Friday, February 3, 2017

3 Dividend Stocks Trading At A Discount

This guest post has been wrote by Mike McNeil, passionate investor, founder of Dividend Stocks Rock and author of The Dividend Guy Blog.

As the S&P 500 just finished its 8th consecutive year with positive returns, the crash of 2008 has become merely an old souvenir for many.

Source: Ycharts

However per, the S&P 500 P/E ratio hasn’t been that high very often:

Source: Multpl

This leaves investors with money waiting on the sideline stuck with this never ending doubt: It's always scary to add to positions because you always think the day after you buy is the day the market crashes. Finding opportunities in the current market has been harder than ever. This is how a strong investing process and careful use valuation models can be of help while researching for your next trades. Using the Dividend Discount Model (DDM), I’ve identified three companies that shows a low double digit potential gain.

Lockheed Martin (LMT) 

Source: Ycharts

Lockheed Martin has been part of my portfolio since 2012. The company financial performance is closely linked to the U.S. Government military budget as about 80% of their revenues are coming from it. Lockheed Martin (LMT) is the world’s largest defense contractor earning 61% of its sales from the US Department of Defense, 21% from other US government agencies and 18% from international clients. Heavy regulation, years of symbiosis with the US Defense department and their know-how are three key elements protecting most of Lockheed Martin’s business. Let’s just say you can’t start building military aircraft and missiles in your basement to compete with this defense behemoth.

After successfully optimizing their structure to improve their earnings while revenues were struggling, Lockheed Martin made a big move in 2015 by acquiring Sikorsky Aircraft in order to increase its revenues growth potential. In 2016, they have received the Congress benediction to seeks for additional international contracts.

In order to determine Lockheed Martin stock fair value, I use a double stage DDM. This allows me to choose a dividend growth rate for the first 10 years and another one as a terminal rate. I’ve used the following assumptions for Lockheed Martin:

With a low payout ratio, I think Lockheed Martin is able to maintain a high single digit dividend growth for several years to come. However, I’ve used a 10% discount rate as the company business model is still highly tied to the U.S. Government military budget. Here are the results of my calculation:

Source: Dividend Monk Toolkit Calculation Spreadsheet

Microsoft (MSFT)

Source: Ycharts

Microsoft is the best known and most important software company in the world. Along with its famous line of software products, Microsoft also offers various services such as servers (including cloud systems), business solutions (support and consulting), entertainment (Xbox) and other online services.

My interest in Microsoft has grown as it shows a continuous growth potential with its cloud business services. Azure, the firm’s public cloud service, has established itself as the number-two player in the space behind Amazon. While reporting their Q3 2016, management has mentioned that Azure revenue and compute usage more than doubled year-over-year (source). This represents a strong growth vector for the future.

The payout ratio seems high at 68.40% to justify a double-digit dividend growth rate. However, if you look at the cash payout ratio (44.06%), the company has plenty of room to continue its generous payout hikes. I’ve used a 10% dividend growth rate for the first ten years and drop it to 7% for the year after.

Here are the results of my calculations:

Source: Dividend Monk Toolkit Calculation Spreadsheet

Union Pacific (UNP) 

Source: Ycharts

Union Pacific is a transportation company focused on railroads. Its Union Pacific Railroad covers 23 states across the western 2/3 of the USA. Union Pacific shows a great diversification in terms of sectors: 10% for Automotive, 17% Agricultural products, 17% Chemicals, 20% Intermodal, 19% Industrial products and 17% Coal. The stock price has obviously been hit quite hard as the coal business is losing steam rapidly. However, the stock hasn’t recuperated fully from its previous peak price back in 2015.

The reason to purchase Union Pacific today is simple; go past the short-sighted challenging environment and look at the big picture. Low oil prices will only last for so long and trucking industry will not stay as fierce competitors over the long run. In the meantime, the management team is doing fabulous work to continue improving the company’s productivity with longer and faster trains all the while controlling costs. This is a strong dividend payer with a relatively good yield (2.35%).

The company shows strong dividend growth potential with a payout ratio at 43.96% and a cash payout ratio at 56.80%. The perfect timing to pick up Union Pacific was definitely in early 2016 as the stock surged nearly 40% over the past 12 months. However, the DDM calculation shows there is still room for growth in this case.

As Union Pacific is still evolving in a difficult environment, I’ve used a 6% dividend growth rate for the first 10 years (please keep in mind announced a 10% dividend increased back in November 2017). I then increase the terminal rate to 7% based on the fact railroad companies will continue to generate strong cash flow for several years.

As opposed to the two other selection, I used a 9% discount rate. I usually use such lower discount rates when a company shows a strong business model in a relatively stable environment. While the railroads follow economic cycles when it comes down to revenue growth, the fundamental of their business model remains solid and there are few competitors. The ownership of railroads itself is a competitive advantage that is impossible to replicate. Here are the results of my calculations:

Source: Dividend Monk Toolkit Calculation Spreadsheet

How I selected those 3 companies

Before I select any companies to be part of my portfolio, I go through an exhaustive investment process. Each company must meet the 7 dividend investing principles. Those principles have been established based on several academic studies and over a decade of my financial experience in the stock market. I also use the Dividend Discount Model (DDM) to determine the fair value of each company along with the right timing to purchase its shares. In my opinion, those are keepers for a dividend growth portfolio.

Disclaimer: I hold in my Dividend Stocks Rock portfolios.

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