Valuation Guide for 2017 + 3 Undervalued Companies

I personally think 2017 will be a good one for the stock market. After going sideways during 2015 and the first couple of month of 2016, the economy has been put back on track with solid numbers and the stock market follows. However, after a strong bullish market since 2009, buying opportunities are getting rare. This is why a strong valuation process is important.

My Favorite Tool for Valuation

There are tons of methods to value companies. Each of them have their pros and their cons. My favorite one is the Dividend Discount Model. It helps me looking at each company as it was a money distributor (I kind of like this idea!). By discounting the value of each dividend payouts, I get an idea of how much I should pay for shares of company XYZ.

The DDM is relatively easy to use, but could sometimes be misleading if our assumptions are to optimistic. By using a low discount rate (meaning you don’t expect much return) or by boosting expected dividend growth rate, you could easily find deals everywhere on the stock market. Therefore I’m offering a small refresh on how I use it.

How to adequately select your discount rate

By definition, the discount rate should correspond to your expected rate of return. If you invest in the stock market, you should expect a minimal return of 7-8%. However, if you use such a low discount rate to make up a value using popular models such as the Discounted Cash Flow analysis or the Dividend Discount Model, you will find that pretty much all dividend growth stocks are trading at a discount. This is not true either.

I try to become more selective in my approach. This is why I use a discount rate between 9% and 12%. When a company is in stellar condition, I will use the 9% discount rate. However, this company must show most of the following criteria:

  • geographically diversified (being a leader in several countries)
  • diversified products (many billion dollar brands)
  • solid balance sheet (low debt and high repayment capacity)
  • unique economic moat (a competitive advantage nearly impossible to replicate)
  • steady and increasing revenue streams

Such companies can be found but they are rare. Most of the time, I find a solid company showing most of those criteria, but there is always something leading me to use a higher discount rate. This is why I pick 10% as a default discount rate. I use 1% less (9%) for exceptional companies and 1% over (11%) for riskier companies. Rarely, but sometimes it happens, I use a 12% discount rate when I think the company has a strong upside potential but also shows some serious issues. I tend to never have more than 10% of my portfolio invested in such companies.

Using a sustainable dividend growth rate

When I see investors using an 8% discount rate, I find it’s not greedy enough. I think they put their investment at risk thinking all their investment will reward them with a 8% return. We all know this is not true and you need stronger picks to compensate. This is why using a 10% discount rate will push many companies aside at the valuation stage.

A similar thinking should be applied toward dividend growth rates. I like using the double stage dividend discount model calculation as I can use 2 different rates. A first one that will be good for the first 10 years and another one that will be used forever after. The first rate could be more generous if it reflects the current situation of a company. When a business is growing in a flourishing economy, we can believe it will become more generous with its shareholders for the time being. After that, it is time to become more reasonable and expect a more conservative rate. The idea is to find the balance between the past 5 years that has simply been amazing and the next 25 years where we can’t really know what will happen.

The Dividend Discount Model – 3 Undervalued Companies

In order to illustrate how I use the double stage dividend discount model (you can check the excel spreadsheet here), I selected 3 companies with undervalued share prices. Those will be a good start for your potential buy list for 2017.

Clorox (CLX) Potential Gain: 43%

The reason an investor would pick CLX to be part of his portfolio is somewhat obvious: it is an ever increasing dividend stock. Clorox is part of the selective group of dividend aristocrats that has increased its dividend for at least 25 years consecutively. In 2016, they have reached their 39th consecutive year with a dividend raise.

The company goals are to support a 3-5% organic sales, improve margins by 25 to 50 bps and to generate free cash flow of 10-12% of sales.

Calculation:

 

Results:

Source: Dividend Toolkit Spreadsheets

Lowe’s (LOW) Potential Gain: +30%

Focus on a recovering U.S. economy and additional growth from acquisitions should continue to push LOW’s stock price higher. Its strong brand and the way it helps its customers to go through bigger projects by offering a “one-stop-shop-&-advice” service will secure LOW’s market share and improve margins over the long haul. Lowe’s has been able to transform a simple home product store into a great service offering for home projects. There is definitely more room for growth in the upcoming years.

