Every portfolio should have a dividend stock at its core to provide a degree of diversification and stability.
The best dividend stocks are usually found within the consumer goods sector as the sector's defensive nature means that cash flows are predictable. A predictable cash flow creates the perfect environment to support a sustainable dividend payout.
Philip Morris (NYSE:PM) is the perfect dividend stock. The company is one of the most profitable in the world and offers an attractive 4.5% dividend yield.
However, is now the time to buy Philip Morris, or should you wait for a better price?
Only bad prices
The Godfather of value investing, Benjamin Graham, stated that there are no bad assets, only bad prices. Philip Morris is a good asset, there is no doubt about that, but how do we know if the company is trading at a bad price or a good one?
Well, for a start we can compare the company to its peers, for example, Altria, Reynolds American, and Lorillard, which trade at forward P/Es of 14.7, 16.5, and 16.6, respectively, in comparison to Philip Morris' forward P/E of 15.3.
This in itself is not enough as Philip Morris is an international tobacco company, therefore we should compare it to international peers, not domestic peers like those above. What's more, Lorillard and Reynolds are currently in the midst of merger talks, so they have skewed valuations.
An appropriate valuation
We could spend all day comparing Philip Morris to its peers using simple valuation metrics and not really get anywhere. However, there is one key metric that needs to be taken into account above the rest--the fact that Philip Morris is the single most profitable company in the world in terms of free cash flow as a percentage of revenue.
Specifically, Philip Morris converts 29.1% of its revenue to free cash flow, followed by Pfizer (NYSE:PFE) at 26.4%. British American comes in fourth, converting 24.6% of its revenue, and Imperial Tobacco comes in ninth. Altria, Reynolds and Lorillard do not feature in the top 20.
Furthermore, Philip Morris has hiked its dividend payout 104% since 2008 and has repurchased a total of 25.6% of its shares since 2008.
These are all impressive metrics and lead me to conclude that Philip Morris should not be valued on earnings or compared to its tobacco peer group, but instead compared on cash flow to other free cash flow behemoths.
So in comparison with free cash flow leaders Johnson and Johnson (NYSE:JNJ) as well as Pfizer, how does Philip Morris compare?
Philip Morris' free cash flow was $8.3 billion for 2013 and the company is currently worth $136 billion, or 16.4 times its annual free cash flow.
Pfizer's free cash flow was $16.3 billion for 2013 and the company is currently worth $189 billion, or 11.6 times its annual free cash flow.
Johnson and Johnson's free cash flow was $13.8 billion for 2013 and the company is currently worth $286 billion, or 20.7 times its annual free cash flow .
So then, in comparison with its free cash flow peers, Philip Morris looks to be trading at an average valuation.
All in all, Philip Morris' defensive nature and attractive dividend yield make the company the perfect 'back bone' for any portfolio.
However, it would appear that at current levels, when taking into account the company's free cash flow, Philip Morris looks a bit expensive in comparison with peer Pfizer.
Although it only offers a dividend yield of 3.5% at present, 1% below that offered by Philip Morris, Pfizer looks more attractive on a valuation basis and capital growth could make up for the lack of dividend income.
Rupert Hargreaves owns shares of Altria Group. The Motley Fool recommends Johnson & Johnson. The Motley Fool owns shares of Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.