Use access key #2 to skip to page content.

Dividends4Life (31.07)

7 Dividend Stocks Trading Below Fair Value

Recs

8

May 03, 2010 – Comments (0) | RELATED TICKERS: ABT , CL , KO

Fair value is really a simple concept. Given some select information such as dividends, dividend growth, holding period, discount rate and few other inputs, one can easily calculate the fair value of a stock. As with most simple things, the devil is in the details – the inputs must be correct to calculate a reasonable fair value, otherwise, garbage in, garbage out.

Accurately determining free cash flow, dividend growth rates and such on a forward looking basis is no simple task. Most analysts look to a company’s past to help determine how they will behave in the future. I am certainly no exception to that convention. My fair value model was constructed back in 2007 at a time many stocks had already fell from grace. As a result, a large number of companies were trading below fair value based on historical metrics. To reduce this number and focus in on only the best companies, I took an extremely conservative stance with my fair value model.

Calculating Fair Value

As a reminder, I consider the following when calculating fair value:

Avg. High Yield Price: Price calculated by dividing current dividend per share by the average high dividend yield for each of the last 5-years (dividend per share divided by the year’s low share price).

20-Year DCF Price: Price calculated by taking the Net Present Value (NPV) of the next 20 years of dividends and the estimated value of the stock at the end of 20 years.

Avg. P/E Price: Price calculated by multiplying the EPS (trailing twelve months) times the minimum of: 1.) 5-year average of high and low P/Es or 2.) Last years high P/E.

Graham Number: Price calculated by taking the square root of 22.5 times the tangible book value per share times EPS (trailing twelve months). Benjamin Graham, Warren Buffett’s mentor and the father of value investing, developed rules for the defensively screening stocks. This formula uses his principles to calculate the “maximum” price one should pay for the stock. He believed – as a rule of thumb – the product of P/E ratio and price-to-book should not be more than 22.5 (P/E ratio of 15 x price-to-book value of 1.5). The 15 P/E was was a result of Graham wanting his portfolio to have a yield equal yield to that of a AA bond (back then around 7.5%). The inverse of this yield is 1 divided by 7.5%. That works out to 13.3; he rounded up to 15.

Mid-2 Price: Of the four fair value calculations,  “Avg. High Yield Price”,  “20-Year DCF Price”,  “Avg. P/E Price” and “Graham Number”, the highest and lowest fair values are excluded and the remaining two calculations are averaged to calculate the Mid-2 price.

NPV MMA Price: The price where the NPV MMA value equals the NPV MMA target. The basis of NPV MMA value calculation is a hypothetical $1,000 investment in the subject stock and a Money Market Account (MMA) earning a 20 year average rate (I use a 20 year Treasury as a proxy). The value calculated is the net present value (NPV) of the difference between the annual dividend earnings of this investment and the interest income from the MMA over 20 years. Other assumptions include: 1.) dividends grow at a historically calculated rate, 2.) dividends are reinvested, 3.) share price appreciation is not considered, 4.) interest income is reinvested in the MMA. The NPV MMA target is determined based on the number of consecutive years of dividend increases. The formula is: Target = Base – (Years x Increment) + Minimum where Base=3,000, Increment=100, Minimum=500. Thus 0 years of dividend growth yields a $3,500 target and 30 years of growth yields a $500 target.

Historically, I have conservatively taken the lower of the the Mid-2 Price or NPV MMA Price as the stock’s fair value. Over the last year as the market has recovered and companies histories now include some very lean times, the pendulum has swung to the other extreme where very few companies were trading below my conservative calculation of fair value (in most cases driven by a low Mid-2 value).

Changes To The Fair Value Calculation

I have added to my model the ability to calibrate the Fair Value calculation based on where we are within the market cycle. Below are the various options:

Option: 1 = The lower of the Mid-2 price or the NPV MMA price (the historical option).
Option: 2 = Lesser of the Mid-2 price or NPV MMA price + lower of 10% increase or 25% of the difference between Mid-2 price and NPV MMA price.
Option: 3 = same as Opt: 2 except + lower of 20% increase or 50% of the difference.
Option: 4 = same as Opt: 2 except + lower of 30% increase or 75% of the difference.
Option: 5 = The higher of the Mid-2 price or the NPV MMA price.
Option: 6 = Weighted: 25% Mid-2 price + 75% NPV MMA price.

I am currently running with Option 4. It is pointing out some stocks that are still priced well when focusing on their dividend fundamentals, but are trading above their recent lows.

Seven Dividend Stocks Trading Below Fair Value

Here are some stocks that were identified as trading below their fair value:

Abbott Laboratories (ABT) | Analysis | Yield: 3.36%
- Recent Price: $51.20
- Fair Value: $61.24

Kimberly Clark Corp. (KMB) | Analysis | Yield: 4.33%
- Recent Price: $60.93
- Fair Value: $63.86

Harleysville Group Inc. (HGIC) | Analysis | Yield: 4.03%
- Recent Price: $33.46
- Fair Value: $38.44

The Coca-Cola Company (KO) | Analysis | Yield: 3.27%
- Recent Price: $53.88
- Fair Value: $57.92

Cincinnati Financial Corp. (CINF) | Analysis | Yield: 5.23%
- Recent Price: $30.21
- Fair Value: $33.09

Meridian Bioscience Inc. (VIVO) | Analysis | Yield: 3.51%
- Recent Price: $19.38
- Fair Value: $23.32

Colgate-Palmolive Company (CL) | Analysis | Yield:  2.44%
- Recent Price: $83.27
- Fair Value: $91.57

Like most investors, I prefer to have it all – a great dividend stock at a low price. However, this isn’t always possible. As a dividend investor first and a value investor second, I will always favor dividend fundamentals over fair value when forced to choose. Consider these two quotes by Warren Buffett:

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

“Time is the friend of the wonderful company, the enemy of the mediocre.”

If you make a mistake and pay too much for a great company, eventually time will correct that problem. The same can’t be said for a poor or mediocre company.

Full Disclosure: Long ABT, KMB, HGIC, KO. See a list of all my income holdings here.

Related Articles:
Dividend Investing With ETFs
High Yield, High Risk Dividend Stocks
The Best Dividend Stocks In The World
Dividend Stocks: A Disciplined Approach
10 Stocks With 100+ Years of Dividend Payments

0 Comments – Post Your Own

Featured Broker Partners


Advertisement