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Shares of tobacco giant Altria (NYSE:MO) have risen to multi-year highs of $35 in recent times. Despite this strong move up in shares, the stock is still yielding a robust 5% as of this writing. Indeed, the stock is bought as a bond equivalent for most investors as the company operates rather like a utility in that it pays out the vast majority of its earnings in cash dividends. Given the rise in shares and the still-gigantic yield, are shares worthy of your capital? This article will take a look at MO shares in a DCF context in order to determine a fair price based on the company's earning capacity.

To determine a fair value for Altria shares, we'll use a DCF-type analysis that requires some assumptions: 1) book value and analyst growth rates from Yahoo! Finance 2) perpetual growth rate of 4% (my estimate) 3) dividend growth rate of 7% per annum (my estimate to roughly match earnings growth) and finally 4) discount rate of 10% (my estimate). Of course, you may disagree with some or all of my estimates but I used what I believe to be reasonable approximations for Altria's prospects given available information. Keep in mind that all forecasting is subject to conjecture.

 

 

  

2013

2014

2015

2016

2017

2018

Earnings Forecast

       

Reported earnings per share

  

$2.39

$2.57

$2.76

$2.97

$3.19

x(1+Forecasted earnings growth)

  

7.50%

7.50%

7.50%

7.50%

7.50%

Forecasted earnings per share

 

$2.39

$2.57

$2.76

$2.97

$3.19

$3.43

        

Equity Book Value Forecasts

       

Equity book value at beginning of year

 

$1.58

$2.09

$2.64

$3.25

$3.91

$4.63

Earnings per share

 

$2.39

$2.57

$2.76

$2.97

$3.19

$3.43

-Dividends per share

$1.76

$1.88

$2.02

$2.16

$2.31

$2.47

$2.64

Equity book value at end of year

$1.58

$2.09

$2.64

$3.25

$3.91

$4.63

$5.42

x Equity cost of capital

 

10.00%

10.00%

10.00%

10.00%

10.00%

10.00%

Normal earnings

 

$0.21

$0.26

$0.32

$0.39

$0.46

$0.54

        

Forecasted EPS

 

$2.39

$2.57

$2.76

$2.97

$3.19

$3.43

-Normal earnings

 

$0.21

$0.26

$0.32

$0.39

$0.46

$0.54

Abnormal earnings

 

$2.18

$2.31

$2.44

$2.58

$2.73

$2.89

x discount factor (10%)

 

0.909

0.826

0.751

0.683

0.621

0.564

Abnormal earnings disc to present

 

$1.98

$1.90

$1.83

$1.76

$1.69

$1.63

        

Abnormal earnings in year +6

      

$1.63

Assumed long-term growth rate

      

4.00%

Value of terminal year

      

$42.36

        

Estimated share price

       

Sum of discounted AE over horizon

 

$10.80

     

+PV of terminal year AE

 

$23.89

     

PV of all AE

 

$34.69

     

+Current equity book value

 

$1.58

     

Estimated Current share price

 

$36.27

     

Given my model's inputs, Altria has an approximate fair value of $36.27 today. With shares trading at $35.16 as of this writing, the stock is trading at a very small discount to my fair value estimate. It is important at this point to understand what the fair value estimate means. The model's output is a price at which, given the parameters specified, shares can be bought at a "good price" today. The estimated fair value is the net present value of the company's cash flows plus its current book value. Therefore, the fair value of the business today, according to my estimates, is just over where shares are trading.

That the company is roughly fairly valued should be no surprise given that the cigarette business is very stable and predictable; with uncertainty comes market dislocations so when virtually no uncertainty exists, dislocations can be scarce. However, that doesn't necessarily mean the stock isn't worth buying. Recall that I postulated most investors buy MO shares as a sort of bond equivalent, eschewing potential capital gains for steady, robust income. Therefore, in MO's case, I would argue that the stock trading near fair value isn't necessarily a reason to avoid the shares.

While healthy capital gains are likely not in the cards from a $35 price point for MO shares, the huge dividend and share buybacks should buoy shares and allow you to safely collect the dividend. With my estimated 7% dividend growth rate, MO shares should return approximately $13.48 per share over the next six years, or roughly 38% of the current share price. This alone provides a nominal return of roughly 6% per year with zero capital gains; the dividend is the reason to buy the stock.

There are risks, of course, to this strategy as MO could be subject to the continuing decline in smoking rates in the US and elsewhere. For instance, if MO's earnings growth rate slows to 4% from the analyst's expectations of 7.5%, a fair value would be more like $32, indicating the stock would need to be re-priced and the dividend growth rate revised down. If that happens, I would revise the dividend growth rate to 4%, indicating only $12.14 worth of dividends would be collected over the next 6 years, or roughly 10% less than my original forecast. This would reduce the total return on the stock substantially but that is the risk of buying a stock near its highs.

However, given MO's ability to overcome a shrinking customer base in the past by simply passing on price increases, I don't perceive the risk of slowing earnings growth to be of substantial concern. MO has shown an incredible ability to continuously raise its already huge dividend and provide steady, current income to shareholders.

The final risk I would caution shareholders with is that of interest rate risk. Given the Federal Reserve's efforts to decrease interest rates across the yield curve, high-income issues like MO have been bid up as other income options have become less attractive. When (or if!) quantitative easing comes to an end and interest rates begin to rise again, MO shares may be sold down to increase the yield in relation to other high income stocks and bonds. If this happens, substantial capital losses may be accrued depending on the severity of the re-pricing. However, in my view, we are still a few years away from such re-pricing as the Fed is showing no signs of slowing its quantitative easing efforts so far. As a shareholder, however, it is something to be aware of. Despite this risk, if you are looking for a nice amount of current, steady, safe income, MO could be a great place to park your money.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Altria: An Oasis Of Yield In A Quantitative Easing Desert