Legendary mutual fund manager Peter Lynch, who generated a 29.2% annual rate of return during his 13-year tenure as portfolio manager of the Fidelity Investments Magellan Fund, believed that investors should always do their research.
Lynch once said: “The person that turns over the most rocks wins the game. And that’s always been my philosophy.”
Valuation analysis is a major component of equity research. There are many ways to value stocks; one of the more popular valuation tools is the price-to-earnings-growth ratio, or PEG ratio for short.
The PEG ratio compares the expected earnings growth rate of a stock over a given period, typically five years, with the current share price of a stock.
Healthcare giant CVS Health (CVS) appears to be undervalued right now, according to the PEG ratio.
Healthcare Retail on Sale
Shares of CVS have declined about 2% in the past 12 months. The stock has significantly underperformed the S&P 500 Index, which has risen 17% in the past year. CVS’s relative underperformance to the broader market index is twofold. First, investors fear the general downturn of the brick-and-mortar retail industry, which is under severe pressure from e-commerce. Second, investors are particularly worried about pharmacy retailers, due to the threat of Amazon entering the healthcare industry.
CVS’s declining share price in the past year has made the stock significantly cheaper. Today, CVS has a price-to-earnings-growth ratio of 0.99; a PEG ratio below 1.0 indicates undervaluation. Indeed, CVS stock could be undervalued, as the company still has a positive growth outlook. For example, CVS reported 2.2% revenue growth in the most recent quarter. Meanwhile, adjusted earnings-per-share increased 27% for the quarter. CVS has growth catalysts for the future that the market might not appreciate today, but should be reflected in the share price over the long-term.
CVS’s major growth catalyst is its $77 billion acquisition of health insurer Aetna (AET). CVS is already an industry giant—it is one of the largest retail pharmacies in the U.S. with over 9,000 retail locations. It also has a pharmacy benefits management business with nearly 90 million plan members. The merger of CVS and Aetna will create an even bigger company, with over $220 billion in combined annual sales.
Bringing in Aetna could restore CVS’s growth by allowing it to significantly expand its reach. Aetna is one of the largest health benefits providers in the U.S. with more than 40 million members. CVS will be able to expand its pharmacy business, which is one of its strongest-performing segments. In the most recent quarter, CVS grew revenue in its Retail segment by 5.7%, due to strong prescription growth of 9.5%. Pharmacy same-store sales increased 8.3% for the quarter, which more than offset a 1.0% decline in front-store sales, a result of weak store traffic.
CVS’s huge store count provides a tremendous competitive advantage. Consumers still need their prescriptions filled, and due to the aging U.S. population, there is still significant growth potential ahead in pharmacy retail. Adding Aetna only expands CVS’s reach. These growth catalysts are reflected in CVS’s optimistic outlook. The company expects adjusted earnings-per-share of $6.98 to $7.08 for 2018; this would represent growth of 18% to 20% for the year. At least 5% annual earnings growth over the next five year is easily attainable.
In addition, CVS stock has a current dividend yield of 2.5%, which pays investors well to be patient while the company engineers its turnaround. The dividend is highly secure, as CVS is likely to have a dividend payout ratio under 30% for 2018, which leaves plenty of cushion to pay dividends to shareholders and invest in growth initiatives.
The combination of earnings growth, valuation changes, and dividends could result in expected annual returns in the high-single digit range. The PEG ratio is useful in discovering undervalued stocks. According to the PEG ratio, CVS is undervalued, especially if the company’s future earnings growth accelerates.
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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