by Greg Patrick, Co-Founder of Daily Trade Alert
Over the past month or so I’ve buying several stocks, but there’s one stock in particular that I’ve been loading up on. I ended up investing almost $37,000 into it which bought me 1,000 shares.
Even though the stock has shot up in price since I bought it — it jumped 7% after reporting quarterly earnings on November 12 — I still think it’s a good deal today.
So if you don’t already have a full position, and if you want to pick up shares of a high-quality dividend growth stock at an attractive price, then now could be a good time to buy.
I’ll be breaking down today’s write-up into two parts:
In part 1, I’ll tell you which stock I’ve been loading up on and why I think it looks like a good deal today. In part 2, I’ll go through a quick summary of the specific purchases and income trades I’ve been making with this stock for:
a) guaranteed high income in the short-term, and
b) relatively safe, reliable and growing income over the long-term
Part 1: Why I’ve Been Loading Up on Cisco Systems (CSCO)
By the beginning of November, Cisco — a Dividend Challenger that has paid its shareholders more and more income every year for the past 9 years — was actually down over 20% year-to-date.
As someone who invests for income, I get excited when a high-quality dividend growth stock falls in price because it gives me the opportunity to buy more shares and collect more income with less potential risk.
In the case of Cisco, thanks to that big price drop, the stock got significantly cheaper and its dividend yield shot up to nearly 4%. So I jumped on the opportunity.
Now, to be fair, Cisco’s revenues and profits — in dollar terms — have suffered as a result of less demand for its core networking products during the pandemic… and recovery has been slower than expected.
Source: Cisco Q1 FY’21 Earnings Presentation
So you could argue the business itself got weaker and therefore deserves a lower valuation. But I don’t think a 20%-plus drop was warranted, especially if you’re investing for the long-term.
The pandemic won’t last forever, I think most people will eventually return to a work place and companies will need to go back to upgrading their networking infrastructure. And they’ll be buying from a trusted and reliable company like Cisco.
Network infrastructure is critical — think about how important things like network speed and security are, or data storage and security.
So they’ll be buying from a brand they can trust, and one of the most trusted names in the business is Cisco.
And they won’t be buying just hardware: Cisco is currently in the process of transforming its business model — it’s shifting to focus less on hardware and more on software and subscriptions, which could see an added jolt of demand as the “Internet of Things” market continues to expand.
So with all of this in mind, when I saw Cisco’s price plummet over 20%, I looked at it as a long-term income and growth opportunity.
At the time I was buying shares, multiple valuation models and Wall Street analysts pegged the stock as undervalued…
Source: Tip Ranks
… and as I’m about to show you, even after its recent post-earnings pop, Cisco still looks undervalued today. And that’s the opportunity that you have right now: If you don’t already own shares of Cisco or if you’re interested in buying more, now could be a good time to buy.
Estimating Cisco’s Fair Value Price
If we want to maximize our potential income and minimize our risk, all else equal, we want to buy a stock when it is undervalued. And the more undervalued, the better. We get to lock in a higher dividend yield and we get a bigger margin of safety.
But how do we know if a stock is undervalued? How do we know if its current market price is LESS than what the stock is truly worth. Valuing a stock is part art and science, and there are a lot of methods or approaches we can take to help us figure out what a stock’s fair value price is.
If you follow Jason Fieber’s Undervalued Dividend Growth Stock of the Week series, you know that he blends a Dividend Discount Model analysis with fair value estimates and 12-month target prices from Morningstar and CFRA. And that’s a fantastic and diversified approach.
Today, for the sake of introducing you to possibly a new approach — and also because this is how I typically value a stock — I’m going to walk you through how I’d value Cisco right now.
Like I said, the stock’s not the bargain it was when I bought it pre-earnings, but I think it’s still attractively priced.
The valuation approach I’m going to walk you through is largely based on one put out by Dave Van Knapp, author of his upcoming Top 30 Dividend Growth Stocks for 2021.
If you haven’t seen it, Dave put together a fantastic lesson on how he values a stock. I modify his approach a little bit. He uses four valuation models — I like to use three of those four models and average them together to come up with an estimated fair value price.
Valuation Model 1: Current P/E vs. 5-year average P/E
For the first model we use FAST Graphs to compare Cisco’s current P/E ratio to its 5-year average P/E ratio.
This is a model that uses relative valuation because we’re comparing the company’s current earnings multiple to its own historical earnings multiple to basically answer the question: Is Cisco a better deal today, based on the company’s stock price and its earnings per share, than it has been — on average — over the past 5 years?
The black line in the chart above is Cisco’s stock price. The solid blue line plots its average P/E ratio over the past 5 years, which FAST Graphs calls its “normal” P/E. It’s fairly straightforward to interpret: When the black price line is BELOW the blue “normal” P/E line, the stock is undervalued. When the black line is ABOVE the blue line it’s overvalued.
So in this valuation model, we can see that Cisco is undervalued. And we can put a number to that and calculate just how much undervalued it is. Its P/E ratio is sitting at 12.97… while its “normal” P/E is 14.26. So this model suggests the stock is 9.1% undervalued.
To calculate its fair value price we first divide its current P/E by its normal P/E to get the valuation ratio, and that comes out to 0.91. We then divide Cisco’s current price by that valuation ratio, so $41.40 divided by 0.91 gives us an estimated fair value price of $45.49.
