Undervalued Dividend Growth Stock of the Week: Lowe’s Companies, Inc. (LOW)

I really wish I would have had an opportunity to learn more about money back in high school.

Instead of spending so much time memorizing the periodic table (which serves me no value today), I could have been learning about how compounding works, how to balance a budget, and how the concept of being able to retire in your 30s or 40s is actually realistic.

But check this out…

I didn’t even pick up a book on investing until I was almost 28 years old.

At the time, I was flat broke.

Strike that.

I was worth a negative amount of money, meaning I was below broke.

Yet compounding is so powerful that I was still able to make it work for me in a very short period of time.

Indeed, I was able to retire in my early 30s after aggressively saving and investing for six years. All on a decidedly middle-class salary.

I put myself in this position by first saving as much money as I could.

Learning how to budget isn’t terribly hard, no thanks to the school system that “educated” me.

And then you just have to intelligently allocate that capital.

I’ve invested all of my hard-earned cash into high-quality businesses that pay growing dividends to their shareholders.

My personal portfolio that funds my early retirement is filled with dividend growth stocks like those you’ll find on David Fish’s Dividend Champions, Contenders, and Challengers list.

High-quality dividend growth stocks struck me as excellent long-term investments pretty much right away.

Now, there are a lot of different investment options out there.

Real estate. Stocks. Bonds. Index funds. Art. Precious metals.

So on and so forth.

But high-quality dividend growth stocks have been shown to outperform just about every other asset class out there over the long run, including the broader stock market itself. Since the broader stock market is one of the best long-run investments available, this is saying a lot.

And then there’s the income component, which is wonderful.

My portfolio should spit out more than $11,000 in dividend income this year.

But it gets better…

First, that income will only likely continue to grow this year, next year, and every year thereafter.

That’s because the companies I invest in have a penchant for regularly increasing their dividend payouts to their shareholders.

This growth tends to outpace inflation over the long term, meaning my purchasing power will only grow.

In addition, the income is totally passive.

I don’t have to manage properties. I don’t have to call anyone. I don’t have to sell off assets.

I just sit back and collect.

But as great as all of this is, there’s more to it than just saving and investing.

The investing side of the equation means one should be doing due diligence on every potential dividend growth stock they’re considering buying.

So that involves doing a full quantitative and qualitative analysis.

That’s so that you’re sticking to only the best available businesses out there.

While a lengthy dividend growth track record is a great initial litmus test for quality, it’s only one (albeit important) aspect of a company’s story.

From there, it’s extremely important that one then go about figuring out how much a stock is worth.

Just like you don’t go out in the world and pay any price for everything you buy, you most certainly don’t want to pay any price for stock.

Every business out there has an intrinsic value. A company has worth that is directly tied to its operational performance.

This might sound really complicated, but it’s not.

There’s actually a wonderful valuation guide that’s available right here on the site that’s designed to simplify the process of valuing just about any dividend growth stock out there.

Put together by fellow contributor Dave Van Knapp, it puts the power of valuation in your hands.

It’s important to know the value of any dividend growth stock before you buy it.

A dividend growth stock can be undervalued, fairly valued, or overvalued.

If a stock is deemed to be worth $40, then a price below $40 would mean it’s undervalued. Conversely, a price above $40 would mean it’s overvalued.

What you pay is up to you.

But I can tell you that buying a high-quality dividend growth stock when it’s undervalued is generally a pretty good idea.

That’s because undervaluation usually offers the opportunity for greater yield, better long-term total return prospects, and less risk.

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

But the benefits are numerous and fairly obvious.

All else equal, a lower price will equal a higher yield. That’s because price and yield are inversely correlated.

That higher yield then positively impacts total return, as yield is a major component of total return.

And capital gain, the other component, is also positively impacted due to the upside that exists between price and value.

If you pay $35 for a stock worth $40, that’s $5 of upside per share.

A stock’s price can be volatile and disconnected from value over the short term, but value tends to matter over the long run.

All of this also reduces risk.

Paying less means less capital risked on a per-share basis.

But it also gives one a margin of safety.

Just in case the business doesn’t perform as expected, or in case the company does something wrong, you have a cushion between the price you paid and the intrinsic value of a company.

That way if the fair value is pressured downward due to unfavorable developments, you’re not necessarily looking at an investment worth less than you paid.

With all this in mind, I’m always on the lookout for a high-quality dividend growth stock that appears to be undervalued.

And I believe I found one…

Lowe’s Companies, Inc. (LOW) is one of the largest home-improvement retailers in the world, operating more than 2,300 home improvement and hardware stores across the US, Canada, and Mexico.

This company really needs no introduction, as it’s just a monster in its space.

The odds are pretty good that you have a Lowe’s store in your city. Or there’s one very close to you.

Stores average approximately 112,000 square feet. And each store stocks about 36,000 items. So you can’t miss their footprint.

In an industry where scale, selection, availability, and price matters, there’s a very limited number of big, national players.

And Lowe’s is one of them.

While the business is very solid and impressive, the dividend metrics are absolutely phenomenal.

In fact, it’s really a prototypical dividend growth stock across the board.

Their business domination has in part allowed them to increase their dividends to shareholders for 54 consecutive years.

That’s more than five straight decades. We’re talking multiple wars, changing business dynamics, regulatory ups and downs, 9/11, and the Great Recession.

CaptureLowe’s kept on powering through, and their shareholders kept right on receiving higher payouts.

Over the last decade, the company has increased its dividend at an annual rate of 22.9%.

I’ll sometimes hear about how there’s no way a company can keep increasing its dividend at an attractive rate after 30 or 40 years of growth, as maturity naturally limits dividend growth.

Well, you can see here that that’s not necessarily the case a lot of times. Decades into its dividend growth story, Lowe’s is still handing out sizable dividend increases.

