I grew up in Michigan.

And there was a saying I used to hear a lot. It goes: “If you don’t like the weather, just wait 10 minutes.”

I think that’s a saying that’s probably pretty common across the country, especially in places where weather can be pretty volatile.

But the reason I mention this is because I see a lot of parallels between weather and the stock market.

Like the weather, the stock market, too, is quite volatile.

[ad#Google Adsense 336×280-IA]The wonderful thing about volatility, though, is that we can use it to our advantage.

I view short-term volatility as a long-term opportunity.

And so if you don’t like the price on a stock, it probably makes sense to wait until a better price presents itself.

Even while the broader stock market (the S&P 500) is roughly flat on the year, there are many stocks that are down well into the double digits YTD.

So while the stock market as a whole might be “partly cloudy”, some stocks are very stormy.

Why should you care?

Well, because it could mean more money and income in your pocket.

If you’re able to find a stock that’s been unreasonably hammered, there could be an opportunity there to reduce your risk, increase your income, and increase your potential long-term total return.

If a stock is down 20% or 30% over a short period of time even while the business is still relatively solid, you could have yourself an undervalued stock on your hands.

An undervalued stock is one where the current price is lower than the intrinsic value.

But how do you determine the intrinsic value?

Actually, that’s not all that difficult.

A little art, a little science. Using a system designed to accomplish the feat with minimal input, however, is imperative. Such a system was discussed here on the site by fellow contributor Dave Van Knapp, which, when used properly, should be able to get you a ballpark intrinsic value for any dividend growth stock you might want to look at.

Once you have intrinsic value in hand, it’s easy to take control and only pay a price that’s attractive relative to that value.

Being able to pay a price that’s significantly below that which you think a stock is worth adds a huge margin of safety. That means even if you’re somewhat wrong, you’ll still likely accomplish all that I laid out above.

You reduce your risk by laying out less capital for the same number of shares when you buy cheaper. And with that margin of safety, you reduce the risk that your capital is permanently destroyed. Conversely, paying a price too far above intrinsic value means you could see your capital evaporate as the price moves closer in line with fair value. Getting a great deal, though, reduces this risk.

And since, all else equal, price and yield are inversely correlated, a cheaper price gives you a higher yield. A higher yield means more income in your pocket for the same capital outlay. Why wouldn’t you want more income?

Moreover, a higher yield correlates to a potentially higher total return over the long haul. Yield is one component of total return. The other – capital gain – is also likely to come your way when you pay much less than you should for a stock, as there is a good shot that a favorable repricing occurs when the market realizes that a stock is on sale.

However, buying undervalued stocks might not be all that great of an idea if you’re not working with high-quality stocks.

Buying a poor business at a great price is not something I ever recommend, as I don’t think any price is good enough for a business that is unlikely to do well over the long haul.

But buying high-quality dividend growth stocks at prices below that which they’re worth can be an incredibly wonderful way to build long-term wealth and growing income.

You get all of that which I just laid out, but you also get to participate in the growing profit and dividend income that a great business should provide over the long term.

That’s why I stick to only investing in businesses that not only pay dividends but also increase these dividends year after year.

These stocks can be easily found on David Fish’s Dividend Champions, Contenders, and Challengers list, which is a fantastic resource available for you readers right here on the site.

Mr. Fish’s list is a compilation of almost 800 US-listed stocks that have all increased their dividends for at least the last five consecutive years. But many of these stocks have been increasing their dividends for more than three straight decades.

So if you’re sticking to investing only in companies that have the wherewithal to pay and increase dividends for years on end, you’re looking at businesses that are, generally speaking, very financially successful.

After all, you can’t just send out bigger and bigger checks to shareholders for decades without the growing cash flow to support those checks.

And buying these stocks when they’re priced in your favor boosts your odds of success pretty much across the board.

Well, the good news is that I may have found a high-quality dividend growth stock that is undervalued right now.

Want to know which one it is?

Read on…

Gap Inc. (GPS) is a retailer of apparel and accessories for men, women, and children. They operate under the Gap, Old Navy, Banana Republic, Athleta, and Intermix brands. They have over 3,700 company-operated or franchised stores across 51 countries, with the ability to ship products to 214 countries.

Gap is a household name in apparel through deft advertising, apparel design, and the availability of a product mix across multiple price points.

However, recent weakness in comparable store sales for its Gap Global and Banana Republic Global brands have led to a stock that has been absolutely decimated – GPS is now down more than 35% YTD.

But there could be an opportunity at hand here…

First, let’s consider the dividend growth pedigree.

The company has increased its dividend for the past 11 consecutive years.

A nice, budding record there, especially for retail apparel where the winds of fashion can change quickly.

What’s really impressive, however, is the rate at which the dividend has increased: Over the last decade, the company has increased its dividend at an annual rate of 25.3%.