Calculation:

Results:

Source: Dividend Toolkit Spreadsheets

Honneywell (HON) Potential Gain +32.5%

Honeywell has made impressive efforts to improve their internal practices over the past 15 years after failing to merge with General Electrics (GE). Those efforts paid well as the company operating margins improved from 7.6% in 2004 to 15.2% in 2014. Those impressive margin increase lead HON EPS to increase by 10% in 2015 as the company is facing a challenging economy. The company was also able to increase its dividend by 10% CAGR over the past 5 years. HON is a leader in the aerospace control and safety systems and should benefit from its leadership position during the commercial aircraft upcycle.

Calculation:

Results:

Source: Dividend Toolkit Spreadsheets

 

Disclaimer: I hold CLX and LOW in my dividendstocksrock portfolios.

My Favorite Tool for Dividend Stock Valuation at 50% Rebate… Until Monday Midnight!

As you know, I’m currently travelling with my family across Central America countries for one year. 100% of my income is coming from my websites. The reason that I’m able to finance my trip through my investing website is that I offer great quality and I’m fully committed to my readers.
Over the past six years, I’ve purchased this blog, built a unique dividend investing platform (DSR) and bought The Dividend Monk. When I bought the Dividend Monk back in March 2015, I did it for a very specific reason; because The Dividend Monk created the most useful tool to determine a dividend stock fair price. The easy-to-use calculation spreadsheet comes with a very detailed eBook explaining how to perform strong and sound stock analysis. This resource is called the Dividend Toolkit.
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The Dividend Toolkit includes two components:

1) The 200 page PDF Stock Analysis Guide for individual investors, which describes the extremely efficient method to analyze a dividend stock, how to build and manage a dividend portfolio, and what you need to know about MLPs, REITs, and asset allocation. It offers plenty of content, but is divided into modular sections so that it’s easy to read through. The first chunk of the book is introductory content for new investors, and the later part of the book gets into the useful specifics. Even if you rely on newsletters or blogs for your stock ideas, this guide will give you a deeper understanding of your investments and will give you specific tools to check the accuracy of any stock ideas that you’re given.

2) The Valuation Spreadsheet File, which contains a streamlined and easy-to-use tool to instantly calculate the intrinsic value of a stock. Unlike many financial books that give equations without an efficient way to use them, this book comes with the the tool to apply the specific concepts in the book. It has a few different options, including the Dividend Discount Model, so that you can calculate the fair value to pay for any stock.

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Black Friday 50% Rebate

Since its creation in 2012, The Dividend Toolkit was downloaded several thousand times. The Toolkit usually retails for $19.95 USD but I offer a 50% rebate to bring it down to $9.95 for the package during the Black Friday weekend… this ends Monday at midnight!
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General Electric is Dressed to Please but You have to Sell it Now

DSR Quick Stats

Sector: industrial

5 Year Revenue Growth: -4.73%

5 Year EPS Growth: -31.80%

5 Year Dividend Growth: 14.87%

Current Dividend Yield: 3.06%

What Makes General Electric (GE) a Good Business?

First, a company with an emblematic founder named Thomas Edison. Second, a company that has been around for over one hundred years and that has been paying dividend for a century to its shareholders. Third, a company with an enormous portfolio of products and services operating across the world. The company counts 8 division among their “GE Store”:

  • Power: combustion science and services, installed base.
  • Energy connections: electrification, controls and power conversion technology.
  • Renewable energy: sustainable power systems and storage.
  • Oil & Gas: services & technology.
  • Transportation: engine technology and localization in growth regions.
  • Lighting: LED bulbs.
  • Healthcare: diagnostics technology.
  • Aviation: advanced materials, manufacturing and engineering products.

Which such a resume, you would think that GE should be the perfect holding for any dividend growth investors, right? The company is certainly a big player in several markets, but the drop of 31% of its earnings over the past 5 years concern me. Let’s dig further.

