You’re unlikely to find a bigger fan of dividend growth investing than me.
After all, it’s really been my salvation.
I was below broke back in early 2010. That’s right, I was worth a negative amount of money.
While it was really humbling to take a look at my net worth back then, I also realized I had a huge opportunity in front of me.
Dividend growth stocks like those on David Fish’s Dividend Champions, Contenders, and Challengers list quickly struck me as great long-term investments.
That’s because you have the quality on one hand when you’re dealing with blue-chip companies that sell products and/or services that are demanded by consumers, other businesses, and/or governments all over the world.
And you have the growing dividends on the other hand that not only serve as “proof in the profit pudding” but also a great source of passive income that could one day buy me my freedom.
Well, it’s more than six years later.
The six-figure portfolio I’ve built that’s chock-full of high-quality dividend growth stocks should spit out $11,000 or so in dividend income over the next year, which is enough to cover a significant portion of my core personal expenses.
Now financially free, dividend growth investing has definitely been my salvation.
But as much as I love dividend growth investing, one shouldn’t go out and buy any dividend growth stock at any price.
It’s really quite imperative that you’re sticking to great businesses at great prices.
While a great business might not be terribly difficult to spot, a great price is a bit more nuanced.
First, what is a “great price”?
I’d submit that a great price is one that’s as far below fair value as possible.
Said another way, one should be looking to buy high-quality dividend growth stocks that are undervalued.
An undervalued stock is a stock that’s priced less than its intrinsic worth.
It’s effectively “on sale”.
Undervalued dividend growth stocks are highly desirable for a number of reasons.
First, your yield is almost always going to be higher.
That’s because price and yield are inversely correlated.
All else equal, a lower price will equal a higher yield.
Second, your potential long-term total return is positively impacted.
Total return is composed of both dividends and capital gain.
Well, both sides of the coin are positively impacted when paying less.
You’ve already seen how it goes with yield.
Capital gain, however, is also given a nice boost by virtue of the upside that exists between the lower price paid and the higher value of the stock.
While price and yield can diverge quite a bit over the short term, they tend to converge over the long run.
Third, your risk is lowered.
This is intuitive.
Is it riskier to pay more or less for something?
You should always aim to pay less, whether we’re talking about stocks or socks.
While this all makes a lot of sense, one first needs to know what a stock is worth before determining whether the price makes sense or not.
That’s why reading through fellow contributor Dave Van Knapp’s dividend growth investing lesson on valuation is highly recommended.
Once you know what a stock is worth, you’re in control. You’re able to make a stand and seek out only those high-quality dividend growth stocks that appear to be undervalued.
Well, let’s make a stand right now…
I’m going to discuss a dividend growth stock (from Mr. Fish’s aforementioned list) that right now looks undervalued.
Williams-Sonoma, Inc. (WSM) is a nationwide multi-channel retailer of high-quality home products and furnishings.
Williams-Sonoma is known for quality.
Just look at some of these brands: Pottery Barn, West Elm, and the namesake Williams-Sonoma.
The company sells a wide variety of home products and furnishings.
Furniture, cookware, bed and bath products.
While these could be thought of as commodities in some respects, many consumers are willing to pay up for quality and design. That’s where Williams-Sonoma flourishes.
And while a major threat to longstanding retailers is the rise of e-commerce, Williams-Sonoma has taken the bull by the horns and led the charge: ~50% of the company’s revenue comes from e-commerce sales.
This has translated into a lot of profit.
Fortunately for shareholders, the company has been busy returning plenty of that profit to the very owners (shareholders) of the company via growing dividends.
They’ve increased their dividend for 11 consecutive years.
Not the longest streak around; however, Williams-Sonoma has been making up for that by increasing its dividend rather aggressively: the five-year dividend growth rate is 20.2%.
The dividend raises have slowed a bit recently, due in part to the fact that the company started out with such a low payout ratio 10 years ago; underlying profit growth, meanwhile, has also slowed of late.
However, the payout ratio is only 44.3% currently, so there’s still plenty of room for more dividend raises.
