Welcome back to the Valuation Zone. Once a month, we look for good, solid dividend growth companies that are selling at a fair price. Or better yet, selling at a bargain price.
This month’s stock is Verizon (VZ). I just bought Verizon for my Dividend Growth Portfolio, and as part of that decision I re-valued Verizon to be sure I was getting a good price. In this article I will share the valuation process with you.
It is the largest wireless carrier in the United States, serving about 114 million connections.
Verizon provides communications services to consumers, businesses, and government via both wireless and wireline.
Verizon is a Dividend Contender with a 13-year streak of increasing its dividend.
Verizon’s dividend falls into the high-yield, slow-growth category. The company currently yields 4.8%. Its most recent dividend increase was 2.2% last November.
As always, before we take a look at Verizon’s valuation, we’ll check to see if its dividend is safe. Most dividend growth investors require a safe dividend before considering investing at all.
Verizon’s Dividend Safety
For a complete discussion of dividend safety and reliability, see Dividend Growth Investing Lesson 17: Dividend Safety.
I use Simply Safe Dividends to assess dividend safety. They analyze cashflow, payout ratios, and several other metrics to arrive at an opinion about dividend safety. They summarize their results on this scale.
Here is how Simply Safe Dividends scores Verizon:
Simply Safe Dividends’ score of 73 out of a possible 100 points places Verizon in their 2nd-highest safety category. They believe that Verizon’s dividend is safe and unlikely to be cut.
I also use a second service, the Oxford Club’s Safety Net Pro. This is their scale for scoring dividend safety.
Here is their rating on Verizon.
Verizon is also in Safety Net Pro’s 2d-highest safety category, indicating a safe dividend with a low risk of being cut. I contacted them to ask about the prior “F” rating, and this was the response:
When it was rated [F], VZ had a one and three year free cash flow growth that was negative. Additionally the payout ratio was too high. With the 2017 annual report, one year free cash flow growth is now positive and the payout ratio has come down.
With that cleared up, let’s value the stock.
Valuation Steps
To value a stock, I employ 4 methods and then average them out. For a complete discussion of how this works, please read Dividend Growth Investing Lesson 11: Valuation.
Step 1: FASTGraphs Default Valuation
In the the first step, we check the stock’s current price against FASTGraphs’ basic estimate of its fair value. For its basic estimate, FASTGraphs compares the stock’s current price-to-earnings (P/E) ratio to the historical average P/E ratio of the whole stock market. That historical average is 15.
That fair-value reference is shown by the orange line on the following graph, while the black line is Verizon’s actual price.
By this first way of estimating valuation, Verizon is undervalued, because its price line is below the orange reference line.
We can calculate the degree of undervaluation by comparing P/E ratios. We divide the stock’s actual P/E ratio of 12.6 (circled in red) by the ratio of 15 that was used to draw the orange line.
We get 12.6 / 15 = 0.84, or 84%. This suggests that Verizon is 16% undervalued.
If we divide Verizon’s currrent price by that ratio, we get an estimate of the stock’s fair price. The calculation is $49 / 0.84 or about $58 for a fair price. (I round prices off to the nearest dollar so as not to create a false sense of precision.)
Step 2: FASTGraphs Normalized Valuation
The next step is to compare the stock’s current P/E ratio to its own long-term average P/E ratio. This lets us judge fair value by recognizing how the market has historically valued Verizon itself rather than by how the market has valued all stocks. I use the stock’s 5-year average valuation ratio for this step.
This 2nd step paints a similar picture. That’s because Verizon’s 5-year historical P/E has averaged out to 14.8, which is practically the same as the ratio of 15 that was used as a reference point in the first step.
Using the same equation as in the first step, the degree of undervaluation is 12.6 / 14.8 = 0.85, or 15% undervalued. We get a fair price of about $58 again.
Step 3: Morningstar Star Rating
The next step is to see how Morningstar values the stock. I use Morningstar, because they take a different approach to valuation.
Morningstar ignores P/E ratios. Instead, they use a discounted cash flow (DCF) model. They discount all of the stock’s projected future cash flows back to the present to arrive at a fair value estimate. (If you would like to learn more about how DCF works, check out this excellent explanation at moneychimp.)
Under Morningstar’s 5-star system, 3 stars means that they think that Verizon is fairly valued. They calculate a fair price of $52, which is about 6% above Verizon’s current price.
Step 4: Current Yield vs. Historical Yield
The 4th and final valuation method is to compare 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.
This display from Simply Safe Dividends shows Verizon’s yield over the past 5 years.
The company’s current yield of 4.8% is above the 5-year average of 4.5%. That suggests a slight undervaluation. The degree of undervaluation is 4.5 / 4.8 = 0.94, or 6% undervalued. I consider anything within +/- 10% of fair value to be “fair.”
Using the same equation as in prior steps, the 6% undervaluation suggests a fair price of $49 / 0.94 = $52.
Valuation Summary
Now we average the 4 approaches.
The average of the 4 fair-price estimates is $55 compared to Verizon’s actual price of $49. That’s an 11% discount to fair value, suggesting a nice margin of safety.
Disclosure and Caution
I own Verizon.
The fact that a stock’s price is undervalued does not mean that anyone should buy it. A fuller analysis would be required.
Therefore, as always, this is not a recommendation to buy Verizon. Perform your own due diligence. Check out the company’s dividend record, quality, financial position, business model, and prospects for the future. Also consider whether it fits (or does not fit) your long-term investing goals.
— Dave Van Knapp