Undervalued Dividend Growth Stock of the Week: Target Corporation (TGT)

I’m a long-term buy-and-hold dividend growth investor.

In my opinion, it’s one of the easiest and most robust ways to increase one’s wealth and income.
And that’s an opinion that’s backed by plenty of research.

My strategy simply involves identifying wonderful businesses that have longstanding track records of handing out increasing dividends to shareholders. And then I buy shares in these businesses when they’re priced less than they’re worth.

Well, easier said than done, right?

I suppose so, but there are a lot of tools at investors’ disposal today – tools that weren’t available a decade or so ago.

One such tool is David Fish’s Dividend Champions, Contenders, and Challengers list, which is a compilation of almost 800 US-listed stocks with at least five consecutive years of dividend raises.

So if you’re looking for dividend growth stocks, much of the homework has already been done for you.

From there, you just need to identify those high-quality companies that fit your unique investment vision.

I can tell you my vision is embodied by my Full-Time Fund, which is my real-life, real-money portfolio.

This portfolio has been carefully crafted over the last six years, now chock-full of high-quality dividend growth stocks.

And I’m expecting to receive almost $11,000 in purely passive dividend income over the next year.

Better yet, this income should just grow over the years, likely faster than inflation.

This passive income, by the way, covers a substantial chuck of my core personal expenses, which has effectively rendered me financially free at the tender age of 33 years old. As such, you’ll find few investors who are bigger fans of growing dividends than me.

But I also mentioned earlier that I buy shares in these businesses when they’re priced less than they’re worth.

How does one go about doing that? And why is it so important?

Well, in order to pay less than a stock is worth, you first need to know its intrinsic value. Can’t pay less than it’s worth if you don’t know what it’s worth.

And here we have another tool at our disposal, in the form of fellow contributor Dave Van Knapp’s dividend growth investing valuation lesson.

This lesson is a guide that makes valuing most dividend growth stocks pretty easy.

Once you have an estimate of what a stock is worth, it’s then up to you to pay less than that.

This is important, because undervalued dividend growth stocks offer some fantastic benefits.

An undervalued dividend growth stock will offer a higher yield, greater long-term total return potential, and less risk.

This is relative to what the same stock would offer if it were fairly valued or, worse, overvalued.

And it’s easy to understand why.

First, price and yield are inversely correlated.

All else equal, a stock will always offer a higher yield when it’s priced lower.

This yield has a positive impact on the long-term total return potential, since yield is a one of two components of total return.

The other component, capital gain, is also given a possible boost via the upside that exists between the lower price paid and the higher value of the stock.

Meanwhile, the risk of the investment is lessened by introducing a margin of safety.

If you pay less than what a stock is worth, you have some cushion there that wouldn’t exist if you would have otherwise paid a higher price.

Say a stock is worth $50 but you pay $40.

That means the company could conceivably take a $10-per-share hit in regards to its intrinsic value (through corporate malfeasance or any other myriad of reasons) but you’d still have an intact investment that isn’t worth less than you paid.

With all that in mind, I think it’s easy to see why one should aim to purchase high-quality dividend growth stocks when they’re undervalued.

And I’m going to show you readers what this looks like in real-time by uncovering a stock from Mr. Fish’s list that right now appears to be priced less than it’s worth.

Target Corporation (TGT) is a North American retailer that operates approximately 1,800 stores across the US.

One of the most successful retailers of all time, Target has proven its staying power.

Founded in 1902, they’ve become one of the largest and most enduring retailers in the country, which is saying a lot when considering how much the retail landscape has changed over the years.

Long known as a general merchandiser, Target has moved aggressively in recent years to broaden its grocery offerings and exposure to e-commerce.

If their history is any guide, this will only add to their long-term endurance.

That endurance is evidenced by their ability to raise their dividend – funded by increasing profit – for decades.

The company has increased its dividend for 49 consecutive years – almost unheard of in retail.

And over the last decade, that dividend has grown at a compound annual rate of 19.6%.

capturePlus, check this out: the current yield is 3.53%, backed by a fairly moderate payout ratio of 46.6%.

There’s a lot to like here in regards to the dividend.

You’ve got a hefty yield, moderate payout ratio, really strong dividend growth, and a track record for dividend growth that is truly elite.

Consider, too, that the current yield of 3.53% is 100 basis points higher than the stock’s five-year average yield of 2.5%.

That’s a pretty massive spread.

