In this High Quality Dividend Growth Stock of the Month series, stocks are selected based on their quality. Good valuation is not a prerequisite for inclusion. That allows me to bring your attention to great companies that may not be well-valued at the moment.

Some investors, especially younger ones with long investing careers ahead of them, may not be very concerned about current valuations. They figure that in 10-15 years, they won’t care what they paid for the best companies; they will just be glad that they own them.

Here are the first two articles in the series, if you want to go back and catch up:

October 2020: Apple (AAPL)

November 2020: Amgen (AMGN)

This month, we stay in the Health Care sector.

December 2020’s HQ Stock: Bristol-Myers Squibb (BMY)

As you might imagine from the compound name, Bristol-Myers Squibb (BMY) came about through mergers. Two of them took place in the 1800s, and the one that produced today’s company was completed in 1989.

BMY’s increase streak just moved up to 13 years, as it announced an 8.9% dividend increase, payable in February, 2021.

Its ex-dividend date is December 31 (which means to get the newly increased dividend, you would have to buy the stock by December 30). The company has paid uninterrupted dividends since its present-day formation in 1989.

BMY is a biopharmaceutical giant. Its products are sold worldwide, principally to wholesalers and specialty distributors, as well as to retailers, hospitals, clinics, government agencies, and pharmacies. A little over half of its revenues come from the USA.

About a year ago, BMY completed one of the largest pharmaceutical mergers in history when it acquired Celgene for about $80 billion. That merger directly raised BMY’s annual sales by about 50%.

In October 2020, BMY announced plans for another major acquisition. It will buy biotech company MyoKardia for $13.1 billion with cash and debt.

While the deal will increase BMY’s leverage, which it had been reducing since the Celgene acquisition, the company stated at its recent Q3 earnings presentation that it remains committed to long-term debt reduction as well as to maintaining its dividend.

(Source: Q3 BMY Earnings Presentation)

Morningstar awards BMY a wide moat, meaning that it has durable competitive advantages. Their assessment is based on several factors, including:

  • BMY’s broad lineup of patent-protected drugs, which confers both pricing power and a time cushion to move its developmental drugs along in the pipeline
  • Entrenched salesforces, which confers an advantage over companies that lack such a distribution channel
  • Economies of scale

Bristol-Myers Squibb’s High Quality

As explained in Dividend Growth Investing Lesson 20: Quality Snapshots, I derive an overview of a company’s quality from the following sources, which I have come to trust and respect over the years:

I grade these snapshots by awarding up to 5 points in each category. BMY scores 23 points of a possible 25, giving it the third-highest grade possible.

Simply Safe Dividends reaffirmed BMY’s “safe” dividend safety score (79) in October, following the MyoKardia announcement, stating that it expects BMY’s dividend to remain well covered by cash flow.

That seems to have been confirmed by BMY’s recent dividend increase announcement. Below is a picture of BMY’s long-term dividend growth followed by its near-term payment schedule, including the first quarterly dividend for next year.

BMY’s Dividend Record

(Source: Simply Safe Dividends)

BMY’s current yield is 3.2%, and with its 2020 and 2021 increases both being in the 9% range, I would categorize BMY as a mid-yield-medium-growth DG stock.

Bristol-Myers’ Valuation

To value a stock, I use four different valuation models, then average them. For more details on my approach, see Dividend Growth Investing Lesson 11: Valuation.

Models 1 and 2: FASTGraphs P/E Comparisons

FASTGraphs present a stock’s price on the same chart as valuation reference lines for easy visual comparison. You can draw the reference lines anywhere you like. I use two that are pre-built into the system:

  • An orange line based on formulas regarding the performance of the stock market historically and the company’s own earnings growth rate. The orange line usually is drawn using a P/E ratio of 15, although in BMY’s case it is a little different.
  • A blue line based on the stock’s own P/E ratio for any time-period you choose. I usually select a 5-year backwards look. That requires an 8-year display of the chart, because of the future years displayed.

