Part of my dividend growth strategy involves finding undervalued dividend growth stocks, determining a target price to buy them at and then waiting for the price to fall below that target. In this article I’ll go over a quick way to identify undervalued stocks. By comparing the current dividend yield to historical averages, you can quickly see if a stock is undervalued. The idea being that if the dividend is sustainable and the current yield is higher than the three, five, and 10 year high yield averages then the stock is likely undervalued.
Once undervalued stocks have been identified I come up with a target price to buy them at. This week I thought I’d use this technique to find undervalued dividend growth stocks in the Canadian energy industry.
Dividend growth stocks in the Canadian energy industry
Looking at the May 31 Canadian dividend all-star list, I came up with Suncor Energy Inc. (USA) (NYSE:SU), Imperial Oil Limited (USA) (NYSEAMEX:IMO) and Canadian Natural Resource Ltd (USA) (NYSE:CNQ) as good dividend-growth candidates in the energy industry.
Imperial Oil has the longest dividend streak having increased the distribution for 18 consecutive years. Its dividend yield is too low for me to consider investing in it right now and it also has the lowest average annual dividend growth rates, which range from 6.3% to 9.1%.
That said, Imperial Oil Limited (USA) (NYSEAMEX:IMO) has the lowest payout ratio and its most recent dividend increase was 9.1%. With a reasonable estimated average annual growth rate of 4.7% and its low payout ratio, Imperial Oil has lots of room for dividend growth. The dividend yield is too low for me right now, but if it got up to 2.0% or 2.5% then I’d consider investing.
Suncor Energy Inc. (USA) (NYSE:SU) has the highest yield and strong average annual dividend growth rate, which makes it very appealing. The payout ratio is the highest of the three, and the future estimated growth rate is low, which had me a bit concerned so I did some more research to come up with an expected future dividend growth rate.
Analysts expect EPS to be $3.24 in five years. Using the five and 10 year historic payout ratio averages of 21.6% and 14.6% would indicate a decrease in dividend growth. I don’t think this is likely.
With Suncor Energy Inc. (USA) (NYSE:SU)’s recent dividend increase of more than 50%, it looks like management plans to pay out more of its earnings as dividends. I’d guess that Suncor Energy will be paying out 30% to 40% of earnings going forward. This would result in an average annual dividend growth ranging from of 4.0% to 10.1%. With Suncor Energy’s strong dividend growth history and its large recent increase, I expect dividend growth at the high end of this range, or higher.
Undervalued dividend growth stocks
From a value perspective these companies look relatively cheap, but Suncor Energy Inc. (USA) (NYSE:SU) and Canadian Natural Resource Ltd (USA) (NYSE:CNQ) look like the best options when I compare their current yield to historic averages.
You can see from the table that Suncor Energy Inc. (USA) (NYSE:SU) and Canadian Natural Resource Ltd (USA) (NYSE:CNQ) are currently yielding significantly above their historic averages, while Imperial Oil Limited (USA) (NYSEAMEX:IMO) is within 1.0% to 7.3% of its average. Based on this table, it looks like Suncor Energy and Canadian Natural Resources are undervalued. I looked at some Morningstar information and it confirms my findings. Morningstar has a four-star rating for Imperial Oil and a five-star rating for Canadian Natural Resources and Suncor Energy.
Suncor Energy Inc. (USA) (NYSE:SU) and Canadian Natural Resource Ltd (USA) (NYSE:CNQ) both have five-star ratings, but Suncor Energy has a better dividend yield. If Canadian Natural Resources’ price were to drop to $25.00, which would result in a dividend yield of 2.0% I’d consider investing in it. Imperial Oil Limited (USA) (NYSEAMEX:IMO) has a very low yield and the price would have to drop significantly to get to a yield ranging from 2.0% to 2.5% so I didn’t bother determining my target price.
Bottom line
There are some other compelling options in this industry right now, but only one of them meets my minimum dividend yield requirements, so for the time being Suncor Energy Inc. (USA) (NYSE:SU) is looking like the best option from a dividend growth perspective.
Michael Weber has a position in Suncor and Imperial Oil. The Motley Fool has no position in any of the stocks mentioned.
The article Canada’s Undervalued Dividend Growth Stocks originally appeared on Fool.com.
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