Target Overvalued Despite Dividend Hike

| About: Target Corporation (TGT)

Summary

The dividend growth model is not the end-all be-all to determine the value of a company, it is just one method.

Management just increased the dividend by 7.1% for August and I believe they can increase it another 6.25% in 2017.

The stock appears to be overvalued by 2% based on next year's earnings and dividend growth potential.

A dividend is just one of many ways a company can reward its shareholders by paying them out in cash. The investor can then choose to take the cash and run, reinvest it in the company, or invest it in a different company. After a company has made their net income for the quarter they have the choice of what to do with it and the choices are usually to either plow the money back into the business for other investments or pay some of that money back to the shareholders in the form of a dividend.

Most Recent Dividend Announcement

Target (NYSE:TGT) recently announced a quarterly dividend of $0.60 per share with an ex-dividend which was on August 15 th, making the must own date August 14 th. This marks a 7.1% increase in the dividend from the previous year. The dividend is going to be payable to owners of the shares on September 10 th. The dividend is currently good for a 3.5% yield on today's share price of $68.42. Based on trailing earnings, the dividend is good for a payout ratio of 45% which is pretty good for my taste. From a cash flow perspective the company has paid $1.365B in dividends over the past twelve months on free cash flow of $3.109B which is good for a 45% cash flow payout ratio. With the new payout ratio the company it is anticipated that the company will pay $1.414 B on 589 M outstanding shares, which is still good for a 45% cash flow payout ratio if the free cash flow remains the same.

Potential Future Dividends

The company has been increasing its dividend for the past 48 years with a five-year dividend growth rate of 20.8%. Over the past five years the company has been increasing its dividend during the month of August and it wouldn't surprise me if it did the same thing in 2017.

The company is projected to earn $5.65 per share in earnings for next year and if the EPS payout ratio remains the same at 45% then the company should distribute about $2.55 annually starting August 2017 (or a 6.25% increase). That amount seems pretty reasonable and I do believe the 45% payout ratio is sustainable for the long-term.

Earnings growth projections for the company are pretty decent for an discount store with a one year growth rate of 9.82% and five year growth rate of 9.25%. With that said, the 6.25% increase to the dividend would be much more prudent than the 7.1% increase investors received this year. A 4.5% increase would constitute an annual dividend of$2.55 for 2017 if it increases the dividend in August again next year.

Dividend Valuation

Now let's get to the meat and potatoes, the dividend valuation model to determine a price that the stock should be at based on the dividend alone. Since I just mentioned that the company has been increasing its dividend for the past 48 years we know that it has a pretty good history of increasing it and should continue to increase it going into the future. The dividend growth model equation takes the form of:

Annual Dividend [D]

Rate of Return [R] - Dividend Growth rate [G]

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Where D is equivalent to the current dividend, R is the rate of return desired by the investor, and G is the anticipated growth rate of the dividend. For the D value I'm going to use the existing dividend rate of $2.40.

For the R value I'm going to use 9.82% because it is next year's earnings growth estimate. For the G value of the equation I'm going to use a dividend growth rate of 6.25% because I definitely believe the company could increase the dividend by that much at least for the next year to keep investors happy. When you plug and chug all the numbers you get a stock value of $67 which makes the stock overvalued by about 2% from today's price of $68.47. For reference, the 52-week high on the stock was$85 during July of last year.

Conclusion

The dividend discount model is just one of many ways to value a company and should be taken into consideration while trying to evaluate a company. Assumptions are always made while using valuation models and I believe I've selected some of the most conservative criteria for the valuation in this article. This valuation model shows the value of the dividend stream and that the stock is overvalued based on the dividend alone. The company has been around for quite some time and can definitely afford to increase the dividend when August 2017 comes around.

The stock has dropped precipitously since mid-April and the company currently trades at a trailing 12-month P/E ratio of 12.9, which is inexpensively priced, but I mainly like to purchase a stock based on where the company is going in the future as opposed to what it has done in the past. On that note, the 1-year forward-looking P/E ratio of 12.08 is currently inexpensively priced for the future in terms of the right here, right now. Next year's estimated earnings are $5.65 per share and I'd consider the stock inexpensive until about $85. The 1-year PEG ratio (1.31), which measures the ratio of the price you're currently paying for the trailing 12-month earnings on the stock while dividing it by the earnings growth of the company for a specified amount of time (I like looking at a 1-year horizon), tells me that the company is fairly priced based on a 1-year EPS growth rate of 9.82%.

I actually initiated my position in the company in earlier this week and have been pretty ambivalent with the purchase thus far but it has been too short of a holding period. But I never look to initiate a full position in a name immediately and think the stock is a buy as long as it is below $75 (which is the midway point of the 52-week range). I never like to dive full bore into a name, I always buy in increments.

I swapped out of Eaton Vance (NYSE:EV) for Target during the portfolio change-out in the second quarter of 2016 because I had a good gain in Eaton Vance ( 19.4% or 53% annualized) and felt that it might lag the rest of the market for the coming three months.

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For now, the chart above compares how Target and Eaton Vance have done against each other and the S&P 500 since I swapped the names. It doesn't look like the trade has worked out from the chart and that is because it is still too short of a holding period. However, I am actually down 0.44% on the name because it has been a short holding period so far. For now I'm going to make purchases in the name because it is below the level I feel that it offers value and the recent announcement of the dividend boost shows management is confident in their company.

Disclaimer: This article is in no way a recommendation to buy or sell any stock mentioned. This article is meant to serve as a journal for myself as to the rationale of why I bought/sold this stock when I look back on it in the future. These are only my personal opinions and you should do your own homework. Only you are responsible for what you trade and happy investing!

Disclosure: I am/we are long TGT.

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.