Cardinal Health (CAH) is a dividend growth stock with an attractive 3.7% yield. It has also raised its dividend each year for over 30 years in a row, which makes it a member of the exclusive Dividend Aristocrats club.
Cardinal Health is deeply undervalued today, but it might not stay cheap for long.
There are many ways to value stocks. One of the most popular valuation methods is the Dividend discount model.
The dividend discount model uses a companies’ current dividend payments, its expected future growth rate, and a reasonable discount rate to estimate fair value. The dividend discount model values stocks by treating their dividends as cash flows and valuing them appropriately.
In the case of Cardinal Health, 6% annualized dividend growth is conservative going forward. Based on the stocks Beta of 1.05 and risk-free rate of 2%, a fair discount rate for Cardinal Health is 8.4%. With these inputs, the dividend discount model implies a fair value for Cardinal Health shares of $84, 58% higher than the current share price of $53.
It’s no surprise that Cardinal Health also looks cheap based on its price-to-earnings ratio. Cardinal Health stock trades for a price-to-earnings ratio just over 10, based on the company’s earnings guidance for the upcoming year. This is a very low valuation for a highly profitable company that maintains a top industry position. A more reasonable estimate of fair value for Cardinal Health would be a price-to-earnings ratio of 15-16.
Returning to Growth
Cardinal Health has had a tough year. The stock has declined 14% year-to-date, and 22% in the past 12 months. There are a number of factors contributing to the decline. As a healthcare distributor, Cardinal Health’s bottom line has suffered from eroding profit margins, due to falling drug prices. Not only that, but the entire industry has grappled with the threat of e-commerce giant Amazon (AMZN) entering the healthcare distribution business.
Cardinal Health recently announced financial results for the fourth quarter and full fiscal year. Revenue increased by 7% for the most recent quarter, and 5% for fiscal 2018. While lower pharmaceutical prices helped Cardinal Health ship more products, it came at a steep cost to the bottom line. Adjusted earnings-per-share fell by 23% in the most recent quarter, and by 7% for fiscal 2018.
The near-term outlook for Cardinal Health is uncertain, but investors should feel confident in the long-term. First, Cardinal Health’s medical product portfolio is helping to offset weakness on the pharmaceutical side of the business. Revenue and profit in the Medical segment increased 15% and 16%, respectively, for fiscal 2018.
Separately, Cardinal Health has taken steps to shore up the pharmaceutical business. Its pharmaceutical product joint venture called Red Oak Sourcing has allowed the company to negotiate better pharmaceutical prices. Acquisitions will help boost Cardinal Health’s growth in new areas. Last year Cardinal Health acquired the Patient Recovery business from Medtronic (MDT) for $6.1 billion, to broaden the company’s product offerings.
Furthermore, Cardinal Health will benefit from a powerful demographic force—the aging population. The U.S. is an aging society, and Cardinal Health will naturally benefit from higher demand for healthcare products over the next several years.
Distributing Steady Cash Flow and Dividends
Cardinal Health is a high quality and shareholder friendly stock. The company has struggled in recent years, resulting in a bargain valuation.
Buying into great businesses at bargain prices is a tried-and-true recipe for wealth compounding. Cardinal Health stock currently has a 3.7% dividend yield. Assuming it returns to fair value – based on either the dividend discount model or price-to-earnings ratio analysis – valuation expansion could add 8% to 10% per year to annualized returns over the next 5 years. Adding in expected growth of 6% gives Cardinal Health stock expected total returns of around 20% per year over the next 5 years.
Ben Reynolds is CEO of Sure Dividend. Sure Dividend helps individual investors build high quality dividend growth stock portfolios for the long run.
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