It’s becoming more and more difficult to find high-quality dividend growth stocks trading for attractive prices.
With the S&P 500 just a few points away from its all-time high, most stocks are also near their respective all-time highs.
But why should you care?
What does it matter whether or not a stock is expensive?
And what is expensive?
[ad#Google Adsense 336×280-IA]These are good questions, and I believe an intelligent investor will have them already answered before they start investing their money.
First, a stock is expensive when its price is higher than its fair value.
Conversely, a stock is cheap when it’s priced below what it’s deemed to be worth.
You’ll notice that you need two key pieces of information in order to determine whether a stock is cheap or expensive – price and value.
Price is simply how much a stock costs you; value is what a stock is intrinsically worth.
And you should care about a stock’s valuation because it can have a dramatic impact on your long-term net worth and income.
Now, I focus on, write about, and personally invest in dividend growth stocks like those you can find on David Fish’s Dividend Champions, Contenders, and Challengers list, a compilation of more than 700 US-listed stocks with at least five consecutive years of dividend increases.
I believe high-quality, blue-chip companies are the best long-term investments out there.
A company that’s able to so routinely and regularly increase its profit that it’s also able to send out ever-larger dividend checks to shareholders all over the world strikes me as the type of enterprise I want out there working for me.
Forget the companies that can’t turn a profit. I also don’t want to invest in businesses that are steadily declining in prominence and profitability.
I only want to put my money to work with companies that are slowly but steadily selling more products and/or services to people, and it’s preferable that these products and/or services are ubiquitous, branded, and sought after.
Of course, I also want my fair share of those growing sales. That’s where that increasing dividend comes into play.
But I’m also not interested in paying any price for a stock, even a dividend growth stock that’s high quality.
Specifically, a dividend growth stock that’s undervalued is likely to have a higher yield, greater long-term total return prospects, and less risk when compared to paying a fair price or higher for that stock.
That first part, the higher yield, is extremely important.
A stock paying a quarterly dividend of $0.25 that’s estimated to be fairly valued at $50 will yield 2% if you purchase it at that estimated fair value.
But it will yield 2.5% if you’re able to buy it when it’s 25% undervalued, at $40.
This relationship exists because price and yield are, all else equal, inversely correlated, meaning yield will almost always be higher when the price is lower (assuming the dividend hasn’t been cut).
That spread of 50 basis points has a material impact on your income both now and for the life of the investment.
In addition, it helps to propel excess total return (relative to what’s possible at fair value), seeing as how yield is a major component of total return.
And the other component, capital gain, is also given a nice potential boost by the upside that exists between the price you paid ($40) and the fair value of the stock ($50).
So your prospects for greater total return are helped on both sides of the coin.
Of course, by virtue of maximizing upside, you’re simultaneously minimizing your downside. That “margin of safety” provides you a nice cushion in case things go wrong, thereby limiting your risk.
What does all this mean? What does an undervalued dividend growth stock look like?
Let me show you…
Viacom, Inc. (VIAB) is a global entertainment and media company, connecting with audiences in over 165 countries and territories.
While Viacom might not be a household name, its many different networks are.
They offer content across television, motion picture, online, and mobile platforms.
Their leading brands include Nickelodeon (and its various offshoots), MTV, Spike, CMT, VH1, and Comedy Central.
In addition, Viacom owns and controls Paramount Pictures.
Paramount Pictures is, of course, the oldest studio in America, today operating as a global producer and distributor of motion pictures that include the likes of the Transformers series, the recent reboot of Star Trek movies, and the Mission: Impossible series.
While content delivery continues to change dramatically and rapidly with the advent of streaming services, content production itself hasn’t changed quite as much.
Quality content is still expensive to produce, and there doesn’t appear to be any sign that consumers have any new preference for low-quality content. Online content that isn’t produced to be longer in format, however, is a major change in media.
Meanwhile, there are only six major U.S. film studios, of which Paramount is one. As long as people continue to demand movies (recent box-office totals continue to break all-time records), business should remain robust here in terms of fending off streaming competition.
But all of this is for not for a dividend growth investor like myself if Viacom isn’t producing growing profit and sharing that growing profit with shareholders in the form of a growing dividend.
Well, Viacom doesn’t disappoint here.
They’ve been paying out an increasing dividend for six consecutive years now.
While short, that track record is somewhat limited by the fact that Viacom as it exists in its current form came about after CBS Corporation (CBS) split from the former Viacom in 2006. So the company, as it exists now, simply couldn’t have ever had a multi-decade track record of dividend raises.
But what they maybe lack in length, they make up for in terms of growth rate.
Over the last five years, Viacom has increased its dividend at a compound annual rate of 38.5%.
Now, seeing a monster growth rate isn’t uncommon when a company starts out with a 0% payout ratio. But even the most recent dividend increase of over 21% is still pretty impressive.
And with a current payout ratio of just 28.7%, there’s still plenty of room for the company to continue aggressively growing its dividend for the foreseeable future, even absent much near-term EPS growth.
What’s perhaps even more attractive about the dividend right now is the yield.
At 3.74%, the stock is offering a monster yield that well exceeds the broader market and every other media stock I know of.
Moreover, that yield is more than 150 basis points higher than the stock’s five-year average yield of 2.2%.
