How I Determine My 'Buy Range' For DGI Stocks

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Includes: ABBV, ABT, AMGN, CLX, JNJ, MRK, NVS, SHPG
by: Dividend House

Summary

Once I’ve decided that I want to purchase a specific stock, I start evaluating whether it is currently trading at an attractive price.

I typically evaluate four price points: 1) Morningstar’s fair value estimate, 2) S&P’s fair value estimate, 3) S&P’s 12 month price target, and 4) FastGraphs.

Using these sources, I have developed guidelines that indicate whether a stock is under, over or fairly-valued and a process for developing my buy range.

Using this approach, I opened a position in Merck last month.

I hope this article helps you think about determining your own buy ranges for DGI stocks!

What Gets Measured, Gets Attention!

I recently upgraded the spreadsheet I use to track my DGI retirement portfolio. This new version does nifty things like automatically pulling the most recent financial info on a stock ticker into my spreadsheet. Now, I have up-to-the-minute information on what each stock position is contributing to my overall portfolio, both in terms of market value and dividend income. This saves me a lot of time that I used to spend manually inputting this data. Way cool!

Another feature of the new spreadsheet is a column that shows the original price I paid for each stock. My original purchase price is then conveniently calculated into a "yield on cost". To be honest, I never paid much attention to this information before. Periodically, debates rage on Seeking Alpha about the value (or lack thereof) of the metric "yield on cost". Personally, I come down on the side of the discussion that says what I paid for a stock is water under the bridge. My perspective is that yield on cost is a "feel good" measure that isn't very useful in making decisions about what to purchase going forward. But, there are plenty of others here who disagree.

So, why does my new spreadsheet do this? I confess that I didn't design it. Instead I purchased it from Seeking Alpha contributor, George Schneider for its nifty stock price and dividend updating features (which I love!). I've always wanted to figure out how to get a spreadsheet to automatically load this kind of data. Now that I see how this spreadsheet does it, I can design my own!

Meanwhile, the consequence of having the "investment cost" information so readily accessible is that, if I am considering purchasing more shares of a stock I already own, I find myself looking to see if I will be averaging up or averaging down. I am finding that this is distracting me from focusing on what a stock is worth today. Snap out of it, Dividend House!

To my way of thinking, it matters not what I may have paid for a stock in the past. That historical detail shouldn't impact whether or not I purchase more of a particular stock now. The key question when evaluating a stock for purchase is "What is my acceptable buy range for this stock today?"

Before I dive into how I determine a target price range for a specific stock, I complete due diligence to determine whether or not a stock (including adding more shares of it) is an attractive addition to our portfolio. The nine steps of the Dividend House rating system available in this article, rank a dividend stock's attractiveness for our portfolio, given our risk tolerances and investing goals. Generally, if a stock earns a rating of 10 houses or higher, it is considered highly attractive for our portfolio.

How I Determine My DGI Stock Buy Range

Once I've decided that I want to purchase a specific stock, I start evaluating whether it is currently trading at an attractive price. Even if a stock's price isn't attractive today, I might put in a limit order in hopes that it dips into my buying range. In fact, I've got limit orders set for several utility stocks right now.

For stocks I'd like to purchase, I typically evaluate four price points: 1) Morningstar's fair value estimate, 2) S&P's fair value estimate, 3) S&P's 12 month price target, and 4) FastGraphs.

Guidelines Indicating A Stock May Be Attractively Priced

  • Is the stock trading at a discount to Morningstar's and S&P's fair value estimates? If the stock is a core holding, is it trading at or below a 5% premium to Morningstar and S&P's fair value estimates?
  • Looking at FastGraphs, is the stock trading at or below its normal 10 year P/E (in other words, is the black stock price line at or below the blue normal P/E line?) Even better, is the stock price in the dark green area (below both the blue and orange P/E lines)?

If the answers to the questions in the two bulleted areas above are all "yes", you may have found a bargain! But, before you purchase, please be sure you understand why this stock is trading at a value!

An Under-Valued Stock Example - Abbvie (NYSE:ABBV)

Abbvie is an example of a stock that currently looks underpriced.