Revenue

ge-revenue

Revenue Graph from Ycharts

Since its record year in 2009, the company has been suffering greatly. The problem is that GE has become definitely too big to being handled properly. Several segments underperformed and wasted cash and human resources. Management has finally woke up and put effective measure to reposition their massive brand portfolio and show interesting perspective in the past couple years.

How GE fares vs My 7 Principles of Investing

We all have our methods for analyzing a company. Over the years of trading, I’ve been through several stock research methodologies from various sources. This is how I came up with my 7 investing principles of dividend investing. Let’s take a closer look at them.

ge

Source: Ycharts

Principle #1: High Dividend Yield Doesn’t Equal High Returns

My first investment principle goes against many income seeking investors’ rule: I try to avoid most companies with a dividend yield over 5%. Very few investments like this will be made in my case (you can read my case against high dividend yield here). The reason is simple; when a company pays a high dividend, it’s because the market thinks it’s a risky investment… or that the company has nothing else but a constant cash flow to offer its investors. However, high yield hardly come with dividend growth and this is what I am seeking most.

ge-yield

Source: data from Ycharts.

General Electric has posted a steady dividend yield around 3% over the past decade (excluding the short peak in 2009 following the recession). It is important to point out the dividend cut in 2009 as GE Capital business went south due to the 2008-2009 credit crunch. After this dark year, the company has put everything in place to grow back its dividend to its previous level.

GE meets my 1st investing principle.

Principle#2: Focus on Dividend Growth

My second investing principle relates to dividend growth as being the most important metric of all. It proves management’s trust in the company’s future and is also a good sign of a sound business model. Over time, a dividend payment cannot be increased if the company is unable to increase its earnings. Steady earnings can’t be derived from anything else but increasing revenue. Who doesn’t want to own a company that shows rising revenues and earnings?

ge-dividend

Source: ycharts

As I mentioned in the previous chart, the dividend payment as greatly cut in 2009 bringing back the distribution past the 2000’s level. Since then, GE has made a honest effort to compensate their shareholders through 14 Billions in share repurchase and 4 Billions in dividend payment. Unfortunately, as the economy has slowed down in the past 18 months, GE is struggling again to post dividend growth.

GE does not meet my 2nd principle.

Principle #3: Find Sustainable Dividend Growth Stocks

Past dividend growth history is always interesting and tells you a lot about what happened with a company. As investors, we are more concerned about the future than the past. this is why it is important to find companies that will be able to sustain their dividend growth.

ge-sustainable

Source: data from Ycharts.

When you look at both payout and cash payout ratio, you understand why management has to remain cautious about their dividend increase. The payout ratio is steady high around 80% for year and the cash payout ratio is currently deep in the red. The company doesn’t show strong ability to sustain their payouts through the long haul.

GE doesn’t meet my 3rd investing principle.

Principle #4: The Business Model Ensure Future Growth

I think it’s unfair to judge General Electric solely on its metrics. The company still show several positive points throughout its business model. GE has made lots of effort to aligned its various segments in order to create additional synergy. GE is offering more services to its partners and customers in order to assist clients in buying and using GE products. There is definitely room for growth in this area.

The second growth vector GE presents is its strategy to develop the Chinese market. The country will continue seeking for renewable energy, more mass transportation and affordable healthcare due to the size of its population. Those are all areas GE can play a role. For this reason, the company is heavily implementing activities in this region and also works through partnerships with Chinese company.

What General Electric does with its cash?

GE management is well aware they must do something to keep their investor on board. This is not by fluke they have used 18 billions to repurchase shares and hike their dividend in the past few years. GE is also investing massively in their R&D departments in order to keep their edge against their competitor. Since they are active in various industries, it requires lots of cash flow to innovate everywhere.

GE is also using a part of its cash flow to make acquisitions. They have recently purchased Alstom to penetrate the European market as well as Arcam and SLM Solutions to use their technology and become a bigger player in Europe as well.

GE has a strong business model and therefore meet my 4th investing principle.

