I don’t have cable TV.
But I do sometimes watch CNBC while I’m at the gym, running on the treadmill.
There seems to be this implied recurring theme coming from that station that I’ve picked up on: successful investing is hard, and only experts have the answers.
Well, I couldn’t disagree more with that idea.
Successful investing isn’t actually that hard at all. And experts certainly don’t have all the answers.
In fact, I’m a great example of this.
I didn’t know a thing about investing just seven years ago.
But I took it upon myself to learn everything I could about how investing works, what it takes to successfully invest, reading financial statements, and what successful long-term investors have done.
Well, my research led me to believe that regularly buying high-quality dividend growth stocks at good prices is one of the best and most practical investment strategies out there.
What’s really great about it is that it’s not hard to understand how it works.
One simply takes whatever investment capital they have, then invest that money with high-quality businesses that reward their shareholders with a cut of the growing profit these companies are generating. As the profit grows, so should the amount shareholders are getting.
It’s really as simple as that.
Something can be incredibly rewarding and simple at the same time.
Simple and rewarding aren’t mutually exclusive concepts.
Dividend growth investing is right in that wheelhouse.
The rewards are clear to see.
As a result of my saving and investing over the last seven years, I’ve built up a six-figure portfolio that generates almost $1,000 per month in completely passive dividend income.
Just think of what the average person could do with an extra $1,000 per month. That’s almost a full-time income for some people, depending on their state’s minimum wage law.
Yet I’m earning that without lifting a finger.
So dividend growth investing is definitely rewarding. And don’t think it’s an investment strategy that’s particularly hard to understand.
Most of the stocks I research, write about, and personally invest in can be found on David Fish’s Dividend Champions, Contenders, and Challengers list, which is an incredible compilation of more than 800 US-listed stocks that have all paid out increasing dividends for at least the last five consecutive years.
So if finding great stocks could be thought of as a challenge, you can potentially cross that right off the list, as Mr. Fish has already narrowed down the thousands of publicly traded stocks out there to just those that are rewarding their shareholders with a growing cut of company profit.
However, that doesn’t mean one should just pick any random stock off of Mr. Fish’s list and buy it any random price.
That’s not how successful long-term investing works.
You must first find a business that’s within your circle of competence. Understanding how a microchip company works is different from understanding how a beverage company works.
Then you must first quantitatively and qualitatively analyze a company, making sure its fundamentals and competitive advantages are strong.
Finally, you want to make sure you don’t pay too much for the stock.
But how do you know if you’re paying too much?
Well, the only way to know whether or not the price is appropriate is to first discover value.
You can’t know what something is worth without knowing value. And so you can’t possibly know whether or not the price is appropriate without first having an idea as to what something is worth.
Price only tells you how much you’re paying for something.
Value tells you what you’re actually getting in return.
Value gives context to price.
While price is a known number that’s very easy to ascertain for any publicly traded stock, value is certainly not.
But that doesn’t mean we can’t estimate the intrinsic value of a stock.
The good news is that there are a number of resources out there designed to help investors with this exercise.
One such resource is available right here on the site, put together by fellow contributor Dave Van Knapp as part of his series of lessons on dividend growth investing.
One lesson focuses on valuing dividend growth stocks, and it’s a fantastic tool that can help an investor practically and realistically estimate the fair value of just about any dividend growth stock out there.
Knowing value allows you to then pay the “right price”, with the right price being as far below as fair value as possible.
This is otherwise known as buying stocks when they’re undervalued.
The reasons why you’d want to buy a high-quality dividend growth stock when it’s priced less than it’s worth works similarly to why you’d want to get a good deal on anything else in your life; however, undervalued dividend growth stocks offer some really fantastic benefits that you won’t find on most other things.
An undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and less risk.
This is all relative to what would otherwise be offered if the same stock were fairly priced (price and value roughly match) or overvalued (price is above value).
The mechanics of how all of that plays out within the framework of undervaluation are actually pretty easy to understand.
