There are more than 3,500 publicly traded companies in the US.
A lot of choices.
Perhaps too many.
How does an investor narrow things down and focus on the best stocks?
I’ll tell you.
Dividend growth stocks.
These are stocks that pay reliable and growing dividends.
It makes sense to ignore the rest.
Well, there’s no better proof of just how profitable a company is than a growing cash dividend.
A growing dividend is the “proof in the profit pudding”.
Looking only at stocks with growing dividends narrows things down considerably, because there are a lot of lower-quality companies out there that aren’t profitable (and thus cannot afford to pay a growing dividend).
Just check out the Dividend Champions, Contenders, and Challengers list to see what I mean.
That list contains only stocks that have raised their dividends each year for at least the last five consecutive years.
And it’s narrowed down to less than 900 names.
So you’re down to 25% of all available stocks right there.
And then one can easily start to pick out the world-class enterprises.
They tend to be household names that provide people with their everyday products and/or services.
I describe exactly how I did that in my Early Retirement Blueprint.
By living below my means and investing my excess capital into high-quality dividend growth stocks, I built up a significant amount of wealth and passive income at a very young age.
And now I control the FIRE Fund, my real-money dividend growth stock portfolio that generates the five-figure passive dividend income I live off of.
But I didn’t randomly pick stocks off of the CCC list.
No, I made sure to analyze every prospective business before I ever invested a dime.
Successful and intelligent long-term investing requires one to first fundamentally analyze a business for investment suitability.
Furthermore, valuation at the time of investment is critical.
While the price of a stock tells you what you’ll pay, the value of a stock tells you what you get for your money.
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.
Price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.
That higher yield correlates to greater long-term total return potential.
This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.
Investment income is given a boost by the higher yield.
But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.
And that’s on top of whatever capital gain would ordinarily come about as a company becomes worth more over time.
These dynamics should reduce risk.
Undervaluation introduces a margin of safety.
This is a “buffer” that protects the investor against unforeseen issues that could detrimentally reduce a company’s fair value. It’s protection against the possible downside.
It’s obvious that undervaluation should be sought out by every long-term dividend growth investor.
Fortunately, it’s not onerous to estimate the value of just about any dividend growth stock out there.
Fellow contributor Dave Van Knapp has made the valuation process much easier through the introduction of Lesson 11: Valuation.
Part of an overarching series on the dividend growth investing strategy, this lesson in particular expertly lays out the exercise of valuing dividend growth stocks.
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…
Kroger Co. (KR)
Kroger Co. (KR) operates more than 2,700 supermarkets across 35 states (and the District of Columbia), in addition to multi-department stores, pharmacies, jewelry stores, fuel centers, and food processing plants.
Supermarkets account for approximately 95% of the company’s revenue.
Founded in 1883, Kroger now operates as the largest traditional grocer in the United States.
That size gives them unrivaled scale, purchasing power, distribution capabilities, and marketing insight.
In a retail world that is becoming increasingly digital, their size is a unique competitive advantage. Their footprint of stores positions them well.
But physical stores are a bit of a dual-edged sword.
One on hand, these stores are a huge legacy cost to traditional retailers. It’s expensive to run stores.
On the other hand, this footprint is logistically invaluable in terms of servicing customers.
Customers are increasingly demanding an omnichannel experience from retailers.
The days of going to a grocery store, buying your goods, and lugging them home are starting to die out.
It’s now about ordering products online and picking them up, or having them delivered – same-day.
Well, with over 2,700 stores, Kroger has a massive footprint in place to take care of those evolving customer needs.
In fact, the company states that they now provide home delivery services to 91% of Kroger households.
Even e-commerce giants like Amazon.com, Inc. (AMZN) are starting to build out physical stores or buy B&M retailers outright, because they see the value of the omnichannel.
I mentioned earlier that world-class enterprises tend to provide the products and/or services that people need every day.
And that evergreen source of demand leads to a lot of growing profit, which in turns leads to a lot of growing dividends.
That plays out exactly as you’d think here, since groceries are about as everyday a product as you could possibly think of.
Kroger has increased its dividend for 14 consecutive years.
The 10-year dividend growth rate is a heady 11.9%.
Check this out: the most recent dividend increase came in at almost 15%!
That double-digit dividend growth comes on top of an appealing yield of 2.56%.
This yield, by the way, isn’t just higher than the broader market; it’s almost 120 basis points higher than the stock’s own five-year average yield.
And with a payout ratio of only 31.4%, there’s still plenty of room for Kroger to continue handing out generous dividend increases for years to come.
A market beating yield that comes along with a double-digit dividend growth rate.
That’s music to any dividend growth investor’s ear.
But this looking at what’s already transpired.
We ultimately invest in where a company is going, not where it’s been.
I’ll now build out a forward-looking growth trajectory, using a combination of long-term data and a professional forecast for near-term profit growth.
This will help us to model a valuation and estimate the intrinsic value of the stock.
Kroger increased its revenue from $76.733 billion in FY 2009 to $121.162 billion in FY 2018.
That’s a compound annual growth rate of 5.21%.
I think that’s strong. I typically look for a mid-single-digit top-line growth rate from a mature company like this. Kroger delivered, even though they started this period off with a revenue base of over $75 billion in revenue.
Of course, the law of large numbers may start to catch up to them. The starting base – looking out over the next 10 years – is now over $120 billion. So it’ll be even more difficult for them to deliver this mid-single-digit top-line growth.
Meanwhile, earnings per share advanced from $1.72 to $2.11 over this period, which is a CAGR of 2.30%.
