It’s a bit easier to find value after the recent volatility in the stock market.
The S&P 500 took a dive at the beginning of the week on fears over China, global growth, oil prices, and Greece. You name it, and people are probably freaking about it.
Well, this recent volatility is exactly why I focus on value, not price.
Prices of stocks can vary wildly over very short periods of time.
[ad#Google Adsense 336×280-IA]But value doesn’t.
A large company’s market capitalization can oscillate by billions over the course of just one day.
But is the company really worth billions of dollars more or less one day over the next?
Highly, highly unlikely.
Unless the company has some major specific issue that could undermine profit for years to come, a company’s value just doesn’t move very much from day to day.
But the stock market would have you believe that something like that is possible.
Imagine going into your local department store and there were electronic price tags on all the merchandise. Imagine being shocked to see the price of a pair of jeans vary every second.
$40.05. $39.99. $40.08. $40.02.
Now, imagine that you go in the next day and the prices are completely different.
That price of jeans now sees a streaming price that goes like this:
$37.20. $37.24. $37.01. $37.04.
What happened? Is this pair of jeans somehow different than it was yesterday? Will it keep you any more or less warm than before? Is it now less stylish over the course of 24 hours?
Of course not.
The value of that pair of jeans hasn’t changed, but the price has.
That’s why it’s imperative that, as a long-term investor, you focus on value, not price.
If this is a new concept or something you might need a little help with, Dave Van Knapp put together a really great guide which discusses valuing dividend growth stocks.
Dividend growth stocks.
Stocks that not only pay dividends, but also regularly and routinely increase the size of those dividends.
Good stuff, which is why I invest all of my free cash flow into high-quality dividend growth stocks. In fact, I’m betting my early retirement on this strategy, as I plan to live off of growing dividend income by the time I’m 40 years old.
You can find more than 700 such examples of these dividend growth stocks on a great resource that goes by the name of the Dividend Champions, Contenders, and Challengers list. It’s maintained by David Fish.
Every stock on Mr. Fish’s incredible resource has increased its respective dividend for at least the last five consecutive years. Many have been increasing dividends for more than 25 years straight.
As someone who’s interested in living off of growing dividend income in the not-too-distant future, I’m always interested in finding high-quality stocks that I can count on paying me income for years to come.
However, I’m also interested in getting a good deal. I want to buy a stock for fair value or less.
And that’s because my yield is higher, my potential total return is greater, and my risk is lower if I pay less.
Well, there are a number of stocks on Mr. Fish’s list that now appear to be attractively valued after the recent volatility.
But I’m going to take a look at one in particular that seems to be priced significantly less than what it’s really worth.
This could be an opportunity…
Fastenal Company (FAST) distributes industrial and construction supplies through both retail and wholesale channels.
This company competes in the lucrative maintenance, operations, and repair market; an estimated $160 billion market.
Via approximately 2,700 stores along with a number of vending machines on site, Fastenal provides access to more than 1 million products.
And due to the scope and breadth, they keep a knowledgeable staff on hand in order to facilitate proper servicing and ordering. This allows customers to get what they need in a timely manner.
This value proposition has led to pretty stunning operational success, which has translated into a great dividend growth track record.
The company has increased its dividend to shareholders for the past 16 consecutive years.
A solid track record, but it’s made even more impressive by the fact that, over the last decade, the dividend has grown at an annual rate of 25.9%.
Pretty incredible. Growing a dividend by more than 25% a year for ten years straight is not something you see every day.
And because the stock has dropped about 20% YTD, the yield has been pushed up to 2.96% now (yield and price are inversely correlated, all else equal).
That yield is attractive from a number of different angles.
First, it’s almost double the five-year average yield of 1.6% for this stock.
In addition, it’s much higher than the broader market.
Lastly, it’s a rather high yield when taken in combination with the dividend growth rate.
With a payout ratio of 63.6%, however, the dividend growth will likely slow to EPS growth for the foreseeable future.
But let’s take a look at that. Let’s see what kind of top-line and bottom-line growth the company has generated over the last 10 years, which will tell us something about what to expect in the future as well as what the business might be worth.
Revenue is up from $1.523 billion in fiscal year 2005 to $3.734 billion in FY 2014. That’s a compound annual growth rate of 10.48%.
Earnings per share grew from $0.55 to $1.66 over this ten-year stretch, which is a CAGR of 13.06%.
Really impressive stuff here. Improving profitability and a slight reduction in the share count led to that additional EPS growth.
S&P Capital IQ expects profit growth to slow to a 6% compound annual rate for EPS. Slowing new store growth could be cause for concern. But this could be a rather conservative estimate.
The company’s quality is further evidenced by the fact that they have no long-term debt on the balance sheet. As such, they’re extremely financially flexible.
Profitability is also very robust. Over the last five years, the company averaged 12.95% net margin and 25.83% return on equity per year. These are very solid numbers that compete well with anyone in the industry.
Overall, I view the quality here as quite high. A dividend that’s growing aggressively, excellent revenue and profit growth, no long-term debt, and fantastic profitability metrics.
So we might expect the stock to be expensive. Is it?
It’s available for a P/E ratio of 21.49. That’s a bit higher than the broader market, but much lower than the five-year average of 33.6 for this stock.
The yield is much higher than normal while the P/E ratio is much lower than normal. It’s trading for a discount to historical norms, but what’s it actually worth?
I valued shares using a dividend discount model analysis with a 10% discount rate and a 7.5% long-term dividend growth rate. Looking at all the numbers, that seems to be a very reasonable estimate for long-term dividend growth here. The most recent dividend raise was more than 12%, for perspective. The DDM analysis gives me a fair value of $48.16.
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.
Based on what I’m looking at, FAST appears to be severely undervalued. But let’s compare my fair value figure with that of some professionals that track this stock and have taken the time to value it. This should provide for additional perspective.
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 FAST as a 4-star stock, with a fair value estimate of $47.00.
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 FAST as a 3-star “hold”, with a fair value calculation of $42.10.
I’m right in line with Morningstar there, but all three numbers indicate undervaluation. I like to average out the three numbers so we can work with one final figure. That turns out to be $45.75, which would mean this stock is potentially 21% undervalued.
Bottom line: Fastenal Company (FAST) is a high-quality niche player in the larger MRO industry. With plenty of room to grow the store count abroad and strong same-store sales growth domestically, I see dividend growth continuing for years to come. The stock is currently offering a yield almost twice its five-year average along with the possibility of 21% upside. This is an opportunity to strongly consider here.
— Jason Fieber, Dividend Mantra