Hot, new IPOs are all the rage in the market right now.
Companies that are talented at losing money are coming out of the Silicon Valley woodwork to raise billions from going public.
The media loves to jump on this hype.
Guess what the media won’t talk much about?
But they probably should.
Reinvested dividends actually account for the vast majority of the stock market’s total return over the long run.
But it gets better.
That same $10,000 over the same period turns into $2,459,158 after factoring in reinvested dividends.
The sources for this particular data are Morningstar and Hartford Funds, but this is a well-known phenomenon.
This is just one reason I’m a dividend growth investor.
Dividend growth investing takes this phenomenon and supercharges it.
The strategy advocates investing in high-quality companies that have excellent fundamentals and pay growing dividends.
If reinvested dividends account for the vast majority of the market’s total return over the long run, it’s only logical that earning bigger dividends that are growing faster should lead to superior results.
I’ve followed this strategy with my own money, building my FIRE Fund in the process.
I bet my life on this.
And it turned out well.
The FIRE Fund generates the five-figure dividend income I need to cover my essential expenses.
As I lay out in my Early Retirement Blueprint, I was able to retire in my early 30s.
I believe anyone can do the same, assuming they live the right lifestyle and properly execute this strategy.
However, a world-class enterprise paying you growing dividends almost certainly will.
You can find more than 800 dividend growth stocks by checking out the Dividend Champions, Contenders, and Challengers list.
Growing dividends, funded by growing profit, is a major part of the equation.
But it’s very important that you don’t pay too much for any stock.
Valuation plays a critical role in your long-term investment results.
An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.
This is relative to what the same stock might otherwise provide if it were fairly valued or overvalued.
All else equal, a lower price results in a higher yield.
That’s because price and yield are inversely correlated.
Higher yield leads to greater long-term total return potential.
Total return is simply comprised of capital gain and investment income.
A higher yield should improve the latter.
Meanwhile, capital gain could be given a possible boost, too.
That’s due to the “upside” between a lower price paid and higher intrinsic value.
The market isn’t necessarily great at accurately pricing stocks over the short term. But price and value tend to more closely correlate over the long run.
Buying when there’s a favorable disconnect between price and value could give a nice boost to capital gain.
These dynamics should also reduce risk.
A favorable gap between price and value introduces a margin of safety.
This acts as a buffer, which protects the investor against downside.
Value could be impaired through a variety of ways, or the valuation estimate at the point of investment could be too high.
It’s very important that a margin of safety is attained.
This risk reduction is basically free, yet it’s also priceless.
Fortunately, spotting undervaluation and taking advantage of it isn’t a difficult endeavor.
But being able to reasonably judge value is imperative.
That’s where fellow contributor Dave Van Knapp’s Lesson 11: Valuation comes in.
Part of an overarching series of “lessons” on DGI, this particular piece gives you the goods on valuation. It acts as a valuation template that can be applied to almost any dividend growth stock out there.
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…
Williams-Sonoma, Inc. (WSM) is a nationwide multi-channel retailer of high-quality home products and furnishings.
Founded in 1956, Williams-Sonoma now operates as a global business with more than 19,000 employees.
This company markets some of the most respected and sought-after home furnishing brands.
Their enviable portfolio includes the likes of Pottery Barn, West Elm, and the eponymous Williams-Sonoma brands.
They operate in two segments: E-commerce (54.3% of FY 2018 sales) and Retail (45.7%).
In an industry that is somewhat commodified and competing on price, Williams-Sonoma has been able to distinctly separate itself as a purveyor of high-quality furnishings that are worth a premium.
That is in and of itself no small feat.
But what’s particularly impressive here is, they’ve been able to translate that into a very healthy e-commerce presence.
Legacy retailers left and right are being left in the dust as e-commerce starts to take over the entire retail landscape.
Selling home furnishings online isn’t easy.
Selling higher-priced home furnishings online is even less easy.
Yet Williams-Sonoma has adeptly adapted to the new reality in e-commerce.
Not only is their E-commerce segment more than half the business in terms of sales, it’s actually accelerating.
That segment accounted for 52.5% of sales in FY 2017. It’s now at 54.3%.
Lest you think it’s just a cratering Retail segment, the E-commerce segment grew at 10.9% YOY.
This accelerated further in Q4 2018, with 14.3% YOY growth.
And comps are also strong, with FY 2018 showing 3.7% full-year comparable brand revenue growth. Even Pottery Barn, which has lately had some troubles, had a 150 basis points acceleration in comp growth.
The company has never looked better, which bodes well for their ability to pay a growing dividend.
They’ve increased their dividend for 14 consecutive years.
The 10-year dividend growth rate stands at 13.5%.
Surprisingly, there hasn’t been a marked deceleration in dividend growth.
For instance, the most recent increase (announced in March) came in at almost 12%.
With a moderate payout ratio of 47.4%, there’s still a lot of room for future dividend increases.
On top of all of this, the stock offers a very compelling yield of 3.54% here.
That’s almost twice the broader market.
It’s also more than 80 basis points higher than the stock’s own five-year average yield, relating to the point above about undervaluation and yield.
Obviously, the dividend metrics are desirable.
Assuming a static valuation, the sum of yield and dividend growth should roughly equal total return.
Locking in a yield well over 3% with dividend growth in the low-double-digit range sets investors up very nicely here.
Of course, we invest in where a company is going, not where it’s been.
The future dividend growth is ultimately what matters to us.
Estimating that future dividend growth will largely require estimating future earnings growth, since the former hinges on the latter.
