Dividend growth investing is the long-term investment strategy I’ve chosen to build my financial independence around.
There are a number of reasons for this.
The most obvious and relevant might be the tangible nature of dividend growth investing.
After all, common stock simply represents equity in a real-life company.
And since a shareholder is a partial owner of any publicly traded company, shareholders deserve their rightful share of that growing profit.
That share comes in via growing dividends, which makes for a wonderful stream of passive income.
If you buy enough high-quality dividend growth stocks, that stream turns into a river.
Indeed, my real-life dividend growth stock portfolio deluges my life with growing passive dividend income on the order of five figures.
I can’t swim, and so I always have a fear of drowning.
But I’ll tell you that it feels really good to be “drowned” by dividend income.
The amazing thing about this is that anyone can drown themselves in passive income.
One simply has to manage a holistic lifestyle that prioritizes saving over spending, which frees up excess capital that can be invested in high-quality dividend growth stocks.
As straightforward as that sounds – and it really is quite simple – there are a few details one has to keep in mind when the time comes to buy stock.
It’s important to make sure that any business you’re buying into is within your circle of competence. If you don’t understand how a company works and makes money, it probably doesn’t make sense to invest in it.
From there, it’s imperative that you limit your investment opportunities to companies that sport strong fundamentals – top-line and bottom line growth, a good balance sheet, robust cash flow and profitability, etc.
And then perhaps just as important, one should aim to buy stock when it’s undervalued.
While price is what you pay, it’s value that tells you what you’re getting for your money.
Value gives context to price; without knowing value, it’s nigh impossible to know whether or not price is reasonable.
Undervaluation would thus mean the price of a stock is less than its intrinsic value.
And this is appealing to the long-term dividend growth investor due to the numerous benefits it confers.
An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and less risk.
This is in comparison to what the same stock might provide if it were fairly valued (price and value being roughly equal) or overvalued (price being above value).
The higher yield comes about from the lower price: price and yield are inversely correlated.
All else equal, a lower price will result in a higher yield.
That higher yield will very likely positively impact total return, as total return is comprised of income (dividends or distributions) and capital gain.
Higher income via the higher yield naturally moves the needle on total return.
In addition, capital gain is also given a potential boost via the upside that exists between the lower price paid and higher intrinsic value of a stock.
A stock being undervalued would mean there’s a favorable difference between price and value.
While the market isn’t necessarily very good at valuing businesses and stocks over the short term, price and value can and often do more closely reflect one another over the long run.
The gap closing will result in capital gain, and that’s on top of whatever organic upside and capital gain is possible as a business becomes worth more through the process of increasing its profit by selling more products and/or services.
That gap being favorable to the upside thus limits the chances of an unfavorable gap to the downside, as more upside means less downside.
This limits one’s risk to a degree by introducing a margin of safety.
These benefits can be rather significant over the long run, which is why it’s so desirable to buy a high-quality dividend growth stock when it’s undervalued.
The good news is that there are a number of resources designed to help the investor estimate the intrinsic value of just about any dividend growth stock out there, increasing one’s odds of investing at opportune times.
One such resource is Dave Van Knapp’s dividend growth investing lesson on valuation, which is part of an overarching series of lessons on the investment strategy.
But I won’t leave you readers with just that.
I’m going to discuss a high-quality dividend growth stock that appears to be undervalued right now…
Target Corporation (TGT) is a North American retailer that operates approximately 1,800 stores across the US.
I noted earlier that it’s important to invest in companies that are within your circle of competence.
Well, it doesn’t get much easier to understand than a retail giant like Target.
While retail undergoes major changes every generation or so, retail as a business model is about as enduring as it gets.
Target specifically has a corporate history dating back more than 100 years, which means the company has seen its share of changes over the years. Yet they endure.
And I think they’ll continue to endure, with the company making significant investments in the business model moving forward.
Target is investing $7 billion over the next three years to improve their digital channel, open more than 100 small-format stores in priority markets, and reposition more than 600 existing stores.
These moves should help Target only endure, but remain very competitive.
And I can say what else is enduring and competitive: the company’s dividend.
Target has one of the most rich dividend growth histories not just in retail, but in the business world in general.
They’ve paid an increasing dividend for 50 consecutive years.
That’s mighty impressive. That’s up there with some of the most well-known blue-chip stocks.
And over the last decade, the company has grown its dividend at an annual rate of 18.1%.
This is obviously incredible, but there’s been a marked deceleration in dividend growth of late.
The dividend has grown much faster than the business over the last decade, expanding the payout ratio in the process.
The payout ratio is now sitting at 50%, which I actually consider a “perfect” payout ratio. That is a harmonious balance between retaining profit for business growth and returning profit to shareholders.
That said, the payout ratio has roughly tripled over the last decade.
With the most recent dividend increase being in the low single digits, and with the aforementioned investments being rolled out, I would temper my expectations regarding dividend growth moving forward.
But the potential for much lower dividend growth moving forward is somewhat made up by the incredible yield of the stock.
Now yielding 4.24%, that’s more than 150 basis points higher than the stock’s five-year average yield.
One doesn’t need 18%+ dividend growth when a stock is yielding well above 4%.
