual net margin of 47.26% and annual return on equity of 119.45%.
ROE is obviously elevated from low common equity, so I take that with a big grain of salt.
Overall, I think Altria is a very good business that has suffered from some questionable decisions over the last few years. But that has unduly punished the stock’s valuation, pushing the yield up to levels that provides a compelling return all by itself.
And with brand recognition, pricing power, limited competition, inelastic pricing, scale, addictive products, and huge barriers to entry, the business does have durable competitive advantages.
Of course, there are risks to consider.
Competition, regulation, and litigation are omnipresent risks in every industry.
Litigation is a particular concern in this business, as evidenced by the Tobacco Master Settlement Agreement.
However, heavy regulation limits new entrants and creates rational pricing and pricing power for the incumbents.
The balance sheet has deteriorated over the last few years, limiting the company’s flexibility.
And while a moderate volume decline in US cigarettes is expected, any acceleration in secular decline will make it difficult for the business to keep up and offset that with pricing increases and alternative product sales.
The risks are sizable, but I think this stock is a very reasonable investment at the right valuation.
With the stock priced at 2013 levels after a 26% drop from its 52-week high, I think the valuation is very appealing…
Stock Price Valuation
The stock is trading hands for a P/E ratio of 8.67, based on adjusted TTM EPS.
That’s less than half of the broader market’s earnings multiple.
It’s also well off of the stock’s own five-year average P/E ratio of 17.3.
Then there’s cash flow, which shows a similar disconnect.
The current P/CF ratio of 8.4 is almost 1/3 of its three-year average of 21.8.
And the yield, as noted earlier, is substantially higher than its own recent historical average.
So the stock looks cheap when looking at basic valuation metrics. But how cheap might it be? What would a rational estimate of intrinsic value look like?
I valued shares using a dividend discount model analysis.
I factored in an 8% discount rate (due to the high yield) and a long-term dividend growth rate of 2%.
Longtime Altria shareholders might feel humbled and have a lump in their throat when looking at that DGR, but I think it’s a reasonable expectation. Notably, this is similar to where the most recent dividend increase came in at.
The business just can’t keep up with the kind of growth it’s produced in the past, which has caused a bit of a “reset” with the valuation and yield.
That said, I think this reset by the market has been greatly overdone.
The basic valuation metrics are severely depressed. And the yield alone can provide for a great return, even with no growth at all.
As long as Altria can keep the dividend going without a cut, shareholders have a lot to look forward to at this valuation.
The DDM analysis gives me a fair value of $58.48.
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.
Even with a cautious valuation model that sets the bar low, the stock looks quite cheap.
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 MO as a 5-star stock, with a fair value estimate of $54.00.
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 MO as a 3-star “HOLD”, with a 12-month target price of $38.00.
I came out high, albeit not too far from where Morningstar is at. Averaging the three numbers out gives us a final valuation of $50.16, which would indicate the stock is possibly 32% undervalued.
Bottom line: Altria Group Inc. (MO) is a high-margin business with durable competitive advantages. While there’s secular decline in its main market, that market remains a cash cow. With a 9% yield, more than 50 consecutive years of dividend raises, an on-target payout ratio, and the potential that shares at 32% undervalued, this is a compelling idea for dividend growth investors looking for yield.
-Jason Fieber
P.S. If you’d like access to my entire six-figure dividend growth stock portfolio, as well as stock trades I make with my own money, I’ve made all of that available exclusively through Patreon.
Note from DTA: How safe is MO’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 55. 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, MO’s dividend appears Borderline Safe with a moderate risk of being cut. Learn more about Dividend Safety Scores here.
This article first appeared on Dividends & Income
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