As I sit here and write this article from a coffee shop in Chiang Mai, Thailand, I can’t help but notice something.
The place is packed.
There are a couple dozen people here, all enjoying the smell and taste of coffee, which is further enhanced by the atmospheric experience that a great coffee shop provides.
People love coffee. And they particularly enjoy it when it’s a high-quality product served in a comfortable space with good ambience.
Yet it’s not exactly difficult to gain that insight and profit from it.
You simply take a moment to look around you and see what people are doing and buying. Consumer behavior can be seen from a mile away.
One investment philosophy I’ve stuck by over the years is this: keep it simple.
Investing doesn’t need to be, and shouldn’t be, complicated.
Great investing is boring. It’s like watching paint dry.
Of course, even correct and boring investing is still exciting because you’re also watching the money roll in.
Indeed, many of the best businesses in the world operate incredibly simple and boring business models, and they simultaneously watch the money roll in.
Best of all, that money is often shared with their shareholders via dividends.
And as that profit grows, so do those dividend payments.
Those growing dividends can then be used to pay your bills, meaning you’re financially independent. That’s probably the ultimate goal for any investor out there.
Investing in great and simple businesses that rake in the profit and share that profit with you can be an excellent pathway to wealth, passive income, and even financial independence.
Not only that, but it’s possible to achieve financial freedom quite early in life.
I’ve laid out exactly how that’s possible in my Early Retirement Blueprint.
I achieved financial independence in my early 30s by keeping investing simple and putting my capital to work with great companies that pay me growing dividends.
I’ve adhered to dividend growth investing, which is a strategy that involves buying stock in companies that have lengthy track records of paying growing dividends (funded by the growing profit the underlying businesses are producing).
And the result of that adherence is my FIRE Fund, a real-life and real-money dividend growth stock portfolio that generates enough growing dividend income to pay my bills and render me financially free.
Hundreds of companies that operate simple business models, make a ton of money, and pay their shareholders growing dividends can be found on the late, great David Fish’s Dividend Champions, Contenders, and Challengers list – a compilation of more than 800 US-listed stocks that have raised their dividends each year for at least the last five consecutive years.
However, as great as dividend growth investing is, it’s not an investment strategy that should be followed blindly.
An intelligent investor will make sure they’re doing their full due diligence on any potential investment, which involves quantitative and qualitative analysis, risk assessment, and valuation.
It’s that last point – valuation – that is extremely pertinent to today’s discussion, as well as this series as a whole.
Valuation plays a big part in an investment’s performance, especially over the short term.
While price is what you pay for something, value is what something is actually worth.
And buying a high-quality dividend growth stock when the former is lower than the latter is opportune.
That’s because an undervalued dividend growth stock should offer a higher yield, greater long-term total return prospects, and less risk.
That’s all relative to what the same stock might otherwise offer if it were fairly valued or overvalued.
Price and yield are inversely correlated; all else equal, a lower price will result in a higher yield.
That higher yield goes on to affect investment income, which in turn means greater long-term total return potential.
That’s because total return is comprised of investment income (via dividends or distributions) and capital gain.
Meanwhile, the capital gain component is also given a possible boost when undervaluation is present due to the “upside” that exists between price and value.
When there’s a favorable disconnect between price and value, you’re setting yourself up for an advantageous correction of that – via a repricing – down the road, which would result in capital gain if/when it happens.
And that’s on top of whatever organic capital gain would come about through the course of business as a quality company increases its profit, becomes worth more, and sees its stock rise in price over time.
This all has a way of reducing risk, too.
You introduce a margin of safety when you buy a stock for less than it’s estimated to be worth.
This is necessary because we can’t predict the future. An investment thesis could turn out to be incorrect due to any number of unforeseen circumstances.
When there’s a big gap between price and value, you protect your downside. That means there would have to be a major issue with a company, causing a downward revision in value, before you’re upside down on your investment.
Fortunately, valuation isn’t impossible to estimate. I wouldn’t even say it’s difficult.
Fellow contributor Dave Van Knapp has greatly demystified the valuation process through an article that is part of an overarching series of lessons on dividend growth investing.