Current Stock Price (as of April 8, 2016): $58.47

Morningstar Fair Value Estimate: $65.00

S&P Fair Value Estimate: $120.30

S&P 12 Month Target Price: $84.00

Click to enlarge

How can we tell that ABBV is a bargain?

  • ABBV is trading at a 10% discount to Morningstar's fair value estimate and at a whopping 51% discount to S&P's fair value estimate.
  • Looking at FastGraphs, ABBV is trading currently at a P/E of 13.0. This is below its normal 4 year P/E of 15.1 (the blue line). In other words, ABBV's black stock price line is below its blue "normal P/E" line. Even better, ABBV's price is located in the dark green area below both the blue and orange P/E lines (which are practically on top of each other).

But, buyer beware! Since its spin-off from Abbot Labs (NYSE:ABT) a little over four years ago, ABBV has relied on its blockbuster drug, Humira, for the lion's share of its revenues. Even though it is working on expanding its drug portfolio, Humira continues to be responsible for more than 60% of ABBV's revenues. Disconcertingly, sales of Humira are expected to deteriorate when biosimilars enter the fray. Amgen (NASDAQ:AMGN) has already gotten its Humira biosimilar accepted for FDA review. In addition, Merck (NYSE:MRK), Norvartis (NYSE:NVS) and Baxalta (NYSE:BXLT) are reportedly working on their versions of a Humira biosimilar. Talk about revenue risk!

As a result, I classify ABBV as a speculative stock. I would likely classify ABBV as speculative anyway, since that's where I classify all biotechs today. Only you can decide if you are willing to invest in ABBV, given its business strategy and other operating characteristics. The point of this example is not necessarily to recommend ABBV as a stock pick for your portfolio. Rather, it is to illustrate what an under-priced stock looks like.

Guidelines Indicating A Stock May Be Over-Priced

  • Is the stock trading above Morningstar's and S&P's fair value estimates? For core stocks, is the stock price trading significantly (>5%) above Morningstar's and S&P's fair value estimates?
  • Is the stock trading above S&P's 12 month price target?
  • Looking at FastGraphs, is the stock trading above its normal 10 year P/E? (Is it above the blue line?) Even worse, is the stock price in the light green or white area (above both the blue and orange P/E lines)?

If the answers to the questions in the three bulleted areas above are all "yes", know that you are paying up for the stock. Unless you plan to never sell this stock and/or need the income from it immediately, proceed with caution!

A Clearly Over-Priced Stock Example -- Clorox (NYSE:CLX)

Clorox is a great example of a DGI stalwart that is currently selling at a rich price.

Stock Price (as of April 8, 2016) = $128.53

Morningstar Fair Value Estimate: $114.00

S&P Fair Value Estimate: $79.10

S&P 12 Month Target: $109.00

Click to enlarge

How can we tell that CLX is expensive?

  • CLX is trading at a 13% premium to Morningstar's fair value estimate and at a whopping 62% premium to S&P's fair value estimate. CLX is also trading at an 18% premium to S&P's 12 month target price.
  • Looking at FastGraphs, CLX is currently trading at a P/E of 26.6. This is well above its normal 10 year P/E of 18.2 (the blue line). In fact, MRK's black stock price line has skyrocketed above both blue and orange lines past the light green area and into the white area (indicating a very high price indeed)!
  • Once again looking at FastGraphs, CLX's 1 year normal P/E is 21.8. But, at its current P/E of 26.6, CLX is trading above any of its normal P/E's for the last 18 years!

So, what would be my buy range for Clorox?

I would start with S&P's 12 month target of $109 and set that as the very top of my buy range. Even at $109, this price is still slightly above CLX's current 1 year normal P/E of 21.8 (even if you bet on CLX's 6/30/16 earnings estimates coming true). I would then take the 10 year normal P/E and the 6/30/16 EPS estimate to calculate a price of $89.36 (as shown in the table above). Therefore, my price range for CLX would be $89.36 to $109. Of course, this price range looks very unlikely to become reality unless there is a substantial overall market decline.