First, price and yield are inversely correlated.
All else equal, a lower price will result in a higher yield.
That higher yield means more income both in current terms and ongoing terms.
Moreover, that higher yield positively impacts total return, as total return is simply made up of two components: capital gain and dividends/distributions.
Total return is also given a possible boost via the “upside” that exists between the lower price paid and the higher intrinsic value.
If price and value converge – which they should over time – that results in capital gain, which is on top of whatever capital gain would occur as the business sells more products and/or services and becomes worth more over time.
On top of the additional long-term income and wealth opportunities, undervaluation should also reduce risk.
While it might seem counterintuitive, one’s maximum long-term upside is often available precisely when the downside is at its minimum.
Stocks work like most other assets.
Think about buying a house. Let’s say a house is worth $200,000 on the open market. Is it riskier to pay $150,000 or $250,000 for this house?
The answer is obvious.
One should be able to gain a margin of safety when they buy a high-quality dividend growth stock when it’s undervalued.
That means there’s a buffer.
So the company would have to perform much worse than expected, or something would have to go really wrong, before the stock becomes worth less than you paid.
With these benefits in mind, undervaluation is clearly something worth searching for.
But I won’t keep you readers in suspense, and you don’t have to go searching too far.
I’m going to discuss a high-quality dividend growth stock that right now appears to be undervalued…
L Brands Inc. (LB) is a specialty retailer of women’s intimate and other apparel, personal care products, and beauty products.
While not known by their corporate moniker, L Brands is actually one of the most powerful, respected, and well-known companies in women’s apparel, beauty, and personal care products.
However, they company is known by its individual brands, which include Victoria’s Secret, Bath & Body Works, La Senza, and Henri Bendel.
The company has over 3,000 store locations, with the majority of them located in the US.
Two of its biggest risks – the rise of e-commerce and lack of international presence – are also two of its biggest opportunities.
Meanwhile, the company has done incredibly well over the last decade, even while many of its B&M cohorts have struggled.
And much of that shows up in the dividend, as the company has increased its dividend for six consecutive years.
While not a particularly long streak, L Brands has historically paid out a more static dividend that increased somewhat irregularly, along with massive special dividends in certain years.
They continue to regularly pay large special dividends; however, they’ve also adapted a more regular and reliable schedule of dividend increases.
That said, this company doesn’t have the dividend growth legacy of some more established names, so that’s something to keep in mind in terms of expecting clockwork increases.
But that drawback is made up for by a couple key metrics.
First, the dividend growth is outstanding, sitting at 24.6% over the last five years.
Second, the stock offers a substantial yield of 4.75% right now.
That yield is more than twice that of the broader market. Furthermore, it’s more than 240 basis points higher than the stock’s own five-year average yield.
And that’s before even factoring in those special dividends, which also add up.
The payout ratio has crept up, however, due to that aggressive dividend growth. Now sitting at 63.5%, the expectations for dividend increases moving forward, at least over the near future, should be tempered.
But you’re compensated for some of that via the higher yield.
This stock actually looks like a few utility stocks out there. You’re getting that yield creeping up near 5%. Except I don’t know of any utilities with a yield that high that also have a dividend growth rate that comes anywhere near what this stock has produced over the last five years. Moreover, the payout ratio is lower than any utility stock I know of with a yield this high. Plus, that’s before factoring in the special dividends.
Of course, the retail business isn’t the power business, so it’s not totally comparable.
But this stock is still pretty unique.
In order to really get a grasp of the valuation, though, we need to look at what kind of underlying growth the business is generating.
So we’ll see what L Brands has done over the last decade in terms of top-line and bottom-line growth, and we’ll then compare that to a near-term expectation for profit growth. Taken together, we should have an idea as to how fast L Brands is growing.
This will also help us narrow down an expectation for future dividend growth.
From fiscal years 2007 to 2016, L Brands increased its revenue from $10.134 billion to $12.574 billion. That’s a compound annual growth rate of 2.43%.