Here is the FASTGraph for BMY, using the 8-year display period. You can see the blue and orange reference lines. The black line is BMY’s actual market price.

Despite BMY’s impressive earnings growth record (marked by the arrow at the bottom left), its price has languished. It has basically been flat for four years. That results in a great opportunity for prospective buyers, so long as they believe that BMY has good growth prospects.

For BMY, the orange fair-value reference line is drawn at a P/E ratio of 20.1 (not the usual 15) to reflect BMY’s fast earnings growth. The blue line is drawn at BMY’s 5-year average P/E of 21.7.

You can tell visually that BMY is underpriced based on the placement of its price line in relation to the blue and orange valuation reference lines.

The company’s current P/E ratio is 9.6. I create a valuation ratio for each model.

Valuation Ratio = Actual P/E divided by Reference P/E

Valuation ratio #1 (orange line)  = 9.6 / 20.1  = 0.48

Valuation ratio #2 (blue line) = 9.6 / 21.7 = 0.44

Both models suggest massive undervaluation. Let’s look at the other models.

Model 3: Morningstar’s Discounted Cash Flow

Morningstar takes a different approach. They ignore P/E and other valuation ratios.

Instead, they construct a discounted cash flow (DCF) model. Using conservative projections, they discount all of the stock’s estimated future cash flows back to the present to arrive at a fair value estimate. The idea is that a stock’s fair price is equal to the net present value of all of the company’s future cash flows.

Here is Morningstar’s valuation history on BMY. The red line on the graph is Morningstar’s fair-value calculation over the past 10 years, and the black bars represent BMY’s price.

Morningstar’s valuation ratio (circled) is 0.88. That suggests undervaluation, but not as extreme as in the first two models.

Model 4: Current Yield vs. Historical Yield

The final model compares 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. And vice-versa.

We can see the comparison visually with this graph from Simply Safe Dividends:

Just as with the earlier models, we make a valuation ratio. BMY’s current yield is 3.2% and its 5-year historical average is 2.8%.

Valuation ratio = 2.8% / 3.2% = 0.88

BMY’s Valuation Summary

Now we average the 4 approaches.

But first, I am going to adjust the first two valuation ratios. They were extreme compared to the others. What I often do when faced with extreme values is cap them, usually at 20% away from fair value. That preserves their direction, but lowers what would be an outsized influence on the calculation. Thus, I cap both Models 1 and 2 at 0.80.

In the aggregate, the assessment is that BMY is undervalued, with a valuation rato of 0.84.

Now it is easy to calculate a fair price:

Fair price = Current price / Valuation ratio

BMY’s recent price was $60. If we use the formula above, we get $60 / 0.84 = $71.

Because valuation is an assessment, not a physical measurement, all valuations are estimates. Therefore, it is logical to think in ranges rather than exact values. For example, I consider any price within +/- 10% of my calculated fair price to be fairly valued.

If I apply that 10% concept to BMY, that would put the top of the BMY’s fair-price range at $79. However, since the stock is selling for around $60 now, there is no reason to go to the top of the range. BMY is already selling for 15% less than its calculated fair price. So my maximum entry price would be the same as the fair value calculation, or $71.

Closing Thoughts

Bristol-Myers Squibb is selling for a discounted price right now. As with Amgen last month, that demonstrates that high quality stocks can be obtained at good prices sometimes.

If you would like more detailed information, BMY’s Q3 financial results were reported in November. Here are the slides from that presentation.

For what it’s worth, Warren Buffett (through Berkshire Hathaway) started a new position in BMY during the third quarter. You can read more about that in Jason Fieber’s Warren Buffett’s Latest Trades: 10 Buys, 10 Sells.

This is not a recommendation to buy, sell, hold, trim, or add to BMY. As always, perform your own due diligence. Check the company’s complete dividend record, business model, financial situation, and prospects for the future. Also consider your tolerance for risk and how well the company fits (or does not fit) your long-term investing goals.

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This article first appeared on Dividends & Income

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