People fear the idea of investing due to perceived risk.

Since perception is reality, and since people think of investing in stocks as risky, the stock market is thus a risky platform.

However, I’d argue the biggest risk is not taking risk.

Indeed, you could put your money in the bank. And you’d suffer no volatility (what most people perceive as risk).

However, you’d be actually risking something much greater: the slow, steady sapping of wealth by inflation.

Since the rate of return you’re going to get on your money in the bank is going to be well under the rate of inflation, you’re actually losing money over time.

It might not be apparently evident, but it’s nonetheless happening.

By living below my means and systematically investing my excess capital in high-quality dividend growth stocks like those you’ll find on David Fish’s Dividend Champions, Contenders, and Challengers list, I went from below broke in 2010 to financially free in 2016.

And I built a real-money, six-figure dividend growth stock portfolio in the process.

Some may think I “risked” my money.

But the only risk for me was not doing anything at all.

And had I not “risked” my capital, I wouldn’t be generating five-figure passive and growing dividend income today.

Most people don’t like to take risks. And most people are also working far too many hours at jobs they like far too little.

See any correlation?

But if you’re okay with some volatility, putting your money to work with wonderful businesses that reward you with a growing chunk of the growing profit they generate is one of the best possible ways to build more wealth, passive income, and freedom in your life.

That’s really what dividend growth investing is all about.

However, it’s important to buy the right stock at the right price.

While there are over 800 stocks on Mr. Fish’s aforementioned list, not every single stock on that list is a great investment at any time.

You first want to stick with great businesses that sport high-quality fundamentals and durable competitive advantages.

And then you want to buy shares in a business like that when the valuation on the stock is attractive.

There are numerous reasons for wanting to do that.

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

Now, that’s all relative to what the same exact stock might offer if it were fairly valued or overvalued.

Since price and yield are inversely correlated, a lower price will, all else equal, result in a higher yield.

That higher yield gives the long-term potential total return a boost, as income (via dividends/distributions) is one of two components of total return.

The other component, capital gain, is also potentially boosted via the upside that exists between the lower price paid and the higher intrinsic value.

If a stock that’s worth $50 is bought at $30, there’s $20 worth of upside that could result in capital gain if the gap between price and value closes over time.

While price and value can wildly diverge over shorter periods of time, the two tend to correlate more closely over the long run.

All of this also has a way of reducing one’s risk, due to the margin of safety that’s present when one pays much less than that which a stock is deemed to be worth.

If that same $50 stock is bought at $30, there’s a significant buffer that protects one’s downside.

Said another way, the fair value of the stock would have to decline significantly before the investment is upside down – or worth less than the price paid.

The good news about all of this is that it’s not terribly difficult to estimate the fair value of just about any dividend growth stock out there.

For instance, fellow contributor Dave Van Knapp penned an excellent series of articles that act as lessons on dividend growth investing, one of which focuses on valuation.

So if you’re ready to take on some risk, which is likely the less risky path in reality, read on.

I’m going to reveal a high-quality dividend growth stock that appears undervalued right now…

Williams-Sonoma, Inc. (WSM) is a nationwide multi-channel retailer of high-quality home products and furnishings.

When thinking of a high-quality business, a business generally becomes high quality by providing high-quality products and/or services that society is willing to pay a premium for.

Well, Williams-Sonoma could practically write the book on that.

They’re known for their premium home furnishings and accessories, operating through their vaunted brands that include Pottery Barn, West Elm, and the eponymous Williams-Sonoma.

The company offers a range of high-end furnishings and accessories, all the way from cookware to couches.

When a consumer wants to fill their space with premium products, Williams-Sonoma is one of the best possible options out there.

That brand recognition – which automatically conveys premium quality – is an asset that vaults Williams-Sonoma over most other competitors.

However, massive changes in the retail landscape have affected pretty much every retailer out there, including Williams-Sonoma.

That said, the company remains in excellent shape. And the stock has arguably been beaten down way more than the business, which I’ll go over.

But first, let’s take a look at the dividend metrics.

The company has increased its dividend for 12 consecutive years.

And the growth over the last ten years has been blistering: the 10-year dividend growth rate stands at a stout 17.1%.

While I wouldn’t expect that kind of dividend growth to continue on for the foreseeable future, as much of this growth was propelled by a growing payout ratio, the current payout ratio of 45.3% still leaves a lot of room for continued dividend increases, even increases that exceed the rate of underlying profit growth for the next few years.

What’s perhaps best of all about the dividend is the yield.

At 3.45%, it’s one of the best yields you’ll find in retail.

In fact, it’s one of the best yields you’ll find on any Consumer Discretionary dividend growth stock out there.

Furthermore, that’s more than 120 basis points higher than the five-year average yield for this stock.

Combining a yield of 3.5%+ with double-digit historical dividend growth paints a very nice picture.

