This is the second article in a new series that we started last month. High Quality Dividend Growth Stock of the Month replaces the former Valuation Zone series.
Just to reiterate what the new series is designed to do: Stocks are selected based on their quality. Each article includes an overview of the company, reviews of its quality and dividend records, and a look at the company’s valuation.
I will still analyze each stock’s valuation.
If the stock is not well-valued currently, I will suggest a reasonable entry price for those who wish to wait for the price to come back to fair value, or for fair value to rise to meet the price.
Some investors, especially younger ones with long investing careers ahead of them, will not wish to wait. They are not very concerned about current valuations. They figure that in 10-15 years, they won’t care what they paid for the best companies; they will just be glad that they own them. The new series is aimed squarely at them.
Last month, we kicked off the series with Apple (AAPL), which is both very high-quality and very overvalued. I promised that we would find some other HQ stocks that are more fairly valued. We’ve got one this month.
This Month’s HQ Stock: Amgen
This year is Amgen’s 40th anniversary. The company was formed in 1980 and went public in 1983.
Amgen is one of the world’s leading biotechnology companies. The company’s founding mission, which still holds, is deeply rooted in science to transform new ideas and discoveries into medicines to treat serious illnesses. Philosophically based on “biology first,” Amgen develops and delivers human therapeutics based on the science of human biological processes.
Amgen has a presence in about 100 countries, and its therapeutics have reached millions of patients around the world. For more information about the company, you can visit its investor’s page here.
Amgen’s High Quality
As explained in Dividend Growth Investing Lesson 20: Quality Snapshots, I derive an overview of a company’s quality 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
- Simply Safe Dividends’ Dividend Safety grade.
I grade these snapshots by awarding up to 5 points in each category. Amgen scores 23 points of a possible 25, giving it the third-highest grade possible.
Simply Safe Dividends reaffirmed Amgen’s dividend safety score (74) on August 12, 2020 following Amgen’s Q2 earnings report.
Amgen’s Dividend Record
Amgen has been paying dividends since 2011, and this is what its record looks like since then:
(Source: Simply Safe Dividends)
Amgen’s current yield is 2.7%, and as you can see from the display above, it has been growing its dividend fast. (Disclosure: I own Amgen in my Dividend Growth Portfolio.)
To value a stock, I use four different valuation models, then average them. For more details on my approach, see Dividend Growth Investing Lesson 11: Valuation.
Models 1 and 2: FASTGraphs P/E Comparisons
FASTGraphs present a stock’s price on the same chart as valuation reference lines for easy visual comparison. You can draw the reference lines anywhere you like. I use two that are pre-built into the system:
- An orange line based on formulas regarding the performance of the stock market historically and the company’s own earnings growth rate. As a practical matter, the orange line is usually based on a P/E ratio of 15.
- A blue line based on the stock’s own P/E ratio for any time-period you choose. I usually select a 5-year backwards look. That requires an 8-year display of the chart, because of the future years displayed.
Here is the FASTGraph for Amgen, using the 8-year display period. You can see the blue and orange reference lines. The black line is Amgen’s actual market price.
For Amgen, the orange line is drawn at a P/E ratio of 15, which is a common benchmark for companies growing at a medium speed. The blue line (and this rarely happens) is drawn at practically the same level, because Amgen’s 5-year average P/E ratio has been 14.8.
The black line is Amgen’s price. You can tell visually that Amgen is fairly valued under these two models, because the lines are all in practically the same place. Amgen’s current P/E ratio is 15.1.
To translate valuation into fair price, I create a valuation ratio for each model.
Valuation Ratio = Actual P/E divided by Reference P/E
Valuation ratio #1 (orange line) = 15.1 / 15 = 1.01
Valuation ratio #2 (blue line) = 15.1 / 14.8 = 1.02
The valuation ratios then can be used to calculate fair prices.
Fair Price = Actual Price divided by Valuation Ratio
Fair price #1 = $242 / 1.01 = $240
Fair price #2 = $242 / 1.02 = $237
Model 3: Morningstar’s Discounted Cash Flow
Morningstar takes a different approach. They ignore P/E and other valuation ratios.
Instead, they construct 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 valuation history on Amgen. The red line on the graph is Morningstar’s fair-value calculation over the past 10 years, and the black bars represent Amgen’s price.
Morningstar conveniently provides the valuation ratio and their estimate of fair price: 1.12 and $215 respectively.
Model 4: Current Yield vs. Historical Yield
The final model compares the stock’s current yield to its historical yield.
The idea is that 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. And vice-versa.
We can see the comparison visually with this graph from Simply Safe Dividends:
Just as with the earlier models, we make a valuation ratio by comparing the stock’s historical yield to its current yield. It turns out that Amgen’s current yield and its historical yield both round to 2.7%.
Valuation ratio = Historical yield divided by Current yield
Valuation ratio = 2.7% / 2.7% = 1.00
So Amgen’s fair price under this model is its actual price. For the record, the calculation is $242 / 1.00 = $242.
Amgen’s Valuation Summary
Now we average the 4 approaches.
All four valuation models are pretty tightly bunched. In the aggregate, the assessment is that Amgen is fairly valued right now, selling for just 3% over its calculated fair price.
Because valuation is an assessment, not a physical measurement, all valuations are estimates. Therefore, it is logical not to get too precise about it. Think in ranges rather than exact values. For example, I consider any price within +/- 10% of my calculated fair price to be fairly valued. Amgen is well within that range.
For an extremely high-quality company like Amgen, I would be willing to pay up to 10% more than the assessed fair price of $234. That would place my own target price range for Amgen at $257 or below. At that price, Amgen’s yield would be 2.5%.
Amgen is selling for a fair price right now. That “proves” that high quality stocks can be obtained at fair prices sometimes.
Amgen’s presentation of its Q3 financial results just took place on October 28. Here are the slides from that presentation.
Other reading on Amgen:
Mike Nadel: We Just Bought Amgen (AMGN) and Honeywell (HON) for DTA’s Income Builder Portfolio (September, 2020)
Tara Young: Tara’s Breakout Stock Alert: Amgen (AMGN) (July, 2020)
This is not a recommendation to buy, sell, hold, trim, or add to Amgen. 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 your tolerance for risk and how well the company fits (or does not fit) with your long-term investing goals.
Coming Next Month: New E-Book on Dividend Growth Investing
This will be my 8th e-book on dividend growth investing, and my first since 2014. The book has been reorganized, and it will contain much new material, including fresh analyses of 30 of the best dividend growth stocks.
Please click here to get on an email list for one-two more updates on the book’s progress as well as a direct notification when it becomes available. If you sign up, I will send you a free pamphlet about compounding. There is no obligation to buy the book if you sign up. The pamphlet is yours to keep in any event.
— Dave Van Knapp
This article first appeared on Dividends & Income
The goal? To build a reliable, growing income stream by making regular investments in high-quality dividend-paying companies. Click here to access our Income Builder Portfolio and see what we’re buying this month.