Since our valuation of Pharmaceuticals Inc. focuses on dividend yield, the portions of the worksheet pertaining to the price-earnings ratio and earnings valuation have been grayed out.
In the dividend analysis of a firm, the consideration of the safety of the dividend is of great concern. A high current yield itself does not mean that a stock is undervalued. It may indicate that the market feels that the dividend is in jeopardy. For a high relative current dividend yield to be considered a sign of an undervalued stock, the company must be expected to continue to pay and expand the dividend both this year and for years to come.
The payout ratio (dividends per share divided by earnings per share) is particularly useful in gauging the strength of the dividend. Generally, the lower the payout ratio, the more secure the dividend. Any ratio above 50% is considered a warning sign. However, like all ratios, the payout ratio is industry-specific. Very stable industries, such as utilities, have high payout ratios, which is considered normal. A 100% payout ratio shows that a firm is paying out all of its earnings to its shareholders. Figures above 100% indicate that the payout is greater than earnings, a situation that cannot continue forever; negative ratios show that a company is paying out a dividend while losing money.
Pharmaceuticals Inc. has averaged a 66% payout ratio over the last five years, a figure higher than one would generally like to see. Beyond not having enough cash to cover the dividend payment, a policy of high dividend payout may limit future growth if capital expenditures and research and development are reduced to maintain the dividend. Drug firms are not capital-intensive, but they are research-intensive. Investment in research takes many years, if ever, to pay off.
Financial leverage is another indicator of dividend safety. Heavier debt loads saddle a company with required cash outflows to bondholders, who must be paid before dividends can be paid to shareholders. A company with little debt that runs into earnings problems has the ability to borrow. For Pharmaceuticals Inc., we have used the ratio of long-term debt to equity as a measure of financial leverage. This figure was selected because comparable industry data was also available for this ratio. Pharmaceuticals Inc.'s ratio of 6% with a 4% five-year average is very low. This also compares favorably with the industry figure of 12% for Year 5 and the industry's 15% five-year average. While the ratio of long-term debt to equity is a common ratio, it does possess some inherent weaknesses. The ratio does not consider short-term liabilities or other liabilities that are significant for Pharmaceuticals Inc. The ratio of total debt to total assets shows that liabilities are equal to about half of total assets, higher than the 34% figure for the drug industry. (This information was ascertained through AAII's Stock Investor Pro program but can be calculated from a company's balance sheet as well.)
It is the dividend yield portion of the financial ratio section that is of primary importance in the dividend valuation process. Looking at year-by-year figures shows an interesting change in trend. From Year 1 to Year 4, Pharmaceuticals Inc.'s dividend yield was trending down. This was a period of tremendous performance for drug stocks. Since then the yield has risen steadily due to an increasing dividend coupled with a stock price decline. The five-year average high and low yields are 4.6% and 3.3%, respectively, levels significantly below the current yield of 5.7%.
Valuing the Company
The bottom of the valuation worksheet in Figure 1 provides valuations using the dividend-based model. Applying the model to Pharmaceuticals Inc. paints an interesting picture. The first item that needs to be determined is the appropriate per share dividend for next year (Year 6). The worksheet uses Value Line's Year 6 dividend estimate of $2.92, leading to a high valuation of $88.48 and low valuation of $63.48. This compares to a current (mid-Year 6) price of $51.50. But before you reach for the phone to call your broker, let's look at some of the assumptions behind the numbers.
The first area to consider is the dividend itself. The estimated Year 6 figure of $2.92 represents an increase, although small, over the $2.88 dividend for Year 5. If you were to expand last year's dividend by the historical growth of 9.5% you would get $3.15 [$2.88 × (1 + 0.095)], showing that $2.92 falls significantly short of the past trend. This figure even falls below Value Line's 8.5% estimate of long-term dividend growth and is the first signal of a change in trend. It is a good exercise to try different dividend estimates and see the impact on the valuation. If you think a dividend cut is possible, try the valuation with the new dividend. A halving of the $2.88 dividend to $1.44 leads to a valuation range of $31.30 to $43.64, all else being equal.
The next area to look at is the average high and low dividend yields. In considering whether the five-year averages of 3.3% and 4.6% are appropriate numbers, you need to ask whether the fundamental characteristics of the company have changed and higher levels are appropriate. If you assume the government will start to further regulate the industry and set prices, then these drug firms may become more like utilities and trade with higher expected yields, coupled with lower growth rates and lower profit margins. Under this scenario the current price seems fair. Changing the required dividend yield to 6% leads to a valuation of $48.67 using the $2.92 dividend estimate.
By changing the required dividend yield to determine the effect on valuation, you can quickly see that the stock price is even more sensitive to slight changes in yield than to changes in dividend.
Conclusion
Performing sensitivity analysis of this nature is a critical part of the valuation. It helps to provide you with a sense of the factors that drive a stock price and informs you of the factors to focus on when performing the valuation.
The Valuation Worksheet focuses on the quantitative factors of valuation. Any final decision should also be based on a better understanding of the company, its management, and its competitive environment. This can only be accomplished by a thorough reading of the firm's financial reports, as well as the reports and summaries on the firm and its industry.
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