Valuing Dividend Aristocrats - Archer Daniels Midland Vs. Hormel Foods

| About: Archer Daniels (ADM)

Summary

Why I prefer dividend aristocrats.

How I value dividend-paying companies.

Archer Daniels Midland may be a bargain.

Hormel Foods is a great company but not a great price.

Introduction

A reader asked in a comment if any of the Dividend Aristocrats are trading currently at or below my estimated fair value. I have dug through most of the aristocrats and have found very few, but I have decided that it would be best to move those that currently trade at or below fair value to the top of my queue and include at least one in each article until I run out.

For more detail on my methodology and my reasoning of why the market value is not the fair value please consider reading my previous article valuing PepsiCo (NYSE:PEP) and Coca-Cola (NYSE:KO). In short, the fair value for any stock will vary based upon the expected return of each investor. Therefore, my fair value will be what I am willing to pay for expected future returns from the stock which may differ from what other investors are willing to pay. Thus, my fair value may be different from yours.

The market values a stock based upon forward expectations for the next 12-18 months, whereas I value a stock based upon my expectations over the next 20 years. If you have not guessed it yet, I am primarily a buy-and-hold investor. The market makes some mistakes and so do we all. But buying quality at bargain prices and holding for the long term generally insulates me from a lot of mistakes.

Why I prefer dividend aristocrats

I have learned from experience over the last 30 years of investing that most people invest with a goal of having a certain amount of savings available for retirement. I was among that crowd in the beginning. But that kept me focusing on appreciation rather than income. At some point, about 15 years ago, it dawned on me that my goal should be in terms of a future income that I wanted rather than a sum of savings. After all, we never know what the yields will be when retirement is nigh. Think about those poor souls who were counting on having a set sum of money that could be invested safely in long-term bonds and were about ready to retire in 2000 or, worse yet, 2007. If they were chasing appreciation without regard to income they may still be working today.

Some saw their high-flying tech stocks' values cut by more than half from 2000 to 2003 and yields on bonds were down, too. Then in 2007, when it seemed everything was finally good again, the entire market dropped over 50 percent and bond yields fell mercilessly to levels not seen by many still alive today.

Now consider what would have been different for those folks had they been investing for income all along. Had they stuck to quality companies that have a long history of raising dividends every year for 25 or more consecutive years, like the dividend aristocrats, even during the worst years they would have experienced a rising level of dividend income each year. And, unlike many stocks that do not pay dividends, their portfolio values would have recovered far faster than the major indices.

I prefer to use the list of dividend aristocrats as a great place to start when choosing my equity investment. I also consider a few other companies that I expect to join the list in the future. Before I bother to value any company I use a process of elimination to winnow down the list to a manageable number of companies to follow with what I consider the best attributes. My list of attributes include such things as paying a dividend that is equal to or greater than its industry peers. I also like other aspects to be either near or better than the industry average such as: debt to capital (lower), payout ratio (lower), return on capital (higher), 5-year average growth in revenue and earnings (higher), and net profit margin (higher). I also require companies that I invest in to have positive free cash flow and a credit rating of investment grade quality. That process eliminates a lot of companies, even some dividend aristocrats. Only after that process do I determine what price I am willing to pay based upon my desired long-term rate of return. You can find my score card methodology explained in detail in an article I wrote back in 2013, "The Dividend Investors' Guide to Successful Investing." I apply the same principles year after year so the topic and process are never obsolete.

I am always amazed that most people are unaware that over the long term over 40 percent of the total return from the S&P 500 has come from reinvested dividends. Sure, that leaves 60 percent needing to come from appreciation, but I prefer to have the 40 percent as pretty much a given rather than rely totally on appreciation. When the market falls (and it always does from time to time) I have a cushion called income that just keeps going up. Investors banking on appreciation only have nothing to cushion the blow except hope and often, when things get really bad, those same investors sell at a loss. I like something more concrete and tangible; give me rising dividends every time.

Again, if you have a lower required rate of return you will be willing to pay more for a stock than I am and, conversely, if you desire a higher rate of return from your investment your target entry price will be lower than mine. That is how it works. So, when an analyst (including me) tells you that a stock is fairly valued at a certain price take into consideration that s/he may have a different risk tolerance and required return than you do. I bake my risk tolerance into my required return and, sometimes without thinking about it, most others do as well.