Valuation Model 2: Current Dividend Yield vs. Historical Dividend Yield
For our second valuation model we’re comparing Cisco’s current dividend yield to its 5-year average dividend yield. This is another model that uses relative valuation, only this time we’re not comparing P/E ratios, we’re comparing dividend yields.
All else equal, if the stock’s current yield is higher than its historical yield, then buying the stock today is a better time to buy than it has been, on average, over the past 5 years.
This model, like the first model, suggests that Cisco is currently undervalued. To put a price to that suggestion we first divide its 5-year average yield of 3.2% by its current dividend yield of 3.4%. That gives us a valuation ratio of 0.94. We then divide Cisco’s current price by that valuation ratio, so $41.40 divided by 0.94 gives us an estimated fair value price of $44.04. So this model suggests the stock is 6% undervalued.
Valuation Model 3: Morningstar Star Rating
For our third and final valuation model we’re using research from Morningstar. As Dave points out in his lesson on valuation, instead of using P/E ratios, Morningstar uses a discounted cash flow method for valuation, which many investors consider to be the best way to value a stock.
Using this method, Morningstar calculates Cisco’s fair value price to be $48.00, which indicates the stock is trading at a 14% discount.
Averaging the fair value estimates of the 3 different valuation models we used, we get a final estimated fair value price of $45.84. With Cisco trading at $41.40 at the time I’m putting this together, that indicates the stock is currently 9.7% undervalued.
Part 2: How I’m Playing Cisco for Income in My Own Portfolio
In total, I recently bought 1,000 shares of Cisco. I started buying Cisco on September 25, 2020 and then kept buying, and averaging down, as the stock continued to get cheaper and its dividend yield continued to rise.
As you can see in the following table, between September 25 and November 2, I bought a total of 300 shares of Cisco. I bought these shares in my regular brokerage account, which is my buy-and-hold dividend growth investing portfolio.
These 300 shares cost me just over $11,000 and my average cost-basis on them came out to $36.68 per share. Since we estimated Cisco’s fair value price to be $45.84 per share, I got into these shares at a 20.0% discount — a pretty compelling margin of safety.
And since the company pays $0.36 per share per quarter, I locked in a market-beating 3.9% dividend yield and I stand to collect at least $432 in dividend income over the next 12 months.
If Cisco keeps growing its dividend, as it has been for the past nine years, then that number should only go up year-after-year.
Source: Simply Safe Dividends
And that’s a dividend we can depend on, too. Consider this…
Simply Safe Dividends (SSD) rates a company’s dividend safety by reviewing its key financial metrics. SSD takes into account more than a dozen fundamental factors that influence a company’s ability to continue paying dividends, such as:
- Earnings and free cash flow payout ratios
- Debt levels and coverage ratios
- Recession performance
- Dividend longevity
- Industry cyclicality
- Free cash flow generation
- Return on invested capital
Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. You can review how scores are calculated, see their real-time track record, and learn how to use them for your portfolio here.
With all of this in mind, Cisco’s Dividend Safety Score is 91, which indicates that the dividend is not only much safer than the average dividend-paying stock in the market, but actually one of the safest overall.
This is why the stock is now a staple in my long-term “buy and hold” dividend growth portfolio. I don’t plan on selling these shares.
Now, I’ve also been buying shares of Cisco in my 401(k) retirement account, and I’ve been generating guaranteed high income in the short-term by selling call options on those shares. That’s what you see in the following table.
- On October 20, I bought 100 shares of Cisco at $39.31 per share and sold one January 15, 2021 $40 call option for $1.94 per share. With that move I collected $194 in income.
- On October 26, I bought 200 shares of Cisco at $37.45 per share and sold two November 27, 2020 $38 call options for $1.49 per share. This generated $298 in income.
- And then on October 28, I bought 400 shares of Cisco at $35.88 per share and sold four November 27, 2020 $36 call options for $1.78 per share. This generated $712 in income.
From these high-yield trades, I was able to generate $1,204 in instant income in October 2020.
If my shares don’t get called away and I’m “stuck” holding them in my retirement account, that’s perfectly fine with: Those 700 shares would likely pay me over $1,000 in dividends each year for simply holding them. And of course, as the company raises its dividend each year, that $1000 will just keep growing organically.
If shares do get called away then I’ll be selling them at a profit and generating an additional $227 in capital gains in the process. And that’s on top of the $1,204 in call income I already collected when I sold the options in October. So either scenario is a win, which is why I’m such a big fan of selling options like this on high-quality dividend growth stocks that I wouldn’t mine owning for the long-term anyways.
If you’d like to learn more about how I sell options for income — and generate tens of thousands of dollars per year in the process — check out this video I put together.
At the end of the day, Cisco is a high-quality dividend growth stock that, at recent prices, looks cheap and is paying historically high income. If you don’t already have a position in the stock, consider building one now or any any pullbacks.
P.S. I liked the setup with Cisco so much that I also made a small but leveraged bet on the stock: On October 28, I bought three of the January 15, 2021 $40 strike call options for $0.85 per share. By November 13 these options had already tripled in value, thanks to the earnings pop, so I sold one of them for $2.54 per share. As of November 21, I’m still sitting on the other two options for essentially “free”.