Meanwhile, the company grew its earnings per share from $1.89 to $3.98 over the same period, which is a CAGR of 8.63%.
The excess bottom-line growth can be explained by a combination of share buybacks and expanding margins. Indeed, the outstanding share count is down by about 23% over the last decade, which is significant.
Moving forward, S&P Capital IQ believes L Brands will compound its EPS at an annual rate of 12% over the next three years, which would be a notable acceleration from what the company has done over the last 10 years.
I find that forecast to be aggressive, especially considering the fact that the company is guiding for EPS between $3.05 and $3.35 in FY 2017 (which factors in the VS swimwear exit, China expansion, and US real estate investment).
L Brands is in the midst of investing for the next wave of retail, so an acceleration of growth seems unlikely to me. But the company maintaining a high-single-digit growth rate over the next few years would be, in my view, an excellent outcome.
The company’s balance sheet isn’t fantastic, though it’s also not a major concern.
The long-term debt/equity ratio isn’t applicable due to negative common equity. Common equity is negative due to, in part, sizable share repurchases, which were mentioned above.
L Brands has an interest coverage ratio of just over 5.
While I think this could be improved quite a bit, L Brands has operated with an interest coverage ratio in this range for years. Moreover, many B&M retail companies operate with similar levels of leverage.
Where this company really shines, however, is profitability.
Over the last five years, L Brands has averaged net margin of 7.30%. Return on equity is obviously not measurable.
That’s a very high number for this business model, and margins have been expanding over the last decade, as noted earlier.
While I don’t want to see that number drop, I think there’s actually some wiggle room there. It’s a great sign that L Brands has been able to expand on it while other retailers have struggled.
Overall, L Brands has a lot to like. You’ve got solid growth over the last decade, great brand names, excellent profitability, a very high yield, and special dividends.
But the balance sheet could be improved. And the company’s recent decision to exit swimwear has impacted comparable growth and overall EPS growth over the near term. Plus, there’s the ever-present concern of how e-commerce will continue to impact the business model. And questions remain over whether or not its international expansion will be successful.
These worries have definitely sent the stock plunging, which may just mean the stock is undervalued now…
The stock trades hands for a P/E ratio of just 13.33 right now. Not only is that well below the broader market, it’s substantially below the stock’s own five-year average P/E ratio of 20.7. So the stock has some challenges, but the valuation has come way down. The price/cash flow ratio is half its three-year average. And the stock’s yield, as shown above, is more than twice its own recent historical average.
So the stock seems cheap by pretty much every basic measure you can throw at it, but what’s a reasonable estimate of its intrinsic value?
I valued shares using a dividend discount model analysis.
I factored in a 9% discount rate (to account for the extraordinary yield) and a long-term dividend growth rate of 5%.
That growth rate is substantially below the company’s long-term EPS growth rate, and it’s also below the demonstrated five-year dividend growth. However, near-term challenges and long-term structural worries means I feel more confident with a conservative estimate.
The DDM analysis gives me a fair value of $63.00.
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.
So even a conservative DDM analysis has the stock as undervalued, which jibes with the basic metrics shown earlier.
However, my analysis is just one look at a stock, which is why I like to add perspective by comparing my analysis to that of what professional analysts have come up with.
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 LB as a 4-star stock, with a fair value estimate of $67.00.
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 LB as a 3-star “HOLD”, with a fair value calculation of $52.40.
The three numbers averaged out gives us a final valuation of $60.80, which would indicate the stock is potentially 20% undervalued right now.
Bottom line: L Brands Inc. (LB) has some of the most venerable brands in women’s apparel, beauty, and personal care products. They have to work through some challenges, but the stock has, based on this view, suffered disproportionately. However, that appears to have opened up an opportunity for long-term dividend growth investors, as the stock now offers a yield higher than what a lot of utility stocks now offer, as well as routine special dividends. With the possibility of 20% upside, this could be one of the best dividend growth ideas in retail right now.
— Jason Fieber
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