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

I think a lot of people believe that investing is something reserved for only the “elite”.

It’s as if they assume that the stock market asks you what your annual income is before you can buy stocks… as if you can’t buy stocks unless you live in a mansion of a certain size.

That’s just not the case at all, however.

Fortunately, the stock market is one of the most wonderfully accessible platforms across the spectrum of platforms designed to build wealth for people – and it’s also one of the most powerful.

I think it’s because the stock market has been so amazing at building wealth and income for people that there’s this assumption that it must somehow be difficult to access.

Is the stock market’s gift also its curse?

I’m not sure, but I write dozens of articles every month that, hopefully, dispel some of these notions.

I mean, I’m a great example of just how accessible and powerful the stock market is.

My personal wealth was non-existent just a few years ago. Actually, it was worse than non-existent: my net worth was a negative number.

But by living below my means and investing my excess capital into high-quality dividend growth stocks like those you’ll find on David Fish’s Dividend Champions, Contenders, and Challengers list, I’ve been able to build a real-life six-figure stock portfolio that generates enough passive and growing dividend income to render me financially independent in my mid-30s.

And check this out: I did this on a middle-class salary. That’s powerful wealth building for you.

I worked at a car dealership while I saved and invested my way here. I wasn’t elite. Yet I was able to open an online brokerage account just like anyone else. I could buy and sell stocks just like billionaires could. That’s accessibility for you.

The old cliche is true: if I can do this, anyone can.

But while the stock market is an amazing platform, there are a number of various investment strategies out there. As such, it’s important to invest in the way that’s most appropriate to your long-term objectives.

I personally believe dividend growth investing is the best long-term investment strategy of all, and it’s the strategy I used (and still use) to build my portfolio and achieve financial freedom.

This strategy echos my earlier sentiments about the broader market: it’s very accessible and very powerful, simultaneously.

It’s incredibly simple. One essentially buys and holds shares in fantastic businesses that reward their shareholders with growing dividends (with these growing dividends funded from the growing profit these fantastic businesses are generating).

And it’s incredibly powerful due to both the growing wealth and growing passive income opportunities it provides investors.

You get the former as these fantastic businesses become worth more (increasing profit naturally improves the value of a business).

And you get the latter as these companies increase their dividend payments to shareholders.

Checking out Mr. Fish’s aforementioned CCC list, you’ll see hundreds of companies that routinely increase their dividend payments to shareholders. And many have been doing this for decades. So it’s not like this is some kind of fluke.

However, it’s important not to buy random dividend growth stocks at random prices.

One must first make sure they’re investing in the right business – one should aim for a business that’s within their circle of competence, and one should then make sure the fundamentals and competitive advantages pass muster.

But perhaps just as importantly, one should also make sure that the price they’re paying is below fair value.

Said another way, one should aim to buy a high-quality dividend growth stock when it’s undervalued.

That’s because an undervalued dividend growth stock should offer a higher yield, greater potential long-term total return, and less risk.

This is all relative to what the same stock might offer if it were fairly valued or overvalued.

The higher yield is available because price and yield are inversely correlated; all else equal, a lower price will result in a higher yield.

That higher yield then positively impacts total return, as income (via dividends/distributions) is one of two components of total return.

The other component, capital gain, is also positively impacted via the “upside” that exists between price and value.

If a stock worth $50 is bought for $30, there’s $20 worth of potential upside there.

If price and value converge over a certain period of time, that results in capital gain. And that’s on top of whatever organic upside is available as the business naturally increases its profit and becomes worth more. Plus, there’s the additional income one is collecting all along, assuming the higher yield is in place.

In addition, one’s risk is also reduced when they insist on a margin of safety, or a “buffer”, which is that gap between price and value.

Just in case the investment thesis is wrong… or the company isn’t worth as much as one thought… or the company does something wrong… there’s a buffer in place, which allows for some downside protection before the investment becomes “upside down” (worth less than the price paid).

The great news, though, is that valuation isn’t all that difficult to estimate.

A great resource that’s designed to help investors estimate the intrinsic value of just about any dividend growth stock out there is fellow contributor Dave Van Knapp’s valuation guide, which is part of an overarching series of lessons on dividend growth investing.

This is what today’s article is all about.

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

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.

With over 2,300 stores that average approximately 112,000 square feet each, it’s hard to miss a Lowe’s store if you live in North America.

And it’s that scale that presents a huge competitive advantage for the company, as each store offers about 36,000 items in stock. When you know you need something for your house right away, you can be pretty sure that Lowe’s has it.

Furthermore, they have complementary businesses based around that massive retail footprint.

They have the e-commerce business on one hand. And they have professional services on the other.

These aspects of the company, especially the latter, further insulate the brand.

While a lot of legacy retailers are facing massive headwinds from e-commerce, Lowe’s doesn’t sell clothes or small trinkets.

These are massive items a lot of times (appliances, counter tops, vanities, etc.) and specialized/immediate items a lot of other times (electrical components, hardware, etc.). You’re not going to be ordering a new counter top online, especially if you need it installed.

With this in mind, it’s probably not surprising to see that Lowe’s has one of the best dividend growth track records out there.

The company has paid an increasing dividend for 55 consecutive years.

It’s difficult to put that into perspective, but that time frame spans multiple wars, stock market crashes, economic and political cycles, and the recent financial crisis.

Yet through it all, Lowe’s kept on pumping out bigger dividends.

That provides for a lot of comfort in the face of stock and/or economic volatility, as well as the changing landscape in retail.

And it’s not just the time frame that’s impressive, as Lowe’s has a 10-year dividend growth rate of 22.9%.

So we’re talking not just decades of dividend increases, but we’re also talking a dividend that’s been growing at a rather phenomenal rate.