That said, I wouldn’t expect the company to continue handing out ~20% dividend increases forever.

The payout ratio is right about 51% right now, which is actually a perfect harmony between retaining earnings for company growth and returning profit to shareholders via a dividend.

That ratio, by the way, actually appears to be a bit higher than it really is, due to some adjustments (which I’ll discuss below).

However, it’s still quite a bit higher than the ~10% payout ratio Lowe’s sported about a decade ago.

So what’s happened here is that Lowe’s has increased its dividend far more aggressively than underlying earnings over the last 10 years, and that’s something that can’t continue on indefinitely.

Nonetheless, the dividend is in great shape. I just wouldn’t expect 20%+ dividend growth going forward.

Along with the payout ratio, the stock’s yield has also expanded quite a bit.

The stock now offers a yield of 1.90%, which isn’t terribly far off from the broader market.

So you’re getting income that’s roughly in line with what the market offers; however, you’re looking at dividend growth that greatly exceeds the market.

Moreover, the five-year average yield for Lowe’s stock is just 1.5%.

That means the current yield is 40 basis points higher than its recent historical average.

A higher yield is one of the aforementioned benefits of undervaluation, so you see that playing out here.

But in order to value a business, we must develop a reasonable expectation for future growth.

Well, there’s no better place to start thinking about what a company might do going forward than to look at what it’s already done over a long period of time.

So we’ll get a look at what Lowe’s has done in terms of top-line and bottom-line growth over the last decade.

And then we’ll compare that to a near-term forecast for profit growth.

Lowe’s has increased its revenue from $46.927 billion to $59.074 billion from fiscal years 2007 to 2016. That’s a compound annual growth rate of 2.59%.

Meanwhile, the company grew its earnings per share from $1.99 to $2.73 over this period, which is a CAGR of 3.58%.

So there’s a couple different ways to look at this.

First, Lowe’s is truly massive, as noted earlier. This has pros and cons. The scale is obviously wonderful as it allows the company to purchase merchandise very cheaply and provide a wide variety of products to customers at an attractive price. However, it also limits the growth potential of the company both in absolute and relative terms.

Second, the Great Recession did hit the company’s bottom line. It’s easy to put off home repairs/upgrades when jobs are being lost and people’s economic futures are uncertain.

However, the company didn’t register a steep drop during that time. This speaks to their quality as a business.

In addition, FY 2016 included an impairment charge related to the exit of a JV in Australia; factoring this out, EPS would have come in at $3.29 for the year, leading to a more respectable CAGR of 5.75% for EPS over the last decade.

We should also consider Lowe’s prodigious buybacks – the share count has been reduced by almost 41% over the last decade, which is one of the more impressive feats I’ve ever come across.

Looking forward, S&P Capital IQ believes Lowe’s will compound its EPS at an annual rate of 16% over the next three years.

This would be a sizable uptick in growth relative to what the company has done over the last decade. S&P Capital IQ is assuming a continued recovery in the housing market, new store openings, and more share buybacks. Still, this might be aggressive.

The balance sheet for Lowe’s is pretty solid, especially considering the business model: it’s not cheap to build out that store footprint.

The long-term debt/equity ratio for the company is sitting at 1.44. And the interest coverage ratio is just under 9.

These are reasonable numbers for the industry and business model.

Profitability is also sound for the industry, though there’s some room for improvement.

Over the last five years, Lowe’s has averaged net margin of 4.18% and return on equity of 20.41%.

All in all, Lowe’s has a great business model. If you need something for your home, the odds are pretty strong that you’re going to check in with this company’s offerings. I don’t see that changing anytime soon.

For an investor relying on a regular stream of income, this stock is about as good as it gets. They’ve reliably handed out larger dividends for more than 50 straight years. I also don’t see that changing anytime soon.

Of course, any major downturn in the economy would likely hit the company’s bottom line.

But based on how they’ve fared over the last few decades, I think one should be pretty confident in the business over the long term.

With all this in mind, we might not expect the stock to be undervalued.

But I’d argue it looks fairly cheap here…

The stock’s P/E ratio is 26.77 right now. That’s high, but I think one has to consider that aforementioned JV exit in Australia. Taking that into account, the P/E ratio would be about 22. The five-year average P/E ratio for the stock is 23.3, so you see a slight discount there. In addition, investors are paying less for the company’s cash flow right now compared to the five-year average. And the yield, as noted earlier, is quite a bit higher than its recent historical average.

So the stock does look cheap. 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 8%. This growth rate is much lower than even the most recent dividend increase of 25%. And the forecast for near-term EPS growth is much higher than 8%. However, the payout ratio has expanded quite a bit over the last decade. I think my analysis is appropriately conservative. The DDM analysis gives me a fair value of $75.60.

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 shows a stock that’s modestly undervalued.

But my analysis is just one of many.

As such, I like to compare my conclusion with some perspectives of professional stock analysts.

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 LOW as a 4-star stock, with a fair value estimate of $83.00.

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 LOW as a 4-star “BUY”, with a fair value calculation of $77.90.

I came in a bit low, but you can see there’s a pretty tight range here. Averaging the three figures out gives us a final valuation of $78.83. That would mean the stock is potentially 7% undervalued right now.

LOW_chartBottom line: Lowe’s Companies, Inc. (LOW) is a prototypical dividend growth stock. We’re talking about more than 50 consecutive years of dividend increases here. And based on their dominant industry position, scale, brand name, and pricing power, I don’t see that stopping. With what looks like 7% upside on top of a yield that’s well above its recent historical average, this could be an opportunity to invest in a high-quality company at an appealing valuation in what’s otherwise a broader market at its all-time high.

— Jason Fieber

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