Of course, that opportunity to collect more income on an investment is somewhat offset by slowing dividend growth.

The last couple dividend increases were around 7%, and management is indicating that they expect that to continue for the foreseeable future.

Still, the combination of a yield that’s so substantially higher than the broader market and a growth rate that’s also well above inflation is awfully appealing.

But let’s just see if management’s expectation regarding dividend growth is reasonable.

We’re going to look at what Target has done over the last decade in terms of underlying revenue and profit growth, and then we’ll compare that to a near-term forecast for profit growth.

This will help us later determine what the stock might be worth. It will also allow us to formulate some kind of baseline expectation for future dividend growth.

Target’s revenue is up from $59.490 billion to $73.785 billion from fiscal years 2007 to 2016. That’s a compound annual growth rate of 2.42%.

Meanwhile, the company’s earnings per share grew from $3.21 to $5.31 over this same period, which is a CAGR of 5.75%.

The bottom line was helped by a rather substantial share buyback policy, seeing Target reduce its outstanding share count by approximately 27% over this 10-year stretch.

However, I think these numbers belie Target’s true growth potential.

A rather messy foray into Canada, with a costly exit a short time later, distracted the company and cost them. Before this, Target was growing at a very healthy clip. And it seems like the company is back on track now.

For instance, S&P Capital IQ believes Target will compound its EPS at an annual rate of 10% over the next three years, citing cost reductions and improving omni-channel sales.

That might prove to be a bit optimistic, but I also think the ~6% growth rate we see above is light.

I’d expect something somewhere in the middle.

Nonetheless, that would still allow the company to hand out those ~7% dividend increases, seeing as how the payout ratio is moderate and the underlying EPS growth rate would be in line.

Looking at other fundamentals, we can see that this is really a rather high-quality business.

The balance sheet is leveraged but not uncharacteristically so for the industry.

The long-term debt/equity ratio is 0.92 and the interest coverage ratio is approximately 9.

These are solid numbers. Not great. Not poor. But solid.

Profitability is similar in that its not outstanding but really quite solid.

Over the last five years, the firm has averaged net margin of 3.77% and return on equity of 17.89%.

These numbers are quite competitive for the industry.

Overall, Target is one of my better ideas in the retail industry, if that’s an industry you’re interested in exposure to.

They have great customer loyalty through their REDcard program. Their e-commerce business continues to grow briskly. The sale of their pharmacy business to CVS Health Corp (CVS) consolidates the business into core competencies. And the added proliferation of their smaller-format stores in urban centers adds a nice growth driver.

With all of this in mind, we might expect the stock to be trading hands for a premium.

But it actually looks fairly cheap right now…

The stock’s P/E ratio is sitting at 13.21 right now, although that ratio is being favorably impacted by the sale of the company’s pharmacy business. Nonetheless, it’s still quite a bit lower than the broader market. And consider the stock’s five-year average P/E ratio is 17.0. And as I noted earlier, the stock’s current yield is substantially higher than its recent historical average (as well as the broader market).

So the stock does look cheap here. What, then, would be an appropriate price to pay? What’s a reasonable estimate of the stock’s intrinsic 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 6.5%, which provides a little margin of safety when looking at management’s expectation for the foreseeable future and the expected underlying growth over the next few years. With a moderate payout ratio, I think this is a pretty reasonable number. The DDM analysis gives me a fair value of $73.03.

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 viewpoint is such that the stock is at least slightly undervalued right now, and perhaps even strongly so. But does that viewpoint jibe with perspectives of professional analysts that have taken the time to analyze and value the stock? Let’s find out.

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 TGT as a 3-star stock, with a fair value estimate of $72.00.

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 TGT as a 3-star “HOLD”, with a fair value calculation of $75.50.

So we have a pretty strong consensus here on the valuation, with an average of the three numbers sitting at $73.51. That’s right about where I came out. That valuation would indicate the stock is potentially 8% undervalued right now. Not massive undervaluation, but the appealing yield and 49 years of dividend growth adds a lot of weight to the thesis.

scBottom line: Target Corporation (TGT) is a premier dividend growth stock, with one of the lengthiest dividend growth streaks in the world. They’ve shown a strong knack for endurance, with an ability to adapt for more than a century. I’d bet on that continuing. With the dividend pedigree present, the chance for 8% upside on top of a really appealing 3.5%+ yield should be taken seriously. This is one of my best ideas in retail right now.

— Jason Fieber

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