Principle #5: Buy When You Have Money in Hand – At The Right Valuation

I think the perfect time to buy stocks is when you have money. Sleeping money is always a bad investment. However, it doesn’t mean that you should buy everything you see because you have some savings aside. There is a valuation work to be done. In order to achieve this task, I will start by looking at how the stock market valued the stock over the past 10 years by looking at its PE ratio:

ge-pe-ratio

Source: data from Ycharts.

After declaring a loss in 2015, GE PE ratio has greatly jumped from its previous average. At this point, it seems to me that the market truly believe GE will be able to go against the current challenging environment and generate additional growth in the future. I’m not convinced enough to pay over 25 times its earnings…

By using the dividend discount model, I will have a better idea if GE, as a money distributor, worth my money. I think GE will struggle to increase its dividend over the inflation rate for the first 10 years. For this reason, I will use a 3% dividend growth rate. As a terminal rate, I will use 5% as I think the company has a strong plan and will eventually post revenue and earnings growth. The discount rate I use is 10% since GE raises various concerns at the moment.

ge-input

Here’s the detail of my calculations:

ge-value

Source: Dividend Monk Toolkit Excel Calculation Spreadsheet

As you can see, GE is definitely not valued as a dividend growth stock. The market truly believes in the company and thinks it will post solid growth in the future. However, there is nothing right now justifying its current value as a dividend growth investor perspective.

GE doesn’t meet my 5th investing principle.

Principle #6: The Rationale Used to Buy is Also Used to Sell

I’ve found that one of the biggest investor struggles is to know when to buy and sell his holdings. I use a very simple, but very effective rule to overcome my emotions when it is the time to pull the trigger. My investment decisions are motivated by the fact that the company confirms or not my investment thesis. Once the reasons (my investment thesis) why I purchase shares of a company  are not valid anymore, I sell and never look back.

Investment thesis

If GE is able to generate additional cross selling between its divisions and is able to benefit from future growth in China, this play will become a strong holding for many years to come. An investment in GE today is a vote of confidence in GE management team and its ability to realize its strategy. GE is big enough to reverse the current trends and post several years of growth ahead.

Risks

Unfortunately, there are a lots of “if” in my investment thesis. On the other side, the oil & gas industry is hurting GE revenue as well as the separation from GE Capital, a hectic, but highly profitable division. It will take years for others industrial segment to compensate GE Capital financial performance. Finally, GE is not generating the expected synergy with the acquisition of Alstom. It seems they have a more challenging time integrating this company to their current business model.

GE shows more risk than a strong investment thesis and doesn’t meet my 6th investing principle.

Principle #7: Think Core, Think Growth

My investing strategy is divided into two segment: the core portfolio built with strong & stable stocks meeting all our requirements. The second part is called the “dividend growth stock addition” where I may ignore one of the metrics mentioned in principles #1 to #5 for a greater upside potential (e.g. riskier pick as well).

Having both segment helps me to categorize my investments into a “conservative” or “core” section or into a “growth” section. I then know exactly what to expect from it; a steady dividend payment or higher fluctuation with a great growth potential.

At this time, I can see why there is an interest in GE shares. If all starts are aligned, GE could post solid financial results in a few years from now and reward their shareholders big time. However, it must be taken as a risky play, not a guarantee you will see your money grow.

GE is a growth holding.

Final Thoughts on GE – Buy, Hold or Sell?

In all honesty, GE is not worthy of my money. If I was holding this stock in my portfolio, I would sell it right now. In the industrial sector, I would rather purchase 3M Co (MMM) or Honeywell (HON) way before GE. There are too much uncertainties and too many “if’s” before getting my money back. GE plan to grow is seductive, but it’s just not enough. You can definitely find strong companies elsewhere.

Disclaimer: I do not hold GE in my DividendStocksRock portfolios.

Disclaimer: The opinions and the strategies of the author are not intended to ever be a recommendation to buy or sell a security. The strategy the author uses has worked for him and it is for you to decide if it could benefit your financial future. Please remember to do your own research and know your risk tolerance.