There are many ways stocks can be valued. One of these, although it is only applicable for dividend-paying stocks, is the Dividend Discount Model. It is suitable for all investors, including those that are not interested in employing complicated financial models such as the Discounted Cash Flow Method, as you only need three items to employ this method: the one-year forward dividend, the dividend growth rate and a discount rate.
The calculation is as follows. Fair value is equal to next year's dividend payment, divided by the difference between the discount rate and the expected dividend growth rate.
The model is known under other names, including the Dividend Growth Model, the Gordon Growth Model and the Dividend Valuation Model. The first part, i.e., the forward dividend payment, is easy to find out – one would just multiply the most recent quarterly dividend payment by four, or alternatively use management’s guidance for forward dividend payments, if it is provided.
For the dividend growth rate, investors should make educated guesses about the rate at which the company will increase its dividend payments in future years. Investors should be factoring in items such as the company’s dividend growth rate in the past, management’s goals for future dividend growth, trends in the company’s earnings growth rate and payout ratio, and so forth.
The discount rate is different for each investor, as it is dependent on the returns an investor targets. If you seek to generate an annual return of 10% on your investment, you would use a discount rate of 10%. A discount rate can alternatively be derived through the Capital Asset Pricing Model, or CAPM, which incorporates a calculation that factors in a stock’s volatility, but this is a bit more complicated and may not be suitable for all investors.
Dividend Discount Model for Altria
Company Overview
Altria (MO, Financial) is a tobacco stock that operates in the U.S. primarily, where it sells cigarettes such as Marlboro. Altria owns other businesses on top of that, including smokeless (chewable) tobacco, a wine business, and a stake in publicly traded beer giant Anheuser-Busch InBev. Altria is trading with a market capitalization of $102 billion.
Altria has made two sizeable M&A deals in the recent past, buying a stake in privately held JUUL Labs, which is the leader in the U.S. e-cigarette market, and a stake in publicly traded, Canada-based marijuana company Cronos Group (CRON).
Altria’s management states that these two investments will not be accretive to the company’s profits in the short run. Instead, they will pressure Altria’s earnings growth slightly, due to the fact that Altria had to take on billions in debt to finance these deals. The resulting interest expenses are why Altria’s management forecasts a below-average earnings-per-share growth rate during 2019, as management guides towards earnings-per-share of $4.15 to $4.27 during the current year. This implies a growth rate of roughly 5%, which is less than the high single digits earnings-per-share growth that it had been forecasting before announcing the investments in JUUL Labs and Cronos Group.
These investments will, in all likelihood, nevertheless generate positive returns for shareholders in the long run, as the negative impact from higher interest expenses should soon be overshadowed by the positive contributions from the two investments, once these two firms have gotten more profitable. Altria expects that the returns it will receive from its investment in JUUL Labs will be higher than its cost of capital during the first half of the 2020s.
Altria as an income investment
Altria is oftentimes held by retail investors due to its history of delivering outsized total returns, coupled with a very compelling dividend growth track record. The company has raised its dividend very consistently, and for a long period of time, at least when we adjust for the split from Philip Morris roughly 10 years ago.
Altria also has a very straightforward dividend policy: The company plans to pay out 80% of its adjusted earnings per share every year. Due to the fact that Altria has been able to grow its earnings per share very consistently in the past, investors got very consistent dividend increases, and it seems likely that the same will be true in the future as well.
Altria does not only offer very consistent dividend increases, though. The company offers a quite high current dividend yield too. Based on its current share price of $55, Altria’s dividend yield is 5.9% right here, which is roughly three times as high as the broad market’s dividend yield.
Dividend Discount Model
There are two ways by which we can employ the Dividend Discount Model for Altria, either by assuming what the dividend growth rate could look like in the future, and by solving for fair value, or by plugging in the current share price for fair value and by solving for the assumed dividend growth rate.
Using the second method, we will be calculating with forward dividend payments of $3.20 and a current share price of $55. For the discount rate, we can use the CAPM, which gets us to a discount rate of 3.9%, using a risk-free rate of 2.4%, a market return rate of 5.8% and Altria’s beta of 0.43.
Solving for the dividend growth rate, we get to -1.9%. This means that Altria’s shares would be fairly valued according to the Dividend Discount Model, if the company lowered its dividends by 1.9% a year going forward. If the company’s dividend growth rate is higher, shares are undervalued. Based on management’s guidance, the company’s past dividend growth track record, and its earnings outlook, it seems highly unlikely that Altria’s dividend will not grow during coming years, and a shrinking dividend seems even more unlikely. This means that Altria’s shares are very likely undervalued right here, which makes them look attractive.
Final thoughts
The Dividend Discount Method is a low-effort way to calculate a fair value for dividend-paying stocks. Investors don’t need to build complicated models when employing this method, which makes it suitable for everyone.
The above example shows that Altria is undervalued according to the Dividend Discount Method, at least when we assume that its dividends will not shrink by 1.9% or more annually. Due to the company’s historical performance and recent growth investments into cannabis company Cronos and the leader in the e-cigarette market JUUL Labs, it seems unlikely that Altria will not be able to generate at least some growth going forward. Altria, therefore, looks like an attractive income investment at the current price.