So whereas this stock typically offers a yield more in line with peers and the broader market, it’s currently up there with many utilities.
Will that gap close quickly? Tough to say, but investors getting in now are paid handsomely in the meanwhile, especially relative to what they’re ordinarily offered.
I will quickly note, however, that the company was due for a dividend increase with its most recent dividend announcement, but Viacom instead kept their dividend amount unchanged. It’s difficult to determine whether or not that signals a more permanent change in their dividend growth policy, but the company is working through some issues both internally and externally.
You not only have the ongoing changes in media, but there is currently some questions regarding voting and power with 93-year-old Sumner Redstone, currently of questionable mental capacity, still holding 80% of the company’s voting power.
With this in mind, I think it’s perhaps more imperative than usual to seek out a sizable margin of safety.
But before we can estimate what the stock might be worth, we first must look at what kind of growth the company is generating and what’s expected moving forward.
So we’ll look at the past decade first, before getting a glance at a near-term forecast.
Revenue for Viacom is up from $9.610 billion to $13.268 billion from fiscal years 2005 to 2015. That’s a compound annual growth rate of 3.65%.
Meanwhile, the company improved its earnings per share from $1.73 to $4.73 over this period, which is a CAGR of 11.82%.
There is obviously a big discrepancy there, but it can largely be explained by the company’s aggressive share repurchases – Viacom reduced its outstanding share count by almost 50%, which is one of the most sizable reductions I’ve yet come across over a 10-year stretch.
So while net income didn’t change much (due largely to revenue not changing much), net income on a per-share basis changed quite a bit due to the profit simply being split between less shareholders.
Looking out over the next three years, S&P Capital IQ anticipates that Viacom will be able to compound its EPS at a 4% annual rate. Rating challenges are cited, along with currency headwinds. In addition, Viacom isn’t repurchasing its shares at nearly the same rate as it has in the past.
But even 4% EPS growth over the foreseeable future wouldn’t be bad at all in terms of dividend growth potential when considering the very low payout ratio. And as mentioned earlier, investors buying in now are getting that very attractive yield.
All in all, the growth has been relatively solid. And it’s not like Netflix, Inc. (NFLX) just started up yesterday. Netflix has been a strong force for years, yet Viacom grew somewhat significantly straight through the last decade.
The main issue I actually see with this business right now, besides the internal and external problems they’re working through, is the debt load.
The long-term debt/equity ratio sits at 3.45. While artificially high due to the treasury stock on the balance sheet, even the interest coverage ratio, at under 5, is a bit concerning.
I’m not aware of any competitor with this kind of indebtedness. More than $12 billion in long-term debt for a company with a market cap of just over $17 billion is something to be mindful of. In addition, rising rates could present a problem for the firm over the long run, especially if EBIT doesn’t rise at least in kind.
On the flip side of the coin, profitability is very strong here.
Over the last five years, the firm has averaged net margin of 16.16% and return on equity of 42.27%.
ROE is juiced by the leverage, but the net margin is really solid.
All in all, Viacom is an interesting company at, perhaps, an inflection point. Content production – quality content – offers the company some long-term visibility in terms of their place in media, but content delivery is changing, and Viacom could be at a disadvantage there since customers increasingly don’t necessarily want big pay-television packages, which include a lot of fringe channels under Viacom’s banner.
And the current issues regarding Redstone and management are an unwelcome distraction.
But I think that’s why the stock is so cheap right now…
The P/E ratio is sitting at 7.97 right now, which basically is pricing in long-term decline. That’s almost half the stock’s five-year average P/E ratio, and more than half the broader market’s P/E ratio. All other basic valuation metrics are well below their respective recent historical averages, while the yield, as noted earlier, is substantially higher than what it usually has been, on average, over the last five years.
That seems to be very, very cheap. But how cheap? What’s the stock likely worth?
I valued shares using a dividend discount model analysis with a 10% discount rate and a 7% long-term dividend growth rate. That growth rate is extremely conservative when looking at the five-year dividend growth rate demonstrated by the company, but the possibility of lower growth moving forward, slowed buybacks, and a missed recent dividend increase are all considerations here. The DDM analysis gives me a fair value of $57.07.
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.
My valuation makes this stock look awfully cheap right now, but don’t take just my word for it…
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 VIAB as a 4-star stock, with a fair value estimate of $53.00.
S&P Capital IQ 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.
S&P Capital IQ rates VIAB as a 2-star “sell”, with a fair value calculation of $51.70.
So you see a consensus here, that the stock is likely worth at least over $50. Yet it’s priced just a bit over $40. I’m unsure of the sell recommendation from the latter firm when they’re forecasting positive growth on a vastly undervalued stock, but averaging the three valuation perspectives together gives us $53.92. That indicates this stock could be 21% undervalued.
Bottom line: Viacom, Inc. (VIAB) is a media conglomerate and juggernaut, with a huge stable of networks and brands across multiple platforms that are still incredibly viable and valuable. However, there are internal and external changes occurring. But the stock is down approximately 40% over the last year, leading to a very attractive yield and what appears to be 21% upside. Debt aside, the fundamentals are very solid. This stock deserves a strong look right now.
— Jason Fieber
[ad#IPM-article]