This World Class Dividend Growth Stock Appears 16% Undervalued Right Now

I’ve heard numerous times over the years that the stock market is largely efficient.

If the market were efficient, then every stock’s price already takes into account all known information.

That would mean that whatever price a stock is available at is what it should be priced at; the current price is the correct price.

However, that really makes no sense when you sit down and think about it.

I’ll witness large-cap stocks – shares representing equity in companies worth more than $10 billion – move up or down by 1% or 2% or 3% on a daily basis, with no meaningful news to encourage such a change in price.

[ad#Google Adsense 336×280-IA]When you see the stock of a, say, $100 billion company change by just 1% in price, that means that company’s valuation just changed by $1 billion. The collective investors of the world are now willing to pay $1 billion more or less for that company than they were the day before.

Think about that.

1 billion dollars.

Overnight.

A major, multinational company isn’t going to change that much on a day-to-day basis like that, outside of some event affecting operations either positively or negatively.

Warren Buffett challenged (and effectively debunked) the notion that the stock market is efficient via his famous “The Superinvestors of Graham-and-Doddsville” speech (which was later turned into an article), noting multiple different value investors (including, of course, Buffett) who were able to take advantage of the mispricing of stocks (that volatility just noted above) over the course of many years.

But can mere mortals – us retail investors – also take advantage of mispricing?

I believe so.

It simply requires first an ability to actually decipher the value of stocks.

Just like any other merchandise out there in the world, stocks have both a price and a value component.

Price is what you pay. It’s a number that tells you how much money you’re going to pay.

But value actually tells you what you’re getting, what something is worth.

You’re not all alone when it comes to valuing stocks. There are countless ways to go about valuing a business, but a system that’s available right here on the site, which was put together by fellow contributor Dave Van Knapp, is an excellent start.

So once you have a reasonable estimate of a company’s value in hand, you’re in control. You know what the stock is probably worth, which puts the price in context.

However, there’s another major part of being a value investor.

And that’s having the wherewithal – the intestinal fortitude – to actually go out and buy a stock even when the whole world thinks you’re wrong. It’s about having the ability to think against the grain, focus on the fundamentals, and buy a stock after a 20%, 30%, or 40% drop in price.

It’s a badge I’ve attempted to wear proudly as I’ve built out my own real-life portfolio, one that is now sitting well into the six figures and should generate $10,000 in dividend income next year.

I’ve stepped into the fire many times over the years and picked up stocks after they’ve fallen in price substantially, simply making sure that the quality was still high and the valuation was then attractive.

It’s important to be aware, however, that a major drop in price isn’t indicative of a good value by itself. A stock that was 20% overvalued but then subsequently drops by 15% isn’t all of the sudden a good deal.

Now, one aspect I focus on is a company’s ability to pay and grow a dividend. You’ll notice every stock in my portfolio pays a dividend.

But that’s not all…

They also routinely and regularly increase their dividends, which are hallmarks of dividend growth stocks.

I focus on and personally invest in dividend growth stocks because they tend to exude the quality I’m looking for.

Companies that can increase their dividend like clockwork for decades on end tend to operate at a high level. It’s nigh impossible to simultaneously pay more and more money to shareholders while also running a poor business that isn’t increasingly profitable over time.

To pay dividends you must first have the cash flow to do so.

But to pay a larger dividend year after year after year means you have to have more and more and more cash flow.

So by focusing on these stocks, I tend to weed out a lot of poor businesses right off the bat.

That’s why I use David Fish’s Dividend Champions, Contenders, and Challengers for my main resource when looking at stocks to buy.

It’s basically a “cheat sheet” in the sense that Mr. Fish has already done all the hard work for you – he’s scoured the country for every US-listed stock that has increased its respective dividend for at least the last five consecutive years.

At that point, it’s just a matter of looking at that list and picking out the highest-quality stocks at the best possible values at any given time.

Not an easy task, but that’s what today’s article is for!

I’m going to discuss a prominent dividend growth stock – this is a well-known business that has operated at a very high level for decades now, and it’s increased its dividend to shareholders every year for decades.

Better yet, it appears to be undervalued after a 31% drop in price year-to-date.

Wal-Mart Stores, Inc. (WMT) is a global retailer that operates more than 11,000 stores across the world.

By far and away the largest retailer in the world when measured by revenue, Wal-Mart’s stock has recently fallen on hard times, even though the underlying business really hasn’t.

