A reason why Altria (MO) shareholders have historically achieved such strong outperformance in the market is because tobacco stocks traditionally traded at a low P/E ratio, had a high dividend yield, and a high earnings per share growth rate. From 1987 through 2007, Altria traded at an average valuation of 13.8x earnings, had an average dividend yield over 5.2%, and achieved annual earnings per share growth of 9.2%. The investors that reinvested their dividends along the way reaped 18.3% annual returns because they benefited tremendously from the reinvestment of dividends at a low valuation.
Those attractive valuations are no longer present for Altria. In fact, the excessive jubilation surrounding Altria stock in recent years has become so detached from reality that Altria now trades at its highest valuation in the past forty years. Over the past twelve months, Altria has earned $2.78 per share. This puts the current valuation at over 20x earnings.
Consider this reference point: Altria’s highest valuation from 1987 through the financial crisis of 2008 was 17x earnings. Even after the financial crisis, Altria traded solidly at 15-16x earnings from 2011 through 2014.
However, a combination of four factors has worked in unison to drive Altria’s valuation to never before seen heights: (1) a paucity of new smoking regulations/bans in recent years; (2) lower gas prices in the United States that has facilitated the amount of disposable income available for cigarette purchases; (3) low interest rates that lead investors away from bond-like investments to stocks with long dividend payment histories; and (4) a premium being paid for the SABMiller stake that is being taken over by Anheuser-Busch Inbev.
These are about as good of operating conditions as the shareholders of Altria could hope for. The problem is that it has created a significant headwind for when Altria’s valuation returns to normalcy in response to either higher interest rates, an unexpected wave of new regulations, or a significant increase in the cost of gasoline.
If you’re a prospective shareholder, you should pose to yourself the question and follow-up: “Is it likely that Altria will see a return to a valuation of 15x earnings? And what will be the penalty to shareholder returns for doing so?”
If you answer the first question yes, then it is likely that Altria is about 34% overvalued at the present time. The next question is a bit of an art–Altria could abruptly fall in price to fair value or it could experience stock price stagnation for a while even as earnings grow. If Altria doesn’t see 15x earnings for a decade, then that means shareholders will forfeit about four percentage points per year as an overpayment penalty.
Altria has a 3.4% dividend yield and a likely chance of growing at 8%. The total returns for the next decade, then, ought to be 11.4%-4% or somewhere around 7.4%. That’s not a bad return–that’s why I’m writing this article from the perspective of whether you should buy it rather than whether you should sell it.
However, there is very little cover in the event that earnings disappoint. If you get 5% earnings growth over the next ten years, plus a 3.4% dividend yield, then you’ll be looking at 4.4% annual total returns. That’s only going to beat inflation by about a percent or so.
Normally, people that analyze tobacco stocks are trying to balance the decline in smoking rates against the cheapness of the tobacco stock. The argument is something like “Yeah, people are smoking at almost 4% less per year, but the valuation of 12x earnings more than discounts for this fact.” Those are not the circumstances now. Altria is being priced as if smoking is a growth industry–none of the traditional risks associated with smoking are reflected in the current quotation level of 23x earnings.