That particular lesson is Lesson 11: Valuation.
With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…
Starbucks Corporation (SBUX)
Starbucks Corporation (SBUX) is the world’s leading retailer of high-quality, specialty coffee products. These products are sold in more than 28,000 stores across 76 different markets, in addition to multi-channel retail.
I’m no genius, but I’ve been able to pick up on the fact that people enjoy drinking coffee – and they prefer a high-quality coffee product with high-quality service in a high-quality environment.
As I noted earlier, consumer behavior can be spotted from a mile away.
But I’ve been able to spot this behavior up close and personal, because I’m often in coffee shops myself while I write articles (like this one).
Well, there’s nothing else like Starbucks out there. Not in my experience.
And it’s “experience” that is what separates them from the pack.
As the Internet starts to commodify products, it’s experiences that companies and investors are now chasing so as to provide something really unique to consumers, especially Millennials (like me).
Likewise, consumers, especially young consumers, are more interested in experiences than stuff.
Starbucks knows this better than most. And they do it better than anyone else, at scale.
See, what Starbucks does is, they wrap a product within an experience. You get a high-quality coffee product that comes attached to a high-quality experiential service.
You aren’t really able to separate the two. And when both are high quality, the consumer is hooked.
Moving over to company numbers, revenue from company-operated stores accounted for just under 79% of fiscal year 2016 revenue.
Approximately half of the company’s stores (company-operated and licensed) are in the US, with the other half being in international markets.
While US growth is slowing (due to saturation), it’s international growth that will propel this company forward.
The dividend metrics are already outstanding, and the company is just getting warmed up here.
Starbucks has increased its dividend for eight consecutive years.
And the five-year dividend growth rate stands at 26.2%, which is incredible.
The yield is currently sitting at 2.89%.
That yield might not pop up on a stock screener right now, but that’s because Starbucks has already let the cat out of the bag and announced something really special regarding the dividend.
They’re going to not only increase the dividend by 20% this year, but they’re going to do so a quarter early – with the dividend declaration that’s coming in July.
That’s yet another 20% dividend increase – on top of the 20% increase last year. And it’s coming a quarter early.
That yield is very, very attractive now.
It’s twice as high as the five-year average yield on this stock – more than 140 basis points higher.
With a payout ratio of just 47.1% on that upcoming $0.36 quarterly dividend, there’s still a lot of room for sizable dividend increases in the future.
Of course, we don’t want to see this party stop.
And we invest in where a company is going, not where it’s been.
Since dividend growth will ultimately be funded by underlying business growth, we’ll look at what Starbucks has done in terms of top-line and bottom-line growth over the last decade.
We’ll then compare that to a near-term forecast for profit growth.
Combining the known past and estimated future in this manner should tell us a lot about the company’s growth profile and potential, setting us up for a very reasonable evaluation about the future dividend growth, and allowing us to approximate the stock’s valuation.
Starbucks has increased its revenue from $10.383 billion to $22.386 billion between fiscal years 2008 and 2017. That’s a compound annual growth rate of 8.91%.
Very, very strong revenue growth here.
Meanwhile, earnings per share grew from $0.21 to $1.97 over this period, which is a CAGR of 28.24%.
Wow. Now we see where that incredible dividend growth came from.
There’s a lot of excess bottom-line growth here, fueled by a legendary margin expansion.
Starbucks was struggling with low-single-digit net margin just a decade ago, not utilizing its brand power and unique platform to its full potential.
Well, Howard Schultz returned as CEO in 2008 (after leaving in 2000), and what he did thereafter is nothing short of remarkable.
Net margin has more than tripled, and the company has brand recognition second to none.
Looking out over the next three years, CFRA believes Starbucks will compound its EPS at an annual rate of 15%.
That would be a drop from what we see above, but that growth would still be quite brisk (allowing for at least like dividend growth, by the way).
If anything, though, I think Starbucks might actually do a bit better than that.
Sure, the margin expansion story has been played.