Perhaps what’s best of all about the dividend right now is the yield.
At 2.95%, it’s appealing from a number of angles.
It’s obviously well above the broader market.
In this low rate environment, that kind of income is hard to come by.
Furthermore, that yield is also significantly higher than the stock’s own five-year average yield of 2%.
That’s a spread of almost 100 basis points!
So there’s a lot to like about the dividend.
You’ve got sustainability, growth, and yield.
But in order to determine what kind of dividend growth to expect moving forward, we’ll want to first have an idea of what kind of underlying profit growth the company should be able to generate.
And in order to formulate a future expectation, it makes sense to see what the company has already done over a long period of time. We’ll then compare that to a near-term forecast for profit growth.
All of this will help us later value the stock.
Williams-Sonoma has grown its revenue from $3.728 billion to $4.976 billion from fiscal years 2007 to 2016. That’s a compound annual growth rate of 3.26%.
Meanwhile, the company was able to compound its earnings per share at an annual rate of 7.28% over this 10-year period, increasing EPS from $1.79 to $3.37.
Rather significant share repurchases helped fuel much of that excess bottom-line growth, with the company reducing its outstanding share count by more than 20%.
Looking forward, S&P Capital IQ believes Williams-Sonoma will be able to compound its EPS by an annual rate of 10% over the next three years.
That’s a sizable jump from what we see above. S&P Capital IQ cites growth in comparable brand revenue, new store openings, and additional e-commerce growth.
I believe that would be a hard target to reach. But even a historical growth rate of 7% would be pretty solid, especially when combining that with the current yield.
For instance, take the balance sheet.
The company has no long-term debt.
Profitability is also relatively robust.
Over the last five years, the company has averaged net margin of 6.38% and return on equity of 22.22%.
Retailing isn’t my favorite industry. Razor-thin margins, the threat of e-commerce, brutal competition, and difficulties differentiating a business are all concerns.
However, Williams-Sonoma bucks a lot of these trends.
Profitability is strong. Their e-commerce sales are brisk and growing. And they’ve been able to differentiate themselves in the mind of the consumer through design and quality.
But all of this is for naught if the stock isn’t undervalued.
So is it undervalued right now?
The P/E ratio is sitting at 15.04, which is substantially below both the broader market and the stock’s own five-year average P/E ratio of 20.8. There’s a serious discount at play here. Every other basic metric is below its respective recent historical average, while the yield, as mentioned earlier, is notably higher than it’s been, on average, over the last five years.
Wow. The stock definitely seems cheap right now. But how cheap? What’s a good estimate of its fair value?
I valued shares using a dividend discount model analysis. I factored in a 10% discount rate. And I assumed a long-term dividend growth rate of 7%. That seems like a conservative growth rate, being that it’s well below the demonstrated five-year dividend growth rate and 10-year EPS growth rate of the company. Moreover, a modest payout ratio and forecast for accelerated EPS growth provides even more safety. The DDM analysis gives me a fair value of $52.79.
The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide. The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.
It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today. I find it to be a fairly accurate way to value dividend growth stocks.
My analysis concludes that the stock is at least moderately undervalued – and that’s after using what’s arguably a conservative valuation model. But what do some pros think about this stock and its value?
Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system. 1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.
Morningstar rates WSM as a 5-star stock, with a fair value estimate of $73.00.
S&P Capital IQ is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line. They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.
S&P Capital IQ rates WSM as a 3-star “HOLD”, with a fair value calculation of $55.30.
I came in the lowest, likely due to that conservative take. But I like to average these three valuations out so as to improve the potential accuracy by blending multiple methodologies together. That averaged valuation is $60.36, which indicates the stock is potentially 19% undervalued right now.
Bottom line: Williams-Sonoma, Inc. (WSM) has done a terrific job growing the company, profit, and the dividend. They’ve jumped out in front of the e-commerce train, and that should be commended. Instead, the stock has dropped about 35% over the last year, leading to what looks like 19% upside, on top of a yield that’s well above its recent historical norm. This is a really compelling opportunity that deserves a strong look from dividend growth investors.
– Jason Fieber
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