Dividend growth investing has positively changed my life.
I don’t mean that as a cliché or an overstatement. It’s not hyperbole.
This investment strategy has quite literally changed my entire life.
If our lives are nothing more than a collection of memories and moments – memories and moments which require time – then I owe my life to dividend growth investing.
By taking the excess capital generated by living below my means and investing it into high-quality dividend growth stocks like those that can be found on David Fish’s Dividend Champions, Contenders, and Challengers list, I’ve put myself in a position to live off of the growing dividend income my real-life portfolio generates.
This five-figure dividend income started to cover most of my core personal expenses in my early 30s, rendering me essentially “retired” at 33 years old.
Better yet, this dividend income is likely only going to grow faster than inflation, slowly increasing my purchasing power every year.
That’s right: I basically get “pay raises” without doing anything.
That’s the growth in dividend growth.
As such, I don’t ever have to work again.
Of course, I don’t just sit around all day. I stay active, which is why you’re reading this very article.
But the point is that I now only do that which I want to do, rather than being someone who has to work or complete tasks because the bills won’t otherwise get paid. There’s a big difference between these two concepts.
Indeed, I thus own my time. And since I own my time, I own my life.
The amazing thing is that I’m nobody special. I don’t have special access that others lack.
I simply saved my money. And I invested in high-quality dividend growth stocks when they appeared to be undervalued.
And that’s what today’s article is all about.
I’m going to present a specific dividend growth stock, sourced from Mr. Fish’s aforementioned CCC list, that appears to be a strong investment right now, based on certain quantitative factors and, more particularly, valuation.
Well, before you invest in any stock – be it a dividend growth stock or otherwise – you should first perform your due diligence.
That involves analyzing a business, with itself means you should be looking at a company’s financial statements to discover its quantitative aspects.
So that involves pulling the income statement, balance sheet, and cash flow statement.
You want to look for growing revenue, increasing profit, reasonable debt, robust profitability, etc.
Of course, qualitative aspects – which aren’t math based – are extremely important, too. After all, you want to invest in companies that have competitive advantages.
However, qualitative aspects are quite subjective, up to the individual investor.
Finally, there’s the valuation.
And this is vital.
See, a stock’s price tells you very little.
Almost nothing, really. The only thing price tells you is how much a stock costs.
But value tells you almost everything.
Value gives context to price. Value is what a stock is worth. Without knowing value, price is almost useless.
If you pay $50 for a stock only worth $25, you’re upside down on your investment right away.
Moreover, you’re locking in a lower yield, lesser total return prospects, and greater risk.
That’s significant overvaluation.
And it’s nonsensical.
Likewise, buying a stock when it’s undervalued works oppositely.
An undervalued dividend growth stock should offer a higher yield, greater long-term total return prospects, and less risk.
This is all relative to what the same stock would offer if it were fairly valued (price and value roughly equal) or, worse yet, overvalued (price above fair value).
So let’s break that down.
First, price and yield are inversely correlated.
A lower price will, all else equal, result in a higher yield.
This higher yield has a positive impact on both current income and ongoing income, as well as total return.
The total return is positively impacted because yield is one of two components of total return.
Capital gain is the other component. And capital gain is also positively impacted by virtue of the upside that exists between the lower price paid and the higher intrinsic value of an undervalued dividend growth stock.
If you pay much less than what a stock is worth, there’s a very high likelihood of the market eventually recognizing that worth, thus pushing the price up.
Capital gain thus manifests itself via that increased price.
So undervaluation generally indicates an opportunity to lock in more income and more capital gain.
It’s a win-win.
Plus, this all reduces one’s risk.
That’s because you introduce a margin of safety – or a buffer – when you pay less than what a stock is worth.
That margin of safety means that you have some wiggle room.
If a company does something wrong, or doesn’t perform as expected, the stock has some room to fall in value before you’re upside down on the investment (meaning it becomes worth less than you paid).
So I’m sure you can see by now why undervalued dividend growth stocks are usually so appealing.
Well, I won’t leave you hanging with just that.
I’m going to provide some information on a dividend growth stock that right now is potentially significantly undervalued.
Macy’s Inc. (M) is an omnichannel retailer that operates over 800 department stores, primarily under the Macy’s and Bloomingdale’s names.
Retail has probably never been more challenging, especially for department stores that lack unique products and/or service.
Customers are increasingly shopping online, even for clothing, which reduces foot traffic and overall sales for department stores. Since customers can generally buy a lot of general merchandise from anyone, they’re going to go where the prices are lowest and service most convenient.
Due to that backdrop, Macy’s announced the closing of 100 stores, with 63 of those stores to be closed this spring.
It remains to be seen how legacy department stores like Macy’s will deal with the e-commerce onslaught.
But there’s no doubt the stock has been punished as a result: the retailer’s stock is down 34% over the last year – and it’s down 18% in 2017 alone.
And that has arguably led to undervaluation.
First, we’ll take a look at the dividend pedigree here, which is what qualified it for this article in the first place.
Macy’s has increased its dividend for six consecutive years.
And the dividend growth rate stands at a monstrous 37.5% over the last five years.
Not the longest streak around. With the competitive landscape and short dividend growth track record, I view Macy’s as probably having less commitment than a lot of other stocks (even in retail) when it comes to increasing its dividend, which means a static dividend or dividend cut wouldn’t be a tremendous shock.
That said, they have the wherewithal to continue paying the dividend, even with the issues they’re experiencing. Dividend growth, however, could be muted over the short term.
I most certainly wouldn’t expect dividend growth moving forward to be anything close to what the company generated over the last five years.
