Determining the intrinsic value of a stock can be a difficult task for most investors. Many take the easy road based on current value metrics, such as price to earnings ratio, price to book value, price to cash flow and many other value determinants. There is nothing specifically wrong with this approach, but it is difficult to be accurate. Have you ever looked at a stock that was cheap by PE ratio or book value but not so cheap using other valuation metrics? I like to take a different approach to valuing a stock based on its past and projected growth rates.
By using the average PE ratio and projected EPS growth, you can use the future time value formula to get an estimate of earnings X number of years into the future. Once you have the future projected earnings per share, just multiply by the PE ratio to get a future stock price. All of the projected growth rates are available on most websites providing detailed stock information. This is great information when looking at the future of a stock in comparative terms. Take this one step further, and you can determine the intrinsic value of a stock. Here, you are using the present time value formula based on your required rate of return. The end result is having a fair value estimate of the stock to compare to the stock's current trading price. This comparison will determine if a stock is overvalued or trading at a discount.
My model for performing the intrinsic and future values are shown in the table below using three stocks that are trading at a 20% or discount to their fair value. We use the same concept to determine the future dividend payout and yield in future years. For me, I prefer to project 10 years forward based on past compound annual growth rates [CAPG] of 10 years of data. The number of years can be adjusted for shorter time periods for stocks with less than 10 years of public data. What should your required rate of return be? I am currently using a 10% return on invested capital.
The results indicate that Stryker (NYSE:SYK), AmeriSourceBergen (NYSE:ABC) and Qualcomm (NASDAQ:QCOM) are currently trading at a 20% or more discount to intrinsic value. While the current dividend yields are considered low at around 1.5%, the yield on cost 10 years into the future is projected to be above 8% for SYK and ABC.
Stryker Corporation operates as a medical technology company in three segments: Reconstructive, MedSurg, and Neurotechnology and Spine. The results for Stryker indicate that it is currently trading at a 28% discount to its fair value. This is based on an EPS growth rate of 11% and the average PE ratio of 18.6%. SYK has a dividend CAGR of 18% for the future years. This results in an annual dividend of $4.45 in 10 years. The future dividend yield is projected to be 2.5%, with a payout rate of 46%. The good part is that the yield on cost, if purchased at its current price, will be 8.3% in ten years. The secret sauce for dividend investing is not the 1.6% yield offered by SYK today, but the potential of an 8.3% in 10 years.
AmerisourceBergen Corporation, a pharmaceutical services company, provides drug distribution and related services to healthcare providers and pharmaceutical manufacturers primarily in the United States and Canada. Currently, ABC is trading at a 27% discount to its fair value. It has an EPS growth rate of 13%, with an average PE of 14.4. ABC is projected to have a future dividend yield of 2.5%, but its dividend yield on cost is projected to be 8.8%. This is an excellent investment to buy ABC at a discount and let the dividends grow in the coming years.
Qualcomm Incorporated (QCOM) designs, develops, manufactures and markets digital telecommunication products and services. QCOM has a projected EPS growth rate of 12%, with an average PE of 25 in the past years. QCOM is trading at a 21.8% discount to its fair value. However, QCOM has a lower dividend growth rate than SYK or ABC. The result is shown in the future dividend yield to cost of only 4.4%.
All three of these stocks are compelling investments based on their current discounted prices and their future growth prospects. Dividend growth investors should take a long look at buying these three stocks.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.