Altria Group Inc. (MO, Financial) recently raised its quarterly dividend to $0.565 from $0.52 a share. The stock now yields 4.2% if the share price stays at current levels. The hike reflects Altria´s policy of returning value to shareholders and helps to continue with a good dividend growth, now at 46 consecutive years.
Behind the Growth
Although tobacco consumption is falling in the U.S., Altria´s volumes are increasing due to its leading brand, Marlboro, which is the dominant cigarette brand due to its quality. However, it is expected that cigarette consumption will decline in the range of 3% to 4% per year for the next few years.Â
Relative Valuation and Dividend Yield
The company is trading at a P/E ratio of 20.88x and is close to 10-year high of 23.06x but is a bit expensive than competitors such as Reynolds American (RAI, Financial) and Philip Morris (PM, Financial). By dividend yield, Altria's dividend looks attractive but is below Philip Morris.
| Company | P/E Ratio | Dividend Yield (%) |
| Altria | 20.88 | 4.2 |
| Reynolds | 15.9 | 3.21 |
| Philip Morris | 17.02 | 4.94 |
Intrinsic Value
The Yahoo Finance consensus price target is $58.89. To estimate the fair value of the firm, I will use the Dividend Discount Model (DDM). In stock valuation models, DDM defines cash flow as the dividends to be received by the shareholders. The model requires forecasting dividends for many periods, so we can use some growth models like: Gordon (constant) growth model, the Two or Three stage growth model or the H-Model (which is a special case of a two-stage model).
Once we've selected the appropriate model, we can forecast dividends up to the end of the investment horizon where we no longer have confidence in the forecasts and then forecast a terminal value based on some other method, such as a multiple of book value or earnings.
Let´s estimate the inputs for modeling:
First, we need to calculate the different discount rates, i.e. the cost of equity (from CAPM). The capital asset pricing model (CAPM) estimates the required return on equity using the following formula: required return on stock j = risk-free rate + beta of j x equity risk premium
Risk-Free Rate: Rate of return on LT Government Debt: RF = 3.03%[1]. I think this is a very low rate. Since 1900, yields have ranged from a little less than 2% to 15%; with an average rate of 4.9%. So, I believe it is more appropriate to use this rate.
Gordon Growth Model Equity Risk Premium = (1-year forecasted dividend yield on market index) + (consensus long-term earnings growth rate) – (long-term government bond yield) = 2.13% + 11.97% - 2.67% = 11.43%[2]
Beta: From Yahoo! Finance we obtain a β = 1.01
The result given by the CAPM is a cost of equity of: rMO = RF + βMO [GGM ERP] = 4.9% + 1.01 [11.43%] = 16.44%
Dividend growth rate (g)
The sustainable growth rate is the rate at which earnings and dividends can grow indefinitely assuming that the firm´s debt-to-equity ratio is unchanged and it doesn´t issue new equity.
g = b x ROE
b = retention rate
ROE = (Net Income)/Equity= ((Net Income)/Sales).(Sales/(Total Assets)).((Total Assets)/Equity)
The “PRAT” Model:
g= ((Net Income-Dividends)/(Net Income)).((Net Income)/Sales).(Sales/(Total Assets)).((Total Assets)/Equity)
Collecting the financial information for the last 3 years, each ratio was calculated, and then to have a better approximation I proceeded to find the 3-year average:
| Retention rate | 0.21 |
| Profit margin | 0.19 |
| Asset turnover | 0.70 |
| Financial leverage | 9.85 |
Now, is easy to find the g = Retention rate Ă— Profit margin Ă— Asset turnover Ă— Financial leverage = 26.93%
Because for most companies, the GGM is unrealistic, let´s consider the H-Model which assumes a growth rate that starts high and then declines linearly over the high growth stage, until it reverts to the long-run rate. In other words, a smoother transition to the mature phase growth rate that is more realistic.
Dividend growth rate (g) implied by Gordon growth model (long-run rate)
With the GGM formula and simple math:
g = (P0.r - D0)/(P0+D0)
= ($53.94 × 16.44% – $2.26) ÷ ($53.94 + $2.26) = 11.76%.
The growth rates are:
| Year | Value | g(t) |
| 1 | g(1) | 26.93% |
| 2 | g(2) | 23.13% |
| 3 | g(3) | 19.34% |
| 4 | g(4) | 15.55% |
| 5 | g(5) | 11.76% |
G(2), g(3) and g(4) are calculated using linear interpolation between g(1) and g(5).
Now that we have all the inputs, let´s discount the cash flows to find the intrinsic value:
| Year | Value | Cash Flow | Present value |
| 0 | Div 0 | 2.26 | Ă‚ |
| 1 | Div 1 | 2.87 | 2.463 |
| 2 | Div 2 | 3.53 | 2.605 |
| 3 | Div 3 | 4.22 | 2.670 |
| 4 | Div 4 | 4.87 | 2.649 |
| 5 | Div 5 | 5.44 | 2.543 |
| 5 | Terminal Value | 129.93 | 60.691 |
| Intrinsic value | Ă‚ | Ă‚ | 73.62 |
| Current share price | Ă‚ | Ă‚ | 53.94 |
| Upside Potential | Ă‚ | Ă‚ | 36% |
Final Comment
Intrinsic value is above the trading price by 36%, so according to the model and assumptions, the stock is undervalued and subject to a potential “buy” recommendation. However, we must keep in mind that the model is a valuation method and investors should not rely on this alone in order to determine a fair (over/under) value for a potential investment.
As outlined in the article, the tobacco giant increased its dividend and made me think it is among the best dividend growth stocks, so I recommend investors to add this stock to their long-term portfolios.
Hedge fund gurus like Jeff Auxier and John Rogers have boosted their stakes by 81.56% and 20.73%, respectively. Also bullish were Bill Frels (Trades, Portfolio), Ken Fisher (Trades, Portfolio), Charles Brandes (Trades, Portfolio) and Tom Russo (Trades, Portfolio) in the second quarter of 2015, as well as Diamond Hill Capital.
Disclosure: As of this writing, Omar Venerio did not hold a position in any of the aforementioned stocks
[1] This value was obtained from the U.S. Department of the Treasury
[2] These values were obtained from Blommberg´s CRP function.