You don’t see a long-term dividend growth rate like that every day, that’s for sure.

Although, part of that growth was fueled by an increasing payout ratio.

The payout ratio now stands at 34.8%, which is rather low. But it is more than twice as high as the payout ratio was a decade ago, so it would make sense to lower our expectations in terms of dividend growth moving forward.

But what’s really interesting here is that the stock now yields 3.44%. That’s not only high in absolute terms and relative to the broader market but it’s also 150 basis points higher than what the stock’s yield has averaged over the last five years. That’s what you get when you combine a growing dividend with a falling stock price.

gps statsNow, all of this might not be all that exciting if we didn’t have a quality business on our hands.

But I’d argue that Gap’s underlying fundamentals are rather solid.

Let’s first take a look at their top-line and bottom-line growth over the last decade. This will give us a good picture of what the business is doing, what it might do moving forward, and what the stock is likely worth.

Revenue for the company over the last decade is roughly flat – moving from $16.023 billion to $16.435 billion from fiscal years 2006 to 2015.

I’d prefer to see the top line expand, but Gap has done a tremendous job at doing more with that large base over time.

Through improved profitability and a significant reduction in shares, the company’s earnings per share increased from $1.24 to $2.87 over that 10-year period, which is a compound annual growth rate of 9.77%.

As mentioned, the outstanding share count is down dramatically. Gap has reduced its share count by over 50% over the last decade. That’s one of the strongest share buyback programs I’ve ever run across.

S&P Capital IQ believes the company will continue to produce similar results moving forward, as they believe that Gap will compound its EPS at a 9% annual rate over the next three years. Gap continues to buy back shares aggressively while its Old Navy Global brand continues to do quite well, so I think this is a very reasonable expectation.

The company’s balance sheet is rock solid right now, which gives them a lot of financial flexibility while they continue to work through issues at two of its global brands. With a long-term debt/equity ratio of 0.45 and interest coverage ratio over 27, I see no issues whatsoever with Gap’s leverage.

The apparel industry has its pros and cons. A big drawback is that fashion trends change quickly, which can lead to a very fickle customer base.

However, one really wonderful aspect of the industry is really fantastic profitability. Gap doesn’t disappoint here.

Over the last five years, they’ve averaged net margin of 7.36% and return on equity of 35.22%. I view these numbers as rather impressive, with an overall positive trend looking out over the last decade.

Gap’s issues at Gap Global and Banana Republic Global have led to recent weakness in profit and comparable sales results. Relatively strong growth at Old Navy Global, the company’s largest and most important brand, have offset much of this. However, the recent departure of Stefan Larsson, the former president of Old Navy Global and the executive seemingly responsible for the resurgence in the brand, has potentially dimmed that brand’s prospects.

All in all, though, I think the valuation here is pricing in very low expectations. And recent initiatives announced by the company which includes the closing of underperforming North American stores, a reduction of headcount at Gap headquarters, and renewed focus on online sales could boost the company’s near-term and long-term prospects. And you have incredible alignment between management and shareholders since the Fisher family (the founding family) owns more than 40% of the company.

So how low are the expectations?

The P/E ratio for GPS sits at 10.13 right now, which is substantially lower than the five-year average P/E ratio of 14.1 for the stock. That’s also almost half the P/E ratio for the broader stock market. And as noted earlier, the current yield is nearly twice its five-year average.

Appears to be very cheap right now. But what’s the intrinsic value?

I valued shares using a dividend discount model analysis with a 10% discount rate and a 7% long-term dividend growth rate. That dividend growth rate seems more than reasonable to me when looking at the long-term dividend growth rate, forecast for underlying EPS growth moving forward, and fairly low payout ratio. The DDM analysis gives me a fair value of $32.81.

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.

This appears to be a pretty incredible opportunity when looking at the current price against the valuation I’m coming up with, but let’s see how my take on the stock’s value compares to that of some professionals that track this stock.

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 GPS as a 5-star stock, with a fair value estimate of $45.00.

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 GPS as a 3-star “hold”, with a fair value calculation of $37.90.

I came in with the most cautious figure, but even the lowest number here indicates severe undervaluation. Averaging out the three numbers so as to provide some consensus on this gives us $38.57. That final valuation means this stock is potentially 44% undervalued right now.

gpsBottom line: Gap Inc. (GPS) operates in a very competitive industry, but it has more than held its own over the last decade. Excellent fundamentals across the board, recent restructuring, and alignment between the board and shareholders all bode well. The 35% YTD drop in the stock’s price has led to what appears to be 44% upside on top of a historically-high yield. I recently initiated a position in this company because I believe the current price warrants a lot of enthusiasm. I’d strongly recommend taking a look at this stock right now.

— Jason Fieber, Dividend Mantra

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