In this series, High Quality Dividend Growth Stock of the Month, I cover phenomenally good companies. Their valuations have been a distant secondary consideration in selecting stocks to write about, with the result in a couple of articles about great companies that are way overvalued (Apple and Microsoft).
But I don’t want this series to be discouraging in suggesting that most high-quality DG companies are overvalued. The fact is that there are “always” good valuations to be found.
Here’s how things look so far.
|Stock||Ticker||Article Date||Article Link||Quality Score||Valuation|
|Microsoft||MSFT||Feb 2021||See article||25||Way over|
|Procter & Gamble||PG||Jan 2021||See article||25||Over|
|Bristol-Myers Squibb||BMY||Dec 2020||See article||23||Under|
|Amgen||AMGN||Nov 2020||See article||23||Fair|
|Apple||AAPL||Oct 2020||See article||24||Way over|
High-quality stocks go in and out of style on the market all the time. You’ve probably heard the phrase sector rotation. That’s when investors, for whatever reason, abandon the latest hot thing for the next hot thing. Companies that were formerly market darlings get left behind when sentiment shifts in a different direction.
The following graphic illustrates the 11 GICS sectors by price performance since the Great Recession in 2007-09. As you can see, sectors regularly bounce around in annual popularity.
Follow a particular color to zoom in on any sector over the years. If you scan across the top row, eight of the 11 sectors have been the best-performing sector for at least one year out of the past 14. And at the bottom, six of the 11 sectors have finished last in at least one year.
One thing that’s cool about this chart (in its source presentation) is that you can “touch” a particular sector, and that sector will light up, while the others fade out, so that it is easier to see your chosen sector from year to year. In the following snip, I’ve lit up the Information Technology [INFT] sector.
You can see that in the past couple of years, the Info Tech sector has run away from the rest of the market, with annual price returns of 50.3% in 2019 and 43.9% in 2020. That’s why so many great tech stocks are way overvalued right now.
This month’s High Quality Dividend Growth stock does not come from the tech sector. It comes from the “boring” Consumer Staples [CONS] sector. Here, I’ll light that sector up for you.
I would have thought that Consumer Staples did great during the pandemic of 2020, but it actually ranked 7th out of the 11 sectors, lower than the S&P 500 as a whole. In fact, the Consumer Staples sector has price-underperformed the S&P 500 for five years in a row.
For a value-seeking investor, that’s not bad news. That’s where well-valued opportunities come from.
March’s High Quality DG Stock: PepsiCo (PEP)
PepsiCo (PEP) is often thought of as primarily a beverage company, sort of like Coca-Cola (KO), but it is much more than that. It makes more money from snacks than from beverages, as shown in this breakdown from Trefis (sourced from E-Trade):
The company is organized both by product and geography. Frito-Lay North America –shown as responsible for 42% of PepsiCo’s stock price on the breakdown – is PepsiCo’s snack and food operation in North America. (In other parts of the world, food and snacks are gathered together in divisions defined by geographical regions.)
Overall, PepsiCo has more than a dozen powerhouse brands with more than $1 Billion in annual sales, including Frito-Lay, Gatorade, Pepsi-Cola, Quaker, Tropicana, Lay’s, Naked Juice, Aquafina, Lipton, Doritos, Tostitos, Mountain Dew, Ruffles, Cheetos, and Sierra Mist.
The former Pepsi-Cola Co. and Frito-Lay Inc. merged in 1965, creating today’s PepsiCo. The two main product categories — beverages and snacks/food – complement each other, providing retailers an efficient means of sourcing much of what their customers want. Studies show that over half of consumers who buy salty snacks also purchase liquid refreshments in the same basket.
PepsiCo’s High Quality
I take snapshots of company quality from the following sources, which I have come to trust and respect over the years. For more detail on how this scoring system works, see Dividend Growth Investing Lesson 20: Quality Snapshots.
- Safety and Financial Strength grades from Value Line
- S&P’s Credit rating
- Morningstar’s Moat rating
- Simply Safe Dividends’ Safety grade.
To grade these snapshots, I award 0-5 points in each category. PepsiCo scores five points in every category except for its credit rating, where it gets four points, for a total of 24.
Fewer than 30 companies get 24 or 25 points on this system, so PepsiCo is in rarified territory. I draw your attention to Morningstar’s Wide economic moat rating. It is largely based on PepsiCo’s brand assets and scale/cost advantages.
PepsiCo’s brands rank consistently high in surveys. Pepsi itself is a high-recognition brand, and the company owns the #1 sports drink in Gatorade. In snacks, Frito-Lay products boast high brand recognition status in categories like corn, tortilla, and potato chips.
Great brands lead to business advantages such as pricing power. On top of that, PepsiCo’s sheer scale leads to high production volumes, which tend to mean lower per-item manufacturing costs, lower procurement costs, and better leverage of fixed costs.
The breadth of PepsiCo’s product lines leads to distribution synergies. PepsiCo owns a large portion of its distribution network including bottling plants, warehouses, and delivery trucks. They can fill trucks with both beverage and snack products, which translates not only to economies of scale but also strong relationships with retailers and distribution partners.