The most recent dividend increase of ~5% is probably a good baseline for near-term expectations.
Part of that expectation is built from the stock’s payout ratio of 75.5%.
While high, it’s not dangerous.
Moreover, the company has had to record some substantial charges, including those related to the aforementioned store closings. Adjusted EPS would indicate a payout ratio closer to 48.6%.
Still, I think mid-single-digit dividend growth is a reasonable expectation moving forward, all considered.
But the combination of the stock’s precipitous drop in price and the strong dividend growth exhibited over the last five years has led to a very attractive yield of 5.15% on the stock right now.
That yield actually exceeds that of what a lot of utility stocks offer right now, which is just incredible.
Remember how undervaluation can lead to a higher yield?
Well, consider the stock’s five-year average yield is only 2.8%. So the current yield is more than 200 basis points higher than its recent historical average.
Of course, the last five years has included tremendous dividend growth after a dividend cut during the Great Recession, but there’s still something to be said for a 5%+ yield on a retail stock.
We’ll next get a look at Macy’s underlying top-line and bottom-line growth over the last 10 years, which should help us determine how fast the business is growing, which itself will help us further cement an expectation for future dividend growth.
A near-term forecast for EPS growth will also be looked at.
I consider 10 years a pretty solid proxy for the long haul. Looking at the long term along with what may happen over the next few years should give us an idea as to what kind of growth Macy’s is actually capable of. And it’s underlying profit growth that will ultimately fuel dividend growth.
Macy’s increased its revenue from $26.313 billion in fiscal year 2007 to $25.778 billion in FY 2016. So we’re talking about flat sales, roughly.
Meanwhile, the company’s earnings per share grew from $1.97 to $1.99 over this period. Again, flat.
As noted above, FY 2016 EPS was dramatically impacted by a number of special items. While largely one-time in nature, store closings could be more of an ongoing problem, so using the adjusted EPS might not actually be realistic.
Nonetheless, FY 2016 adjusted EPS came in at $3.11, which would indicate compound annual growth of 5.20% over the last decade for EPS.
The reason for the large difference between revenue and (adjusted) EPS growth over the last decade is buybacks.
Macy’s has substantially reduced its outstanding share count over the last decade – we’re talking a reduction of ~31%.
However, the stock was priced above its current level for much of this period, especially during the more aggressive buying that occurred over just the last few years, indicating that Macy’s may not have used shareholders’ cash terribly wisely.
Looking out over the next three years, S&P Capital IQ believes that Macy’s will compound its EPS at an annual rate of 6%, which would be approximately in line with what the adjusted figure is above. S&P Capital IQ believes that the proactive restructuring works to offset some of the competitive challenges.
While it might be tough for this kind of growth to materialize, the good news is that any buyback activities are significantly cheaper and potentially more accretive for the business, as the stock is so much lower in price today than it was even just a year ago.
Like many of its legacy department store competitors, Macy’s does have debt that is somewhat considerable.
The long-term debt/equity ratio is just over 1.5, for instance.
And the interest coverage ratio is below 4.
These aren’t great numbers. In fact, they’re marginal at best in absolute terms.
But these metrics aren’t out of the norm for the industry.
Furthermore, Macy’s actually has less long-term debt than it had a decade ago, which is very encouraging.
And they’ve operated with a low interest coverage ratio for as far back as I can see, indicating the business runs comfortably with a high level of debt.
Profitability for the company is quite robust, considering the industry (retail typically doesn’t offer high margins).
Over the last five years, Macy’s has averaged net margin of 4.86% and return on equity of 23.37%.
All in all, I would say Macy’s doesn’t exude the kind of quality I usually look for as hallmarks of a great long-term investment.
However, I’m presenting this dividend growth stock today because I think the valuation is extremely compelling, which just may make up for some of the quantitative and qualitative shortcomings.
The P/E ratio on the stock is sitting at 9.63 (on an adjusted basis). That’s less than half the broader market’s P/E ratio. That also compares favorably to the stock’s five-year average P/E ratio of 13.8. Even if you throw out the P/E ratio (due to the heavy adjustments), investors are paying much less for the company’s sales, book value, and cash flow than they have, on average, in recent years. And the yield, as noted earlier, is much higher than its recent historical average.
So the stock does look very cheap right now. But how cheap is cheap? How undervalued might it be? What’s a good estimate of its intrinsic value?
I valued the stock using a dividend discount model analysis.
I factored in an 8% discount rate (due to the higher yield).
And I assumed a long-term dividend growth rate of 4%.
This dividend growth rate is conservative on purpose, as I’m considering the competitive issues at hand.
That dividend growth rate is a little lower than the most recent dividend increase, and it’s also lower than S&P Capital IQ’s three-year EPS growth forecast.
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.
Even with a pretty conservative estimate of future dividend growth, the stock still looks quite cheap here. That’s also evidenced by the low valuation metrics across the board. But my perspective is but one of many. To give you readers a broad view on this, I like to include other perspectives.
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 M as a 4-star stock, with a fair value estimate of $34.00.
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 M as a 3-star “HOLD”, with a 12-month target price of $35.00.
I came in a little high, even with the conservative growth expectation, but that’s why I like to broaden the view. Averaging out the three figures gives us a final valuation of $36.09, which would mean the stock is quite possibly 23% undervalued right now.
Bottom line: Macy’s Inc. (M) is a massive retailer that has been experiencing some headwinds as it continues to reinvent and restructure itself so as to remain relevant in a very tough competitive environment. However, these issues have punished the stock badly, leading to what could be 23% upside on top of a monstrous yield.
– Jason Fieber
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