Income-oriented investors should select carefully the stocks to include in their portfolios in order to achieve the highest possible returns. The Dividend Discount Model provides a simple way to evaluate dividend-paying stocks.
According to the model, the fair value of a stock is equal to its 1-year forward dividend divided by the difference between the discount rate and the dividend growth rate. The output of the formula provides investors with an indication of fair value for a stock today.
There are many valuation techniques that are used to determine fair value of a stock. The Dividend Discount Model is just one example of a common valuation method, but it is a highly common one. According to the Dividend Discount Model, tobacco giant Altria (MO) is still an attractively valued dividend stock, despite its recent rally.
Since it bottomed in the Christmas sell-off, Altria has rallied 25%. Nevertheless, the stock is still 30% off its 2-year high and has dramatically underperformed the market in the last two years, as it has shed 24% whereas S&P has rallied 22% during this period.
One of the reasons behind this underperformance is rising interest rates. As Altria has an exceptional dividend growth record, most of its shareholders are holding the stock for its reliable and growing dividend. Consequently, as interest rates have significantly risen in the last two years, they have rendered the yield of the tobacco giant less attractive. This has exerted pressure on the stock price of Altria.
Moreover, Altria is facing a strong headwind in its business. The percentage of the U.S. population that smokes has been in a continuous decline for many years. Even worse, this trend has accelerated in the last two years due to the transition of smokers from traditional cigarettes to vaping products. The domestic cigarette volumes of Altria decreased 2.5% in 2016 but the annual decline exceeded 5% in 2017 and 2018. In addition, Altria expects the industry to continue declining by 4%-5% per year until 2023.
To address this secular decline, Altria acquired a 35% stake in JUUL, the e-vapor leader, in December. Altria paid $12.8 billion for its stake, thus valuing JUUL at about $37 billion. That amount was almost 2.5 times the $16 billion valuation that JUUL had achieved in an investment round last summer and about 38 times the annual revenues of the e-vapor leader. As a result, the massive valuation placed on Juul seems to suggest desperation on the part of Altria. As the move came too late and at an excessive price, the market punished the stock harshly.
However, we believe that the acquisition of a major stake in JUUL will greatly benefit Altria in the future. The U.S. e-vapor market is expected to grow by 15%-20% per year over the next five years, with JUUL enjoying the greatest portion of this growth. JUUL is by far the market leader in vapor products, with a market share of 34%, and grew its sales volumes 7-fold in 2018.
Source: Altria’s Investor Presentation
Moreover, although Altria paid a hefty premium for its stake in the e-vapor leader, it is likely to easily absorb this premium in the upcoming years. The tobacco giant has spent less than 5% of its operating cash flows on capital expenses every single year in the last decade and has thus enjoyed excessive free cash flows. In the last 12 months, the tobacco giant has posted free cash flows of $8.2 billion. This means that the amount spent on the stake of JUUL is equal to the free cash flows of one and a half year. Furthermore, interest expense consumes only 7% of the operating income of Altria. It is thus evident that the company has ample room to increase its debt without any problem.
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It is also remarkable that Altria announced a cost-cutting project after its JUUL transaction. The project will aim to reduce its annual expenses by $500-$600 million and thus mitigate the effect of higher interest expense. Overall, while Altria essentially paid a penalty for its late response to the headwinds facing its legacy business, the company is likely to easily absorb this penalty in the long run.
About a month after the above stake acquisition, FDA stated that e-cigarettes may face an existential threat if they continue to expand at a fast pace in young population. That statement was negative for Altria, as the company had already paid an excessive premium for its stake in the vapor-product leader. However, we do not believe that e-cigarettes will be banned. Instead, they are likely to face stricter regulation from the FDA. Even if this regulation has a negative impact on the growth trajectory of JUUL, it will greatly benefit the legacy business of Altria. Thanks to its major stake in JUUL, Altria has essentially hedged its business portfolio against any future development in the e-cigarette market and hence it has essentially rendered its future cash flows more reliable.
Altria has an impressive dividend growth record. It has raised its dividend 53 times in the last 49 years. Last year, thanks to the strong tailwind from the tax reform, the company raised its dividend twice for a total 21% raise, from $0.66 per quarter in 2017 to $0.80 per quarter in 2018.
In order to estimate a reliable dividend growth rate for the Dividend Discount Model, we will exclude the second dividend raise of last year from our analysis. Excluding that dividend hike, Altria has raised its dividend at an 8.0% average annual rate in the last six years. During this period, the company has grown its earnings per share at an 11.6% average annual rate.
This is an impressive growth rate, given the continuously declining percent of the smoking population. The tobacco giant has achieved such a great return thanks to the resilient demand for its products, which has enabled the company to implement meaningful price hikes year after year. These price hikes have more than offset the effect of the decline of the percent of the smoking population.
Applying the Dividend Discount Model to Altria
As Altria will continue to take advantage of the resilient demand for its products via price hikes, it is likely to keep growing its earnings per share at a meaningful pace in the upcoming years. Nevertheless, due to the changing business landscape in the tobacco industry, we prefer to be somewhat conservative and assume a 4% average annual growth rate of the earnings per share and the dividend of Altria in the future. Investors should note that conservatism is dictated in the application of the Dividend Discount Model, as it is essentially impossible to make perfectly precise long-term forecasts.
The discount rate is the target annual return of an investor. We will target a 10% annual return in our example. As this is almost equal to the long-term return of the S&P, it should be sufficient for most investors, particularly given the current almost all-time high level of the index, after a decade-long bull market. The dividend growth rate should be approximately equal to the expected annual growth rate of the earnings per share, as these two growth rates should be approximately equal in the long run, particularly in the cases of mature stocks.
Altria is expected to announce its next dividend hike in August. We expect the company to raise its quarterly dividend from $0.80 to $0.85, thus resulting in an annualized forward dividend of $3.40. If we use the above figures (forward dividend of $3.40, target annual return of 10% and long-term dividend growth rate of 4%) in the formula of the Dividend Discount Model, the latter provides us a fair value of $57 for Altria.
As the stock is trading at $54 right now, it is trading at a meaningful 5% discount compared to the fair stock price dividend by the model. In other words, those who purchase Altria at its current price can expect an average annual return above 10% going forward. This is certainly an attractive return, particularly given the current almost all-time high level of the S&P.
Income investors should apply valuation techniques, including the Dividend Discount Model and others, to their stock selection process. The Dividend Discount Model is useful, as it provides them with the fair value of a stock based on its expected future dividends. This model supports the notion that Altria is attractively priced right now.
The stock has dramatically underperformed the market in the last two years due to rising interest rates as well as the uncertainty that surrounds the company’s future prospects amid a changing landscape in the tobacco market.
However, Altria has hedged its future results to a great extent thanks to its major stake in JUUL. As soon as the market regains its confidence on the prospects of Altria, the stock is likely to reward investors who purchase shares at or below their current price.