Value investors seek to buy stocks trading below their intrinsic value, a term popularized by legendary value investor Warren Buffett. At its core, value investing is trying to buy a dollar for 50 cents. Value investors are always on the hunt for cheap stocks that are trading for less than they are worth.
On the other hand, income investors typically aim to buy stocks with high dividend yields above the S&P 500 average. With interest rates at zero and stock prices near record highs, income investors might want to focus on stocks with dividend yields above 3%.
The two strategies—value and income investing—can also be combined. We believe CVS (NYSE:CVS) (CVS) is a cheap dividend stock. CVS has a 3.4% dividend yield, and the stock is trading at a very low valuation which makes it an attractive stock for value and income investors.
Business Overview
CVS Health Corporation is an integrated health-care services provider. The company operates more than 9,900 retail locations and 1,100 medical clinics. CVS also services more than 102 million plan members after the $78-billion acquisition of Aetna (NYSE:AET) in 2018. CVS generates annual revenues of about $265 billion.
CVS stock has performed poorly this year, down 20% year-to-date. For comparison, the S&P 500 Index has increased 7% year-to-date. The deep under-performance of CVS implies the company’s financial results have deteriorated, but that is far from the case. CVS has actually performed quite well in 2020, reporting solid growth across its key metrics.
CVS released earnings results for the second quarter on 8/4/2020. Revenue increased 3% to $65.3 billion, while adjusted earnings-per-share increased 40% year-over-year. The COVID-19 pandemic added an estimated $0.70 to $0.80 to adjusted earnings-per-share and $1.8 to $2.1 billion to revenue results during the quarter, due to higher demand for healthcare products. While so many companies across multiple industries are struggling to keep their profits afloat, CVS is reporting impressive growth in revenue and earnings.
Front of store sales declined 4.5%, which was attributed to less customer traffic due to shelter-in-place directives, but was partially offset with higher average basket size. Same store sales improved 2.4% from the previous year, while medical memberships overall increased 3.3% to 23.6 million members. We expect these growth tailwinds to continue in 2021 and beyond.
Growth Prospects
CVS has a strong historical growth profile. In the past decade, the company grew earnings-per-share by approximately 10% per year. Major health-care providers like CVS are set to benefit over the long-term, from the favorable trends taking place in the United States, specifically the aging population. The company will capitalize on this growth opportunity with a multitude of competitive advantages.
CVS’s most compelling competitive advantage is its entrenched position in the pharmaceutical retail industry. The industry is highly regulated, which makes it difficult for new competitors to enter into the industry and gain market share. In addition, the company is one of the largest pharmacies in the United States (along with Walgreens), which allows it to capture economies of scale and pressure its suppliers into delivering better prices.
Consumers are unlikely to cut spending on prescriptions, health insurance, and other health-care products and services, even during difficult economic times. We believe this makes CVS resistant to recessions. From 2008 through 2010, during a deep economic downturn known as the Great Recession, CVS actually increased its diluted earnings-per-share by 10% over this period. The company has also continued to perform well in 2020, despite the U.S. economy officially entering a recession in February.
2020 is expected to be another highly profitable year for CVS. The company now expects adjusted earnings-per-share of $7.14 to $7.27 for the full year, up from $7.04 to $7.17 previously. Therefore, the steep decline in the share price over the course of 2020 means shares are now deeply undervalued.
Dividends, Valuation And Expected Returns
Based on expected fiscal 2020 adjusted EPS of $7.21, CVS stock trades at a price-to-earnings ratio (P/E) of just 8.2. This is a low multiple, particularly for an industry-leading company with a high level of profitability and a positive future growth outlook. The stock has held an average price-to-earnings ratio of 14.6 over the past decade. Our fair value estimate is a P/E ratio of 11.0, which we view as a reasonable fair value P/E multiple.
Still, this means the stock could be significantly undervalued today. This is important, as an expansion of the price-to-earnings ratio could add 6.1% to the annualized returns of the stock over the next five years. We expect this expansion to combine with 5% expected annualized EPS growth and the 3.4% dividend yield, leading to total expected returns above 14% per year for CVS stock, over the next five years.
Dividends are expected to grow in the long term, but in the short term CVS management has prioritized debt repayment. This is a prudent move by management, as the company absorbed a large amount of debt to finance the Aetna acquisition. Therefore, investors should not expect the dividend to be increased until 2022. Even so, CVS has appeal for income investors, as the 3.4% dividend yield is well above the ~1.8% average yield of the broader S&P 500 Index. And, importantly the dividend payout is highly secure, as CVS has a projected dividend payout ratio of 28% for 2020.
Final Thoughts
Even though stocks have widely recovered their coronavirus-induced losses, evident by the recovery in the S&P 500 Index, investors can still find cheap stocks. There are still multiple high-quality companies with solid dividend yields, that are trading below their intrinsic value. One example is CVS, a leader in pharmaceutical retail that is quickly becoming a diversified healthcare conglomerate.
CVS has a positive long-term growth outlook, but the current valuation of the stock does not adequately price in this growth potential. Investors don’t have pick value or growth with CVS; they get both. We view CVS as a cheap stock, and the 3.4% dividend yield makes it an attractive pick for value and income investors.