How I value dividend-paying companies

I use the dividend discount model [DDM] due to its simplicity and the fact that I invest long-term for dividend income. If you invest short-term you need a different model with greater precision which requires more assumptions which leads to more opportunities for human error. Short-term investing (trading or speculation) is fraught with more risk than I prefer.

I look at the historical rate of average annual compound growth in the dividend over the last one, five, ten and twenty years, adjust it for what I expect is sustainable over the next ten to twenty years. I determine my required rate of return for the company/industry based upon what I want to be paid relative to the risk I perceive. Then I plug those two factors into the model and out comes my estimated fair value.

There is really only one assumption: expected sustainable rate of dividend growth. My required rate of return is what it is and is not an assumption. If I cannot get my required return I will pass and wait either for a lower price that meets my requirement or I will invest in something else. I do not mind holding cash. I am painfully aware of the saying on Wall Street: "Cash is trash." And I know the feeling of regret from having missed some returns. But, in the long run, patience pays off. Why do you suppose that Warren Buffett often has tens of billions sitting in cash? He is waiting for a better opportunity and wants the cash to be available when the opportunity presents itself.

As I explained in my article, "How I Created My Own Portfolio over a Lifetime," there are really three acceptable ways to build a portfolio: dollar cost averaging, buying on the dips, and buying only after a bear market. All three will lead to success over the long term. I lean toward the last one because it has served me well and I rarely have investments get underwater from my original buy price; less pain more gain. This does not mean I only invest after a recession, as I sometimes find great bargains on dips, but that I do most of my investing at that time.

I also use the historical average price-to-earnings [P/E] ratio as a check to make sure that my DDM fair value makes sense. If the two are in the same ballpark I either use my fair value or a price within the range of the two when deciding my desired entry price. If there is a significant difference I explore why it is so. Often the P/E valuation method will spit out a higher price because the stock has enjoyed a premium valuation relative to its peers and the recent earnings took an unusually large jump. There is usually a sensible explanation, but not always. Sometimes I find that a company's stock just does not fall much, even during recessions, and the price stability increases the P/E relative to the growth prospects. Or, in other situations, I find that a company pays a very low yielding dividend but increases it very consistently, but below its rate of earnings growth. My preference for income keeps me from investing in such companies.

Valuing Archer Daniels Midland (NYSE:ADM)

People need to eat and the global population is expected to grow from 7.3 billion now to over 9.4 billion by 2050. That is a lot of mouths to feed! However, based upon my annual industry review from last year that I conduct once all companies I follow have reported for the fiscal year, ADM did not make my list. It failed in three areas: average annual 5-year growth was below the industry average for both revenue per share and earnings per share [EPS]; the net profit margin is much lower than the industry average. This does not mean that ADM is not a great company. It is! But it just does not make my list of companies that I want to own.

Others will have different standards that would not grade ADM so harshly. If so, the stock is now 33.7 percent below its 52-week high and about 44 percent below its recent peak price. In the table below I list the split-adjusted dividend at the beginning of each period for the past 20, ten, five and one years, the current dividend, the compound annual rate of dividend growth, my required return, my estimated fair value and the yield of the current dividend at fair value.

Number of Years

Begin Annual Dividend

Current Dividend

Rate of Increase

Required Return

Fair Value

Yield at Fair Value

20

$0.15

$1.12

10.6%

10

$0.34

$1.12

12.7%

5

$0.60

$1.12

13.3%

1

$0.96

$1.12

16.7%

Adjusted

Expectation

$1.12

9.5%

12%

$44.80

2.5%

Click to enlarge

The current price for ADM as of the close on Friday, January 29, 2016 is $35.35. I have assumed that the future long-term rate of growth of ADM dividends to be 9.5 percent, below any of the historical growth rates. I do so, because I believe that growth in earnings will slow from previous levels over the next ten to 20 years. I also prefer to be conservative in my estimates because I would rather be surprised by my estimates turning out to be low rather than high.

As a check I also looked at the historical P/E ratio for ADM over the past 15 years and found that the average has been 14.3. The range over that period has been a high of 19.7 and low of 8.5. The current P/E is 12.2. Using the average P/E of 14.3 multiplied by the trailing twelve months [ttm] EPS (as of Q3 2015) of $2.90 I get a fair value of $41.57. That is close enough to my DDM fair value for my validation.