Estimating this growth will also help us value the stock.
Building out this estimate will require us to look at what the company has already done over the long run.
I’ll first show you the company’s top-line and bottom-line growth over the last decade.
Then I’ll line that up against a professional forecast for profit growth over the next three years.
Blending the proven past with what they’re expected to do going forward should tell us a lot about the overall growth trajectory.
Williams-Sonoma grew revenue from $3.103 billion in FY 2009 to $5.672 billion in FY 2018.
That’s a compound annual growth rate of 6.93%.
Outstanding. I consider a mid-single-digit top-line growth rate to be great.
They exceeded this handily, all within a retail landscape that is changing rapidly.
Earnings per share advanced from $0.72 to $4.05 over this period, which is a CAGR of 21.16%.
That’s an incredible growth rate, although I don’t think it’s necessarily accurate.
The start of this period was the bottoming out of the Great Recession, which is about as low as these earnings will probably ever get.
However, the retailer has navigated troubled waters with extreme skill.
Notably, the outstanding share count is down by just over 23% over this period. That reduction helped fuel some of this excess bottom-line growth.
Further, the company recently announced an additional stock repurchase authorization of $500 million.
Looking forward, CFRA is predicting that Williams-Sonoma will compound its EPS at an annual rate of 4% over the next three years.
This would be a marked growth deceleration. That’s compared to what’s transpired over the last 10 years.
CFRA notes the uncertainty regarding tariffs, as well as the rapidly changing retail industry as sales shift online.
In my view, this is an overly pessimistic gauge of the company’s growth potential.
Now, I don’t think they’ll continue to grow at 20%+ annually. As I note above, this particular 10-year time frame is precarious.
But even if we shorten the window to what this company has done over the last five years, Williams-Sonoma compounded its EPS at an annual rate approaching 6%.
If we believe that’s a bit more accurate, that would still set us up for dividend growth in the high-single-digit range for the foreseeable future. The moderate payout ratio, which could be slowly expanded, would easily allow for this.
Summing that up, an expectation for dividend growth in the 7%-8% range over at least the next decade would seem very fair.
Moving over to the balance sheet, the quality of this business becomes further evident.
The company has historically carried no long-term debt.
Even now, debt is trivial.
They recently added a minor amount of long-term debt to the balance sheet under a line of credit, but it’s negligible to the overall story.
Whereas retail is fraught with low-margin businesses fighting for and competing on every penny, Williams-Sonoma sports very healthy profitability metrics.
Over the last five years, the company has averaged annual net margin of 5.92% and annual return on equity of 24.98%.
In the retail world, these are great numbers.
For every major challenge that most retailers are facing right now, it seems like Williams-Sonoma has an answer.
E-commerce makes up the majority of sales.
The margins are healthy.
Debt doesn’t burden them.
Plenty of retailers would love to be in spot.
That said, there are some risks to consider here.
Regulation, competition, and litigation are omnipresent risks in every industry.
Almost no switching costs exist in this industry.
In addition, one of the company’s biggest strengths, which is its robust e-commerce business, could be eroded as more companies figure out the curve. Williams-Sonoma has a bit of an advantage here in the sense that they adapted so quickly, but others are figuring it out.
The company is also highly exposed to the housing market. If home sales fall, demand for luxury home furnishings will naturally decline.
Overall, though, this appears to be one of the best-run retailers out there.
The fundamentals, especially in terms of the dividend metrics, are fantastic.
At the right price, this could be an amazing long-term investment.
Well, the stock seems to be quite cheap right now…
It’s trading hands for a P/E ratio of 13.82, which is obviously well below the broader market.
That’s also substantially lower than the stock’s own five-year average P/E ratio of 18.9.
Every other basic valuation metric is well off of its respective recent historical average.
For instance, the current P/CF ratio of 7.6 is notably lower than its three-year average of 8.8.
And the yield, as shown earlier, is almost 80 basis points higher than its five-year average.
So the stock does look like a bargain. But how cheap might it be? What would a reasonable estimate of intrinsic value look like?
I valued shares using a dividend discount model analysis.
I factored in a 10% discount rate and a long-term dividend growth rate of 7%.
This is on the low end of what I showed earlier as a very fair look at the long-term dividend growth potential.
That’s after looking at the payout ratio, historical growth rates, and placing in the market.
If anything, I think the company has a lot of room to surprise investors and hand out dividend increases well in excess of this.
After all, the most recent increase was over 11%.
The DDM analysis gives me a fair value of $68.48.
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.
My valuation doesn’t seem to be aggressive at all, yet the model still spits out a number that implies a very undervalued stock.
And that jibes with what we see with the basic valuation metrics.
But we’ll now compare that valuation with where two professional stock analysis firms have come out at.
This adds balance, depth, and perspective to our 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 WSM as a 4-star stock, with a fair value estimate of $70.00.
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 WSM as a 3-star “HOLD”, with a 12-month target price of $58.00.
I came in right in line with Morningstar, which I think is fair. Averaging out the three numbers gives us a final valuation of $65.50, which would indicate the stock is possibly 21% undervalued.
Bottom line: Williams-Sonoma, Inc. (WSM) is a high-quality retailer that has clearly solved the e-commerce conundrum. With fantastic fundamentals, a yield of over 3.5%, a moderate payout ratio, almost 15 consecutive years of dividend raises, and the potential that shares are 21% undervalued, long-term dividend growth investors would be wise to look closely at this stock right now.
Note from DTA: How safe is WSM’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 61. 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, WSM’s dividend appears safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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