As mentioned just above, the stock is down by more than 30% since the start of the year.

Yet revenue is roughly flat over the last twelve months. And the company’s earnings per share is down about 7% over that same time period.

So we’re looking at a business that basically just hasn’t grown over the last year (though, certainly hasn’t shrunk much), yet the stock is acting as if the entire business has fallen off a cliff.

And that’s where you tend to find opportunities.

Keep in mind this global juggernaut still serves over 250 million customers every week via its more than 11,000 stores across 27 countries, as well as through its websites.

In addition, they’re actively pursuing e-commerce business. Retail has changed quite a bit over the last decade, with more and more sales moving online. Wal-Mart’s global e-commerce sales grew 22% last fiscal year, with more than 75% of sales from walmart.com coming from non-store inventory, which provides additional sales growth and merchandising opportunities beyond traditional stores.

As you can see, Wal-Mart isn’t sitting around, watching competitors totally eat their lunch. They’re also seeing significant growth from online sales.

Now, as a dividend growth investor, I stick to only those companies that can pay and grow a dividend.

Wal-Mart certainly doesn’t disappoint here at all.

They’ve increased their dividend for the past 42 consecutive years.

That’s almost unheard of in the retail industry, which is fraught with change and competition.

Yet Wal-Mart has faced its challenges and delivered more income to shareholders for more than four straight decades. Pretty impressive stuff.

CaptureAnd it’s not just a dividend that’s growing, but one that’s growing rapidly – the 10-year dividend growth rate is 14.8%.

The good news is that I don’t think that incredible record is going to come to a screeching halt any time soon – the company’s ability to continue handing out dividend increases is demonstrated by its low payout ratio of just 42.1%.

That means less than 43% of the company’s profit is going back to shareholders in the form of a dividend, leaving the rest as retained earnings to continue investing in the company so as to grow it.

Even with modest EPS growth, the dividend could continue to grow significantly for years to come. And the retailer is due to announce a dividend increase in February, so look out for that.

On top of all that, the stock is providing for excellent income right now.

Yielding 3.30% right now, it’s attractive not only in absolute terms (in this low-rate environment), but also in relative terms: The five-year average yield for the stock is 2.3%, meaning the current yield is 100 basis points higher. Moreover, this yield is extremely high for the industry.

So there’s just so much to like here with the dividend. You’re getting an above-market yield, a modest payout ratio, and dividend growth that is well in excess of inflation.

But the dividend is just one part of the equation. If the underlying business is significantly deteriorating in a secular manner, then the dividend will eventually be in danger.

However, the retailer’s underlying results remain pretty strong.

Looking at the last decade so as to smooth out economic cycles (and the Great Recession), revenue is up from $315.654 billion to $485.651 billion from fiscal years 2006 to 2015. That’s a compound annual growth rate of 4.90%.

Top-line growth isn’t spectacular, but I think that’s simply a function of the large base with which Wal-Mart is working with. Tough to move the needle on more than $300 billion in annual revenue. These are just monster numbers, which does, to some degree, work against the company in terms of growth.

But I also think it’s more than respectable. We keep hearing about e-commerce taking traditional retailers like Wal-Mart out to the pasture, yet e-commerce isn’t something that started up yesterday. Major online retailers have been in full swing over this 10-year period, yet Wal-Mart continues to post respectable results.

Earnings per share increased from $2.68 to $5.05 over this stretch, which is a CAGR of 7.29%.

Again, very, very respectable. With all of the challenges factored in, including a strong dollar as of late, high-single-digit EPS growth is actually pretty strong.

Strong share buybacks have helped the excess bottom-line growth. The outstanding share count was reduced by almost 25% over the last 10 years. Management continues to buy back shares at cheap levels, which, in my view, is a good use of shareholders’ money. During Q3 2015, the company spent $437 million to buy back 6 million shares.

Moving forward, S&P Capital IQ believes Wal-Mart will grow its EPS by a compound annual rate of 7% over the next three years, which is right in line with what the retailer has produced over the last decade.

S&P Capital IQ is modeling in additional growth from e-commerce sales and smaller-format stores being partly offset by additional fixed costs and adverse currency exchange rates. Thus, that seems pretty reasonable. You’ve got pretty strong long-term tailwinds there, though Wal-Mart’s continued growth does work against them a bit in terms of accelerated growth on a larger base.