But there’s the tax cut from The Tax Cuts and Jobs Act of 2017, unparalleled positioning in its industry, and plenty of international expansion coming.
On that last point, Starbucks acquired the remaining shares of East China Joint Venture (announced in July 2017) allowing the company to operate all Starbucks stores in mainland China (a huge growth market for the company).
That’s a relatively recent move, so that’s just now opening the floodgates for Starbucks.
Plus, Starbucks struck, back in May, a $7.1 deal with Nestle, the world’s largest food and beverage company, for exclusive rights to sell Starbucks’ packaged coffee and tea retail products around the world. That combines a premium retail brand and Nestle’s global distribution machine. And it gives Starbucks a lot of cash.
However, even if Starbucks only comes in at 15%, that would still be an incredible growth story.
The company’s balance sheet is extremely strong, with a long-term debt/equity ratio of 0.72 and an interest coverage ratio that’s over 47.
Cash is more than half of long-term debt, and that’s before the cash from Nestle (these numbers are as of FY 2017).
Profitability is marvelous.
Over the last five years, the firm has averaged annual net margin of 10.63% and annual return on equity of 38.27%.
These numbers include unfavorably skewed numbers from FY 2013, yet they still come out great. And that high ROE (over 50% for FY 2017) is without a lot of leverage.
There’s very little to dislike about this company or its business model.
Investing is best when it’s simple and boring. There’s almost nothing more simple than investing in a coffee company. It’s a straightforward idea with a compelling and long-term global growth story.
The dividend metrics are fantastic. A 20% dividend increase coming a quarter early should make any dividend growth investor happy.
I see the biggest risk as competition. The coffee space is highly competitive. Thus far, though, Starbucks has managed to rise above the rest. That separation doesn’t seem to be abating.
A premium brand should carry a premium valuation, but the stock’s valuation would actually imply quite a discount…
The stock is trading hands for a P/E ratio of 23.29.
That’s using TTM EPS that includes adjusted EPS for Q1 2018, factoring out a large one-time gain that would inappropriately and inaccurately skew the P/E ratio downward.
That’s roughly on par with the market, yet there’s no doubt that Starbucks is growing its business and dividend faster than the market.
The stock’s multiple on cash flow is more than 40% lower than its three-year average.
And the yield, as shown earlier, is more than twice as high as its five-year average.
Undervaluation is indicated, but how much so? What might a reasonable estimate of fair value look like?
I factored in a 10% discount rate and a long-term dividend growth rate of 8%.
That growth rate is substantially lower than the dividend growth the company has delivered on until now, but I’m also assuming a slowdown here as growth and the dividend mature a bit.
Plus, the payout ratio is now as high as it’s ever been for the company.
It’s still very moderate by any measure in relative or absolute terms, but a rising payout ratio has funded some of the dividend growth in recent years (EPS growth has trailed dividend growth more recently).
But I think this is still a very conservative look at the valuation.
The DDM analysis gives me a fair value of $77.76.
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 what I believe to be a conservative look at valuation shows a greatly undervalued stock.
But I’m just one of many looking at this stock and its value, which is why we’ll compare my valuation to that of what two professional stock analysis firms have come up with.
This will add depth and additional perspective to our final valuation.
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 SBUX as a 4-star stock, with a fair value estimate of $64.00.
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 SBUX as a 3-star “HOLD”, with a 12-month target price of $62.00.
Averaging the three numbers out gives us a final valuation of $67.92, which would indicate the stock is potentially 36% undervalued.
Bottom line: Starbucks Corporation (SBUX) is a high-quality company with unparalleled brand power in its industry. Incredible growth, huge margins, and great dividend metrics offer a lot to like. And a recent 20% dividend increase coming a quarter early should make any dividend growth investor smile. A valuation compression has created what could be a “coiled spring” here, with the possibility that shares are 36% undervalued on top of a yield more than twice as high as its recent historical average. Dividend growth investors should be looking to drink this stock up while it’s on sale.
Note from DTA: How safe is SBUX’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 72. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, SBUX’s dividend appears safe and unlikely to be cut. Learn more about Dividend Safety Scores here.
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