I used adjusted EPS for FY 2009, which factors out a one-time impairment charge that inaccurately skews the growth rate.
Likewise, I used adjusted EPS for FY 2018, which factors out a one-time gain (during Q1) from the sale of the company’s convenience store business.
A bit of a mixed bag here.
Admittedly, it’s tough to get a good handle on exactly what kind of bottom-line growth the company is producing. That’s partly because both the beginning and ending fiscal years had massive impacts to GAAP EPS.
Notably, EPS growth is being aided by substantial buybacks. The outstanding share count is down by ~37% over the last decade. This is one of the largest repurchase programs I’ve come across.
Looking forward, CFRA forecasts that Kroger will compound its EPS at an annual rate of 1% over the next three years.
In my view, that’s awfully conservative.
Kroger is guiding for an adjusted EPS midpoint of $2.20 for FY 2019. That would represent 4.3% YOY growth in adjusted EPS.
And I honestly think these numbers are pretty unflattering. Said another way, Kroger would appear to be a better business than some of these adjusted numbers are showing.
There’s a lot to be optimistic about.
First, there’s the Restock Kroger program. This is the company’s three-year transformation plan, focusing on business model evolution and cost savings.
2018 was the first year of this program. Kroger reported over $1 billion in savings through cost controls and process improvements.
In addition, they’re aggressively pursuing the omnichannel strategy.
Digital sales grew 58% last fiscal year. That’s remarkable for a traditional B&M grocer. The annual run rate for digital sales was ~$5 billion at the end of 2018, which implies a long growth runway.
Also helping them push into the 21st century is their Simple Truth in-house brand. The company recently announced a brand extension in Simple Truth Plant Based. This brand extension will offer 100% plant-based burgers and other plant-based foods.
In my view, CFRA’s three-year projection is much too pessimistic.
But even absent significant bottom-line growth, the dividend can continue to grow at a healthy pace for years to come. That’s because the payout ratio is so low.
Unless the business model were to start to somehow implode, which I don’t see any evidence of transpiring, the company has the financial wherewithal to hand out generous dividends for the foreseeable future.
Moving over to the balance sheet, the company is in a good financial position. Although, I do see room for improvement.
The long-term debt/equity ratio, at 1.53, is high.
However, that’s largely because the aforementioned share buybacks have loaded up the balance sheet with treasury stock. That artificially reduces common equity.
The interest coverage ratio is over 4.
I typically like to see an interest coverage ratio over 5. But anything over 2 indicates no problems with covering interest expenses.
I wouldn’t say the balance sheet is in any way stellar. It’s not a fortress. But the company is not in any kind of financial dire straits here.
Profitability is as expected for the industry. That is to say, margins are thin. The grocery business is very competitive and relies on scale.
Over the last five years, the company has averaged annual net margin of 1.84% and annual return on equity of 32.60%.
Overall, I see Kroger as operating a quality business that is making some excellent moves to secure its future in an ever-changing retail landscape.
But there are risks to consider.
Competition, litigation, and regulation are omnipresent risks in every industry.
Kroger will have to continue to invest in the business to offer the omnichannel experience customers are demanding. The cost savings initiative will help to aid this, but the balance sheet offers limited flexibility.
The company’s scale works against them almost as much as it works for them. That’s because the revenue base is so large, it’ll be difficult to meaningfully move the needle.
Also, the very nature of the business model gives very little breathing room in regard to margins. Kroger has to adeptly navigate a tight window as they transform themselves.
At the right valuation, I think this could be a very appealing long-term dividend growth investment.
Well, the stock does look attractively valued right now…
The stock’s P/E ratio is sitting at 12.37.
That’s markedly below the broader market.
It’s also noticeably lower than the stock’s own five-year average P/E ratio of 15.6.
Furthermore, the P/CF ratio is 4.8. That compares very favorably to the stock’s three-year average P/CF ratio of 6.6.
And the yield, as noted earlier, is considerably higher than its recent historical average.
So the stock does look cheap. But how cheap might it be? What would a reasonable estimate of intrinsic value look like?
I factored in a 10% discount rate.
And I assumed a long-term dividend growth rate of 7.5%.
That growth rate is much lower than the company’s 10-year dividend growth rate.
It’s also much lower than the most recent dividend increase.
But I think caution is warranted here, even in the face of a very low payout ratio.
That’s because the company is in the midst of a huge transformation.
Furthermore, the 10-year EPS growth picture is muddied due to adjustments.
A 7.5% dividend growth rate isn’t a terribly high hurdle for the company to clear, though. And I think there’s a good possibility that Kroger could do much better than this, especially over the next 5-10 years.
The DDM analysis gives me a fair value of $27.52.
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 with a pretty cautious valuation model, the stock still looks cheap.
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 KR as a 4-star stock, with a fair value estimate of $27.50.
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 KR as a 4-star “BUY”, with a 12-month target price of $29.00.
I came within pennies of where Morningstar landed. Averaging out the three numbers gives us a final valuation of $28.01, which would indicate the stock is possibly 12% undervalued.
Bottom line: Kroger Co. (KR) is a quality company that’s doing what it takes to thrive in a changing environment. With 14 consecutive years of dividend raises, a double-digit long-term dividend growth rate, an extremely low payout ratio, a market-beating yield, and the potential that shares are 12% undervalued, dividend growth investors should think about picking up this stock while it’s on sale.
Note from DTA: How safe is KR’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 71. 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, KR’s dividend appears Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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