What’s happened here is that the stock has gone from a low-yield, high growth stock to a high-yield, low growth stock.
Whether or not that works for you and your individual investment goals is up to you, but I don’t necessarily think it’s substantially less appealing as a long-term idea than it was before. It’s simply more of an income play now.
But that isn’t to say it should be all income and no growth.
We still want our dividends to continue growing.
And in order to build an expectation for that future dividend growth, we must first look at what kind of underlying revenue and profit growth the business is generating.
This will help us with not only estimating future dividend growth, but it will also aid us when the time comes to value the business and its stock.
What we’ll do is first look at what Target has done over the last decade in terms of top-line and bottom-line growth.
We’ll then compare that to a near-term forecast for profit growth looking forward.
Combined, this should give us an idea as to what kind of overall growth we can expect from Target, which should also be at least somewhat reflected in the dividend and dividend growth.
Target has increased its revenue from $63.367 billion to $69.495 billion from fiscal years 2007 to 2016. That’s a compound annual growth rate of 1.03%.
Less than stellar. In fact, this is disappointing.
But that’s why you’ve seen the stock move from a growth play to a value/income play, and it’s also why Target is responding strongly to changing dynamics within the industry.
Meanwhile, the company’s earnings per share improved from $3.33 to $4.70 over this same period, which is a CAGR of 3.90%.
The bottom line has some excess growth relative to the top line, mostly due to share buybacks: Target has reduced its outstanding share count by over 30% over the last 10 years.
We see, however, that the dividend has most certainly grown much faster than the business, which is why we see the expansion of the payout ratio.
But the payout ratio is still reasonable right now. Target clearly recognized that it can’t continue handing out these huge dividend increases, which saw the most recent increase coming in quite low. This is prudent, in my view.
While they’ve been clearly challenged, I think the company’s response should be heralded.
The big story in retail is obviously the shift toward e-commerce, but Target isn’t exactly dead in the water here. The most recent quarter (Q2 2017) saw 32% growth in comparable digital channel sales, which was an acceleration year-over-year.
CFRA believes that Target will be able to compound its EPS at an annual rate of 10% over the next three years, which would obviously be much better than what Target has delivered over the last decade.
That could be a tough mark to hit.
However, Target doesn’t really need to hit it to be a compelling investment right now. Even just a modest improvement over the last decade would be enough, with 6% EPS and dividend growth providing a lot to like when combined with that 4.2%+ yield.
The balance sheet in particular could be spruced up.
Target’s long-term debt/equity ratio is 1.06, while the interest coverage ratio is just under 5.
These are okay numbers. I’m not particularly concerned about their debt, nor am I worried about Target’s ability to pay its interest expense. But I wouldn’t want to see the balance sheet worsen from here.
Profitability, though, is a strong suit, thanks to the high-income customer that Target caters to.
Target’s net margin came in at 3.93% for last fiscal year, while return on equity came in at 24.99%.
Overall, Target remains a great business. They have a great brand that caters to high-end clientele. The company is investing heavily in its future, focusing on the digital channel and small-format stores in key markets. I think these moves bode well for the future of Target.
However, in my view, the business has deteriorated a bit compared to where it was just five years ago.
They had to pull out of Canada a few years ago due to lackluster results, meaning their international expansion opportunities might not be that great. And growth over the last 10 years has been a bit disappointing. Moreover, e-commerce has continued to encroach on traditional B&M retailers’ businesses.
But the stock now offers a much lower valuation and higher yield as a result, which makes it look pretty appealing here…
The current P/E ratio for the stock is sitting at 11.83, which compares quite favorably to the five-year average P/E ratio of 17.4 for the stock. That P/E ratio is also substantially lower than the broader market, as well as the industry at large. And the yield, as shown earlier, is materially above its recent historical average.
If the stock is cheap, how cheap 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 9% discount rate and a long-term dividend growth rate of 5%.
That DGR is very much on the conservative side. Even though the payout ratio is “ideal” for me, the ongoing investment in the business will likely limit the company’s ability to increase the dividend moving forward. And the most recent increase was only in the low single digits.
The DDM analysis gives me a fair value of $65.10.
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 look at the stock, it still looks undervalued. Of course, my perspective is but one of many, and so we’ll compare my valuation to what a couple professional analysis firms have come up with. This should add depth and weight to the conclusion.
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 TGT as a 3-star stock, with a fair value estimate of $58.00.
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 TGT as a 3-star “HOLD”, with a fair value calculation of $66.64.
I came in just under CFRA’s valuation, so you can see some consensus here. But averaging the three numbers out gives us a final valuation of $63.25, which would mean the stock is possibly 8% undervalued right now.
Bottom line: Target Corporation (TGT) has one of the most incredible dividend growth track records in all of business, with 50 consecutive years of dividend increases. I expect them to continue handing out dividend increases for years to come. The company is taking changes and threats seriously. Meanwhile, the stock offers the potential for 8% upside on top of a 4.2%+ yield while you wait for the company’s investments and changes to take hold. If you’re looking for a big yield and decades of dividend growth wrapped up in an undervalued package, this stock could be for you.
— Jason Fieber
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