That said, the most recent dividend increase was under 6%, which isn’t surprising given all of the commotion in retail right now.

But even mid-single-digit dividend growth could go a long way when you’re starting out with that high yield, and you still have a lot of potential upside from there.

In order to really build that future dividend growth expectation, though, we must look at what kind of underlying business growth the company is generating.

So we’ll look at what Williams-Sonoma has done in terms of revenue and earnings per share growth over the last decade. And we’ll then compare those historical results to a near-term profit growth forecast.

Combining these figures should provide us with a framework upon which we can extrapolate ideas about Williams-Sonoma overall earnings power.

So revenue has increased from $3.945 billion to $5.084 billion from fiscal years 2007 to 2016. That’s a compound annual growth rate of 2.86%.

This is a bit disappointing, in my view. I generally look for mid-single-digit revenue growth from mature companies, and I think Williams-Sonoma qualifies as being mature in its industry.

But it’s really important to point out that more than half of the company’s revenue is derived from its e-commerce segment. Whereas one major problem with a lot of legacy retailers is the lack of exposure to online platforms/sales, Williams-Sonoma has already made a big move toward the future of retail.

Meanwhile, the bottom-line growth over this period was much better, thanks largely to a reduced outstanding share count – down by almost 20% over the last decade.

Earnings per share grew from $1.76 to $3.41 over this 10-year stretch, which is a CAGR of 7.63%.

Even more recent results have been a bit more muted, though. The most recent quarter saw 2.8% same-store sales growth (very solid) and 5.2% YOY EPS growth (also solid). Good numbers, but you can see some challenges.

But with the quality products and brands, and the e-commerce mechanisms already in place, it’s hard to imagine a retailer better equipped to deal with challenges.

CFRA anticipates that Williams-Sonoma will be able to compound its EPS at an annual rate of 10% over the next three years.

That’s an aggressive forecast, in my view. But even if they fall short, and the future looks a lot like the last 10 years, there’s room for at least mid-single-digit dividend growth, as the payout ratio allows for it.

Moreover, they continue to buy back a lot of stock, further bolstering the case for continued dividend growth in that range.

One area of the company’s fundamentals that’s extremely high quality is the balance sheet.
Williams-Sonoma has no long-term debt.

Someone could argue that it’s perhaps not necessarily totally a great thing. With interest rates being so low, using cheap debt to fund growth or retire expensive equity might not be a bad idea.

However, this pristine balance sheet should give investors great comfort when thinking about this retailer’s long-term viability. Debt is essentially a non-issue, giving the company no stress.

Profitability, as probably expected is fairly strong, due to the premium nature of the company’s products.

Over the last five years, Williams-Sonoma has averaged net margin of 6.38% and return on equity of 22.22%.

These are great numbers for a retailer. And ROE should be viewed within the context of no long-term debt.

Overall, I think this is a high-quality company.

You’ve got great dividend metrics. The fundamentals are really strong. Fantastic brand names.

But troubles in retail have swept up this stock in a big way, with the stock down almost 15% over the last year.

Some valuation compression is probably warranted, as the business has had some troubles with growth lately.

But the valuation is substantially lower than where it’s typically been for this stock…

The stock is trading hands for a P/E ratio of just 13.10. Compare that to the five-year average P/E ratio of 20.2. That current P/E ratio is also well below that of the broader market. The price/cash flow is almost half its three-year average. And the yield, as noted earlier, is significantly higher than its recent historical average.

So the stock does look quite cheap, but how cheap might it be?

I valued shares using a dividend discount model analysis.

I factored in a 10% discount rate and a long-term dividend growth rate of 7%.

That dividend growth rate seems reasonable, considering the low payout ratio, historical demonstrated dividend growth, long-term EPS growth rate, and forecast for profit growth moving forward.

The DDM analysis gives me a fair value of $55.64.

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.

As mentioned, some valuation compression might be warranted here, but the stock is selling for almost half (on a valuation basis) of what it has, on average, over the last five years. I don’t think the business has been cut in half, however. But my perspective is but one of many, which is why I like to compare my valuation with that of what select professional analysts 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 WSM as a 5-star stock, with a fair value estimate of $65.00.

CFRA 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.

CFRA rates WSM as a 3-star “HOLD”, with a fair value calculation of $50.40.

Morningstar might be a little aggressive with their call, but averaging these three valuations out gives us a nice blend of the different perspectives and methodologies. That averaged number is $57.01, which would indicate the stock is potentially 27% undervalued right now.

Bottom line: Williams-Sonoma, Inc. (WSM) is one of the highest-quality retailers out there, with well-regarded brands, great fundamentals, and strong dividend metrics. It’s not easy to find this combination of yield and dividend growth wrapped up in an undervalued package, but the possibility of 27% upside on top of a market-beating yield is an opportunity that should be strongly considered here.

— Jason Fieber

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