3 Undervalued Stocks Based on Dividend Discount Model

Published Tue, 02 Feb 2016 18:30 CET by TopYields.nl

The Dividend Discount Model (DDM) seeks to estimate the present value of a given stock based on the spread between the estimated dividend growth and a dividend discount rate. The projected dividend growth is estimated by taking into consideration the stock's dividend history. If a stock delivers an annualized dividend of $1.80 per share and has an actual dividend growth of 120% over the last 15 years, you can calculate the average growth at 8% per year. For the dividend discount rate, which is actually the return you expect on your money, you can calculate a proxy rate based on the dividend’s growth. For instance, when the $1.80 dividend per share (DPS) goes up to $1.94, which is an 8% growth, the $1.94 is actually worth $1.75 to you today, because if you had $1.75 today, you could turn it into $1.94 with 10% discount rate.
Projected growth rates are usually taken by analyst consensus, but you can calculate them on your own as well with the above method.
The DDM calculates the present value of a stock as follows:

Present Stock Value = Dividend per share / (R discount - R dividend growth)

In the DDM, if the present stock value is higher than the market value, then the stock is undervalued, meaning it trades at a lower value than it should, and, therefore, it is a good time to buy this stock expecting its price to rise.

Cross Checking with the Graham Number

Another metric to measure over- or undervaluation of a stock is the Graham number. According to Benjamin Graham, the father of value investing, the Graham Number is the maximum price that you should pay for a given stock, based on the stock’s earnings per share (EPS) and book value per share (BVPS). If the Graham Number (the present value) is higher than the market price, the stock is considered to be undervalued. The formula for the Graham Number = SQRT (22.5 x EPS x BVPS).
So, in fact, seeking for undervalued stocks is like trying to buy a stock with good earnings as low as possible. This is why you should consider a stock’s EPS. It helps you compare how much you are paying for a dollar of earnings for one company or another. Stocks prices are changing on a daily basis and you cannot know when an undervalued stock will appreciate. But the earnings are fairly straightforward.
This article discusses three undervalued large caps that trade in different industries. According to the Graham number as calculated in the table below, all three stocks are trading below their present stock value, thereby representing opportunities to buy.

Name Price ($) Earnings/Share (EPS) Book Value/Share (BVPS) Graham Number Discount to Fair Value Dividend/Share (DPS)
AT&T 36.09 2.37 27.32 38.17 94.6% 1.92
Chevron 82.82 4.61 82.31 92.40 89.6% 4.28
Franklin Resources 32.80 3.29 19.62 38.11 86.1% 0.72

ATT, Chevron and Franklin Resources YoY Stock Performance Graph
AT&T (NYSE: T) is a Dallas-based telecom company that offer telecommunications services both in the United States and internationally. Through its Wireless segment, AT&T offers data and voice services as well as roaming services to nearly 120 million wireless customers, including the government, and small businesses. Through its Wireline segment, the company offers networking services and voice services to 9 million retail consumer access lines, 9 million retail business access lines, and 2 million wholesale access lines.

Dividend Discount Model: AT&T declares a dividend of $1.92 per share and is currently valued at $36.06 in the market. Based on the stock’s dividend history, the projected dividend growth rate is 6% and the discount rate is 10%. Thereby, the present value of the AT&T stock is: $1.92 per share / (0.1 discount - 0.06 dividend growth) = $1.92 / 0.04 = $48. Given that the market value is lower than the present value, the stock is undervalued, representing an opportunity to buy.

Chevron (NYSE: CVX) is a California-based petroleum company that operates in the petroleum, chemicals, and energy sectors internationally. Through its Upstream and Downstream segments, Chevron is involved in the exploration, development, and production of crude oil and natural gas as well as in the refining of crude oil into petroleum products and the manufacturing and marketing of commodity petrochemicals and plastics for industrial use. Chevron is also involved in debt financing activities, insurance operations and real estate activities.

Dividend Discount Model: Chevron declares a dividend of $4.28 per share and is currently valued at $86.47 in the market. Based on the stock’s dividend history, the projected dividend growth rate is 4% and the discount rate is 8%. Thereby, the present value of the Chevron stock is: $4.28 per share / (0.08 discount - 0.04 dividend growth) = $4.28 / 0.04 = $107. Since the present value is higher than the market value, the stock is undervalued, representing an opportunity to buy.

Name Price ($) 52 wk low 52 wk high 52 wk low % 52 wk high % Market Cap ($ b) P/E D/E Beta Payout Ratio
AT&T 36.09 30.97 36.45 16.53% -0.99% 221.84 15.22 0.98 0.46 81%
Chevron 82.82 69.58 112.93 19.03% -26.66% 162.74 18.76 0.19 1.25 93%
Franklin Resources 32.80 31.87 54.85 2.92% -40.20% 20.85 10.51 0.18 1.68 22%

Franklin Resources (NYSE: BEN), formerly known as Franklin Templeton Investments, is a California-headquartered asset management holding company providing investment advisory services to high worth retail investors, institutional, and corporate clients. Franklin Resources manages global equity, fixed income, money funds and hedge funds through its subsidiaries and invests in equity, fixed income and the alternative markets.

Dividend Discount Model: Franklin Resources declares a dividend of $0.72 per share and is currently valued at $34.66 in the market. Based on the stock’s dividend history, the projected dividend growth rate is 13% and the discount rate is 15%. Thereby the present value of the Franklin Resources is: $0.72 per share / (0.15 discount - 0.13 dividend growth) = $0.72 / 0.02 = $36. Given that the market value is lower than the present value, the stock is undervalued, representing an opportunity to buy.

Stock name Dividend Yield
At&t 5.16
Chevron 4.11
Franklin Resources 1.82

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