With a dividend growth rate that high, you’re usually looking at a very low yield.

However, the stock offers a fairly appealing yield of 2.22% right now.

A 2%+ yield and 20%+ long-term dividend growth certainly paints a very nice picture.

Moreover, that current yield is more than 70 basis points higher than the stock’s own five-year average yield.

Remember how undervaluation usually results in a higher yield, which then positively impacts long-term total return?

Well, here you go.

And with a payout ratio of 51.4%, there’s still plenty of room for Lowe’s to continue handing out dividend increases.

In fact, I consider that pretty close to a “perfect” payout ratio, as it’s a great balance between retaining earnings for the company to continue growing and returning capital to shareholders.

That said, the dividend has been growing at a clip that far exceeds the company’s earnings growth over the last 10 years, which has resulted in the payout ratio expanding somewhat significantly.

As such, I wouldn’t expect the dividend to continue growing at 20% over the near term; however, the company does have the capability to continue growing the dividend at a comfortable level, as I’ll discuss below.

But before we get into building that future dividend growth expectation, we must first look at what kind of underlying growth the company is delivering.

After all, it’s the business growth that ultimately fuels the dividend growth over the long haul.

So we’ll first look at what Lowe’s has done over the last decade in terms of revenue and profit growth, and we’ll then compare that to a near-term forecast for profit growth.

Combining the two numbers (historical and future) should give us a pretty good idea as to what kind of earnings power Lowe’s has, which then greatly helps us build that future dividend growth expectation. That, in turn, aids us in valuing the business and its shares.

Lowe’s has increased its revenue from $48.283 billion to $65.017 billion from fiscal years 2007 to 2016. That’s a compound annual growth rate of 3.36%.

Just slightly disappointing here, as I typically like to see mid-single-digit top-line growth from mature companies like Lowe’s.

But this is a huge number they started off with a decade ago. And it’s even bigger now, making it hard to imagine much of an acceleration moving forward.

That said, the last 10 years was challenging, keeping in mind that it included the financial crisis (which certainly impacted housing).

With that in mind, it’s really the bottom-line growth that I place much more importance on.

Earnings per share for Lowe’s have grown from $1.86 to $3.47 over this period, which is a CAGR of 7.17%.

We obviously see some excess growth there for the bottom line, which can be largely attributed to the significant share buybacks that Lowe’s has carried out.

The outstanding share count is down by approximately 42% over this 10-year stretch, which one of the bigger outstanding share count reductions I’ve come across.

Looking forward, CFRA believes that Lowe’s will be able to compound its EPS at an annual rate of 14% over the next three years.

That would be quite an acceleration off of the performance we see above.

While housing shortages, margin expansion, and share buybacks are all opportunities for growth, Lowe’s wouldn’t even need to to make good on that forecast in order for the dividend growth to be impressive, as even an EPS growth rate in the range of 8% to 10% would provide for like dividend growth.

When added to that starting yield of 2.2%+, there’s a lot to like there in terms of both current income and income growth.

But if Lowe’s does grow the business anywhere near what CFRA believes it will over the next few years or so, there’s room for upside surprise.

Said another way, the downside for dividend growth looks muted, while the upside potential could be somewhat huge.

The company’s balance sheet is pretty solid for the industry, and I see no reason to be concerned about their financial position.

While the long-term debt/equity ratio looks awfully heavy at 2.23, the interest coverage ratio is sitting at just above 9.

EBIT is covering interest expenses about nine times over, which is right about what I’d expect for a business with a capital-intensive retail footprint.

Profitability is strong, especially considering that, at the end of the day, this is a retailer.

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

Overall, the business is solid from top to bottom.

The dividend metrics are about as fantastic as you’ll ever see. And there’s reason to believe those metrics will become even more impressive moving forward.

Growth is there. The balance sheet is solid. Profitability is great. The company has unique competitive advantages that should help it in the face of changing retail dynamics.

However, we want to make sure we pay the right price – a price that’s below intrinsic value.

The good news is that the stock does indeed look undervalued here…

While the P/E ratio of 23.20 is pretty much right in line with the stock’s five-year average, the company’s cash flow is available at a discount to its three-year average. And the yield, as noted earlier, is well above its recent historical average. The stock might not be a screaming bargain where you have 40% undervaluation or something, but the quality of the business actually deserves a premium that doesn’t appear to be present.

If the stock is undervalued, by how much might it be? What’s a reasonable estimate of its 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 8%.

That growth rate is admittedly on the high end of what I normally allow for, but Lowe’s has one of the best track records out there for delivering on huge dividend increases. When looking at the historical earnings growth, the long-term dividend growth, the forecast for future growth, and the payout ratio, this looks sensible.

The DDM analysis gives me a fair value of $88.56.

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.

Again, not a screaming bargain, but this stock shouldn’t be. What I think we have is a really high-quality dividend growth stock available for a price that’s nicely below its intrinsic value. Of course, my opinion is but one of many, which is why I like to compare my valuation and conclusion with that of what some 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 LOW as a 4-star stock, with a fair value estimate of $93.00.

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 LOW as a 3-star “HOLD”, with a fair value calculation of $83.50.

We’re all right in the same range here. In fact, I came out right about in the middle. Averaging the three numbers out gives us a final valuation of $88.35, just pennies away from my conclusion. I think that adds weight to my perspective and valuation, and it would mean the stock is potentially 19% undervalued here.

Bottom line: Lowe’s Companies, Inc. (LOW) is one of the largest and highest-quality retailers out there, with numerous unique competitive advantages that should stave off some of the threats that most legacy retailers are facing. With 55 consecutive years of dividend increases, long-term double-digit dividend growth, and the potential for 19% upside, this might be one of the best long-term dividend growth stocks to invest in right now.

— Jason Fieber

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