Even so, CLX provides a good example of how you can set a price range for an over-valued stock that you are considering adding to your portfolio. Of course, only you can decide how much of a premium you may be willing to pay for a DGI stalwart!

A Fairly-Valued Stock Example - Merck

We've covered two obvious examples of under and over-valuation so far (ABBV and CLX, respectively). But, most stocks are much harder to call.

Let's turn our attention to a stock in which I just opened a position last month - Merck.

Here's the background. I really want more healthcare stocks in my portfolio. In fact, I would be willing to have healthcare stocks (excluding biotechs) generate as much as 20% of my portfolio's income. But, since I don't want any one stock to contribute more than 5% of my portfolio's income, I can't just buy a ton of Johnson & Johnson (NYSE:JNJ) and be done with it.

As a result, I have been considering Merck on and off for some time. MRK is only moderately attractive, ranking 8 ½ houses in the Dividend House rating system. MRK gets points off due to the fact that, although it has paid a dividend since 1970, it has been growing its dividend only for the last four years.

If MRK grows its dividend for five consecutive years (which I expect it to do) and if it achieves a 4% dividend growth rate over those five years (which may be a stretch), then it would garner 10 houses in the Dividend House rating system (making it much more attractive). So, even though MRK has a AA credit rating, its Dividend House rating means that I don't want to overpay. Since its string of dividend increases is short and its dividend growth rate is relatively anemic, I am unwilling to pay a premium for Merck.

So, let's see what my buy range is for MRK.

Stock Price (as of April 8, 2016) = $55.36

Morningstar Fair Value Estimate: $63.00

S&P Fair Value Estimate: $54.20

S&P 12 Month Target: $56.00

Click to enlarge

Since S&P's fair value estimate is the lower of the two fair value estimates, I would consider the top of my buying range to be $54.20. FastGraphs shows that Merck's 10 year normal P/E is 13.1. Applying this to MRK's 2015 EPS generates a price of $47.03. So, my buy range for Merck would be from $47.03 to $54.20.

On March 22, I established a new position in Merck at $53.16 (inside the top of my buy range). My purchase price computes to a 2015 P/E of 14.8 or a 2016 estimated P/E of 14.3. FastGraphs shows that MRK has traded at a P/E higher than 14.8 for the last two years.

Click to enlarge

So, as a result of Merck's price dipping into the top of my buy range, I opened a position. You may or may not think Merck is a good addition to your own portfolio. I merely offer it as an example of how to calculate a buy range for a stock that is trading near fair value.

Conclusion

Since the market appears to be fully valued today, I am having some trouble finding coveted DGI stocks that are attractively priced.

Almost every day, I use my new spreadsheet to scan my stocks' current prices vis-à-vis Morningstar's fair value estimates, S&P's fair value estimates and S&P's 12 month price targets. As in my example of Merck above, if a stock's price is trading close to or under analysts' fair value estimates, I check out FastGraphs to help determine my buy range.

As a result of the process outlined above, I opened a position in Merck on March 22. On that date, the stock was trading inside the top of my buy range. (It has since moved back above it.) I plan to continue to use this process to determine other opportunities to add new positions or purchase additional shares in positions we already hold.

I hope this article helps you think about determining your own buy ranges for DGI stocks!

Are there additional methods you use to determine your buy range for an attractive DGI stock? Does your yield on cost impact your willingness to purchase a stock?

Disclosure: I am/we are long ABBV, AMGN, AVA, BBL, BMY, CAT, CBRL, CCP, CLX, CMCSA, COP, CVX, D, DE, DEO, DLR, DUK, ED, EMR, EPD, GAS, GE, GILD, GIS, HCP, IBM, JNJ, KHC, KMB, KMI, KO, LMT, LNT, MAIN, MCD, MMM, MMP, MO, MRK, NEE, NOK, O, OHI, OMI, PEP, PFE, PG, PM, SCG, SEP, SO, SYY, T, TUP, UL, UPS, VOD, VTR, VZ, WEC, WMT, WPC, XEL, XOM, ZMH.

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.