These structural advantages show up in PepsiCo’s finances. As shown on the following charts, the company ranks high on two common measures of efficiency and profitability.
(Source: Simply Safe Dividends)
PepsiCo’s Dividend Record
PepsiCo is currently yielding 3.1%. That is a solid, mid-range yield.
In addition, PepsiCo is riding a 48-year streak of consecutive annual dividend increases. The raises have averaged 9% per year over the past five years, including a 7.1% increase last year.
This year’s increase has been “pre-announced” as 5.1% to take effect with PEP’s next dividend, payable in June. It will be PepsiCo’s 49th annual increase in a row.
That combination of yield and growth makes PepsiCo a mid-yield, mid-growth DG stock.
(Source: Simply Safe Dividends)
To value a stock, I use four valuation models, then average them. For more details, see Dividend Growth Investing Lesson 11: Valuation.
Models 1 and 2: FASTGraphs P/E Benchmarks
FASTGraphs present a stock’s price on the same chart as valuation reference lines for easy comparison. I use two reference lines to denote fair value.
- A magenta reference line based on a standard P/E ratio for most stocks of 18. I explain this new setting below.
- A blue reference line based on the stock’s own P/E ratio for the past 5 years.
Note that in the first model, my self-chosen magenta line at P/E = 18 is new this month. I have adjusted FASTGraphs’ built-in standard ratio of 15 based on my own study of the S&P 500’s P/E ratio going back 30 years. I wish to bring the historical market average reference more into line with the most recent 30-year period.
Here is the FASTGraph for PEP using an 8-year display period. (The 8-year display causes FASTGraphs to use the stock’s 5-year average P/E for the blue line.)
You can see the blue and magenta reference lines. The black line is PepsiCo’s actual market price.
The company’s current P/E ratio is 23.5. I create valuation ratios, one for each model, that relate the reference P/E to the stock’s actual current P/E.
Valuation ratio #1 (magenta line) = 23.5 / 18 = 1.31
Valuation ratio #2 (blue line) = 23.5 / 23.5 = 1.00
The first model suggests that PEP is overvalued, while the second suggests that it is fairly valued at its current price.
Model 3: Morningstar’s Discounted Cash Flow
Morningstar takes a different approach. They ignore P/E and other valuation ratios.
Instead, they use what is known as 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 of PepsiCo. The red line on the graph is Morningstar’s fair-value calculation over the past 10 years, while the black bars represent PEP’s price.
Morningstar’s model suggests that PepsiCo is undervalued. It produces a valuation ratio of 0.91.
I would normally call a valuation ratio within 10% of fair value “fairly valued,” but Morningstar has given a 4-star rating to PEP, which indicates “undervalued” in their world. In my own summary below, I will stick with my own terminology.
Model 4: Current Yield vs. Historical Yield
The final model compares 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.
We can see the yield comparison on this graph from Simply Safe Dividends. PepsiCo is currently yielding more than its 5-year average. It is not that common to be able to buy PepsiCo with a dividend yield of 3%+.
Again with this model, we make a valuation ratio. PepsiCo’s current yield is 3.1% and its 5-year historical average is 2.9%.
Valuation ratio = 2.9% / 3.1% = 0.94
PepsiCo’s Valuation Summary
As sometimes happens, one model – in this case Model #1 – is out of step with the others. But it doesn’t throw off the overall calculation in this case. The other three models balance the outlier.
The aggregate assessment is that PEP is fairly valued, with a valuation ratio of 1.04. Using that ratio, it is easy to calculate a fair price:
Fair price = Current price / Valuation ratio
PepsiCo’s recent price is about $132. Using the formula for fair price, we get $132 / 1.04 = $127.
All valuations are estimates about the future. Therefore, it is logical to think in ranges rather than exact values. I usually regard any price within +/- 10% of my calculated fair price to be “fair.”
If I apply that 10% cushion to PEP, that puts the top of its fair-price range at $140.
With PEP currently trading around $132, I think that now is a decent time to buy PepsiCo shares, especially with its next dividend increase already known.
I own PepsiCo in my Dividend Growth Portfolio. In fact, it was a charter member of the portfolio back in 2008. It has been a good performer since then, not only nearly doubling in value, but also contributing thousands of dollars to the portfolio’s dividend stream over the years, most of which have been used to invest in other stocks and build up the portfolio.
The position occupies almost 7% of my portfolio, so it is maxed out for me. If it were not, I would strongly consider adding to the position at today’s prices. A 5-10% dip would make it even more attractive. You can catch dips like that by using a limit order rather than a market order.
Besides being in my portfolio, PepsiCo is a holding in DTA’s Income Builder Portfolio. For Mike Nadel’s thoughts last year when he added PepsiCo, see this article: We Just Bought Pepsi (PEP), Constellation Brands (STZ) and JPMorgan Chase (JPM) for DTA’s Income Builder Portfolio.
This article is not a recommendation to buy, sell, hold, trim, or add to PepsiCo. 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) your long-term investing goals.
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This article first appeared on Dividends & IncomeWe’re Putting $2,000 / Month into These Stocks
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