The one thing to watch before buying ADM shares is whether the EPS in Q4 2015 come in below that of Q4 2014 and, if so, by how much. That could reduce the fair value estimation using the P/E ratio method. If the difference brings that value down by only a dollar or two, it would still be sufficient to warrant consideration for a long-term position at the current price. However, if the adjustment after earnings are reported lowers the P/E estimated fair value by much more than that, I would suggest waiting for further declines in the stock price before buying.

Valuing Hormel Foods (NYSE:HRL)

Hormel is also in the business of food processing but on the other end of the food chain, so to speak. While ADM processes mostly grains and seed oil, HRL does more processing of meats. HRL share price has been on a tear since last September. The company does not make my list primarily due to relatively low margins compared to its industry average and because of the low dividend. But again, this does not make HRL a bad investment. It just does not meet my criteria for investing. It is a solid company with excellent prospects, but the price is far above what I would estimate to be its fair value under any method.

Number of Years

Begin Annual Dividend

Current Dividend

Rate of Increase

Required Return

Fair Value

Yield at Fair Value

20

$0.15

$1.16

11.0%

10

$0.26

$1.16

16.1%

5

$0.42

$1.16

22.5%

1

$0.80

$1.16

45.0%

Adjusted

Expectations

$1.16

10.0%

12%

$58.00

2.0%

Click to enlarge

The current price of HRL shares is $80.41 as of January 29, 2016. I have assumed that the long-term sustainable rate of annual compounded dividend growth will be ten percent. Again, that is below any of the historical rates of growth. If I were to look at the growth rate for the 15 years of the 20-year period excluding the last five years it would be below ten percent. So, I do not believe that I am being overly conservative when looking out over the next ten to 20 years.

The average P/E for HRL over the past 15 years has been 17.5 with a range from a high of 24.2 to a low of 13.0. The current P/E of 31.7 is well above any annual average P/E over the last 15 years. That also indicates to me that the price is probably above where is should be. The high current P/E ratio is not sustainable for HRL. It is in the food processing business and not technology. The margins rise and then fall in this business. Using the average P/E of 17.5 multiplied by the ttm EPS of $2.54 we find a resulting estimated fair value of $44.57. This may tell me that my expected rate of dividend growth is slightly higher than it should be or that the average P/E could be rising over time. Either way, the difference between the two methods is substantial enough to require further review if the current price were close to the range between the two. But since the current price is far above either, I will simply say that the stock is price beyond perfection and I would not recommend buying it at this price.

Conclusion

Consider the sage words of Benjamin Graham in the book Security Analysis.

"The notion that the desirability of a common stock was entirely independent of its price seems incredibly absurd."

In other words, the price you pay is just as important as the fundamental analysis of a company. For my money the yield I receive on my entry price and what it will grow to over time are the factors that define the value of an investment has to me. During the last round (since the Great Recession) I was still a buyer based upon values through most of 2013. Since then I have been in near hibernation mode in terms of new investments. In fact, I began to employ a low cost hedging strategy to preserve my capital beginning in mid-2014. I was admittedly early but the peace of mind was worth it. And the recent gains from that strategy have more than paid for the cost of my hedging. Now I am beginning to look for value again as many individual stocks have already fallen into bear market mode. I am just waiting for the overall market to catch up and give me a better entry point for each stock I want to own long term.

Of the two, I would lean toward ADM at these prices. Over the long term I would expect a much better income stream to be provided for the same investment dollar amount from ADM compared to HRL at the current prices. I do not intend to buy either at this time. But for those for whom these companies are appealing please remember that a great company is only a bargain when the price is below its fair value.

As always I welcome comments and questions and will do my best to answer all that I can as long as such comments are respectful. I respect the opinions of others and welcome any insight that could prove or disprove my opinions.

For those interested in learning more about my investment philosophy, you can find more details in a series of articles titled, "How I created my own portfolio over a lifetime." For those who prefer to listen rather than read, I was interviewed by Brian Bain, of Investor in the Family, and you can listen to the podcast here.

Disclosure: I/we 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.