Those that are forecasting the end of Wal-Mart due to e-commerce gains from rivals like Amazon.com, Inc. (AMZN) seem to forget that e-commerce isn’t a new thing. E-commerce has been going strong for the past decade, yet you see what Wal-Mart has done over that period.

And let’s not even get into Amazon’s stock trading for 1,000 times its tiny earnings per share.

One other fundamental area of a company’s financial metrics that tells us a lot about quality is the balance sheet. Well, the retailer definitely doesn’t disappoint here, either.

Long-term debt-to-equity is sitting at 0.51, meaning there’s twice as much shareholders’ equity as long-term debt. Great balance here.

In addition, the interest coverage ratio is over 11. That means earnings before interest and taxes can cover interest expenses more than 11 times over, indicating that Wal-Mart has no issues whatsoever with its debt load or ability to pay interest expenses.

Profitability is also strong, relatively speaking. I say that because retail is simply an industry that is known for razor-thin margins, due to the need to compete on price.

Wal-Mart does well relative to many of its peers, thanks to its massive economies of scale, which also gives it a huge advantage when it comes time to negotiate pricing on the supply side.

However, the profitability numbers still aren’t incredibly inspiring on a stand-alone basis.

Nonetheless, they’ve averaged net margin of 3.49% and return on equity of 21.97% over the last five years.

Some of the best numbers in the industry, which I think just goes to show how hard it is to achieve great profitability in retail.

Combine that with intense competition and a changing landscape, and it begs one to wonder why invest in Wal-Mart.

Well, I think the overall picture is really appealing here.

You’ve got a world-class business (especially relative to many peers), great profit and dividend growth, a rock-solid balance sheet, and an outstanding yield in an otherwise low-rate world.

Perhaps that’s what Warren Buffett sees in the business as well, seeing as how Berkshire Hathaway Inc. (BRK.B) is one of the largest shareholders. For perspective, Buffett has more than $3.3 billion invested in Wal-Mart. If one of the “Superinvestors” thinks that highly of the retailer, perhaps it’s prudent to take notice.

Moreover, I think the risk is pretty low on the business side. The odds of the retailer going out of business or something seem scant, and initiatives in e-commerce and smaller-format stores appear to be working well.

People will always need to buy groceries and basic household needs on an almost daily basis, and those that provide quality at the most convenience and lowest price will continue to win customers. Wal-Mart’s massive footprint gives it an inherent advantage both in e-commerce (able to deliver/provide goods quickly to a substantial number of people) and traditional commerce (massive selection at low prices).

On top of that, I think the valuation here limits risk, providing for another margin of safety.

The P/E ratio sits at 12.73 on shares, which is extremely low. That’s almost half the broader market. It’s also more than 10% lower than the five-year average P/E ratio of 14.3 for the stock, which itself is quite low. Every other basic valuation metric is well below recent historical norms, while the yield, as mentioned earlier, is significantly higher than what the stock typically offers.

How attractive is that valuation? How much of an opportunity is present? What’s the stock likely worth?

I valued shares using a dividend discount model analysis with a 10% discount rate and a 7% long-term dividend growth rate. That growth rate is in line with EPS growth over the last decade and the forecast for EPS growth moving forward. It’s also about half the 10-year dividend growth rate. Although recent raises have been low, due likely to the firm’s continued investment in growth initiatives, the low payout ratio leaves plenty of room left for future dividend increases. The DDM analysis gives me a fair value of $69.91.

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.

So I think there’s a great opportunity here for a value investor who likes income and income growth (who doesn’t want all that?). But I’m not alone in that conviction…

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 WMT as a 5-star stock, with a fair value estimate of $75.00.

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 WMT as a 3-star “hold”, with a fair value calculation of $60.80.

I like to average out the three figures so as to smooth out the variations and come up with a final valuation. That final valuation is $68.57, which is pretty close to what I came up with. That price, by the way, would put the P/E ratio closer to its recent historical norm. And that number also means this stock is potentially 16% undervalued right now.

wmtBottom line: Wal-Mart Stores, Inc. (WMT) is a world-class business, and still a dominant force in retailing. They’re well positioned for changes, and they’re not sitting on their laurels. They continue to invest in the business and roll out new platforms. Meanwhile, the stock is offering a very attractive yield, and there could be 16% upside built in. If you want to invest alongside a “Superinvestor”, and if you feel you’re a real value investor, this stock should be right up your alley.

— Jason Fieber

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