Legendary investor Peter Lynch always recommended investors to take a look around.
Great investment ideas are everywhere.
One doesn’t need to be an investment banker working on Wall Street to spot trends.
In fact, those living on Main Street have a better idea of what everyday people are doing.
The day-to-day habits of consumers can provide a ton of valuable insight.
We just need to stop for a moment, take a look at what everyone is doing, and then think to ourselves how we can profit from all of this.
I’ve personally performed this exercise many times.
And it helped me go from below broke at 27 years old to financially free and retired at 33, as I lay out in my Early Retirement Blueprint.
I now control the FIRE Fund, which is my real-money stock portfolio.
It generates the five-figure passive dividend income I live off of.
The Fund is chock-full of world-class enterprises that are profiting from the daily habits of consumers all over the world.
And I profit, too.
These companies are sending me a good chunk of their growing profit, via growing dividends. And as they produce more profit, the value of the businesses go up – increasing the value of my holdings in the process.
See, a quality business produces more profit year in and year out. And shareholders should expect their fair share of that growing profit.
That’s where dividend growth investing comes in.
You can find hundreds of dividend growth stocks by perusing the Dividend Champions, Contenders, and Challengers list.
Of course, one doesn’t blindly buy stock off of that list – or any list, for that matter.
An intelligent investor analyzes a business for its fundamentals, competitive advantages, and risks.
And valuation must be taken into account before investing.
While price is what a stock costs, value is what it’s worth.
Buying when there’s a beneficial disconnect between the two can be hugely advantageous.
An undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and reduced risk.
That’s relative to what the same stock might otherwise offer if it were fairly valued or overvalued.
All else equal, because price and yield are inversely correlated, a lower price results in a higher yield.
This higher yield leads to greater long-term total return potential.
Total return is, after all, the sum of investment income and capital gain.
Boosting yield gives you more potential investment income.
Capital gain gets a potential boost, too, via the “upside” between a lower price and higher intrinsic value.
These favorable dynamics also reduce risk.
Undervaluation introduces a margin of safety.
That’s a “buffer” that protects the investors downside against unforeseen issues.
An undervalued high-quality dividend growth stock can be a tremendous long-term investment.
Fortunately, finding these stocks isn’t terribly difficult.
Fellow contributor Dave Van Knapp has made that easier than ever.
His Lesson 11: Valuation, part of a series of “lessons” on DGI, explains exactly how to go about 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…
Starbucks Corporation (SBUX)
Starbucks Corporation (SBUX) is the world’s leading retailer of high-quality, specialty coffee products. These products are sold in 31,000 stores across 80 different markets, in addition to multi-channel retail.
Company-owned stores accounted for approximately 81% of FY 2019 revenue, while licensed stores accounted for approximately 11% of FY 2019 revenue. The remainder was made up of Other sales.
The company splits its revenue across two primary geographical segments: Americas, ~69% of FY 2019 revenue; and International, ~23%. Channel Development (retail CPG) and Corporate and Other accounted for the remainder of revenue.
I mentioned a simple but effective exercise earlier.
Take a look around you.
Do you see all of those people sitting in coffee shops, buying coffee through the drive-thru, and ordering coffee for delivery?
Of course you see this happening. It’s staring right at you. You can’t miss it.
Well, you can’t miss profiting from it, too.
Unless you avoid another thing staring at you right in the face.
I’m talking about Starbucks stock.
Now, I can’t tell you if the stock will go up or down in price tomorrow.
But I can tell you that Starbucks is paying their shareholders a healthy, rising dividend.
The growing dividend is ultimately funded by all of that consumer behavior. And this cash dividend is coming your way regardless of what the stock market is doing.
The company has increased their dividend for 10 consecutive years.
Not the lengthiest track record around. But they’re just getting started.
The five-year dividend growth rate is 24.3%, so the company makes up in growth what they lack in length.
And with a very moderate payout ratio of 56.2%, Starbucks has plenty of room to continue paying and growing their dividend.
That payout ratio, by the way, comes after the company just announced a 13.9% dividend increase.
As EPS grows over the next year, I expect this payout ratio to dip a bit.
The only dividend metric to maybe not like is the yield.
Yielding 1.95%, the stock is not a high-yield stock. That is clear.
It’s instead one of the highest-quality dividend growth stocks you can possibly find.
Investors can get a higher yield elsewhere. But you might be sacrificing quality in the process. This stock is not skimping on quality.
I do have some good news about the yield, though.
It does slightly beat the market.
It’s also higher than what you typically get from this stock.
The five-year average yield on Starbucks stock is only 1.6%, so we’re now almost 40 basis points higher than that.
I think that favorable situation has been setup by a combination of a significant drop in the stock’s price (down from almost $100 in July) and the very recent dividend increase.
Of course, a lot of this is backward-looking information.
What ultimately matters most to dividend growth investors is where the dividend is going, not where it’s been.
We buy stock today for tomorrow’s dividends.
So I’m now going to build out a forward-looking growth trajectory, relying on a mixture of long-term proven growth and a professional future forecast of EPS growth.
Let’s look at some numbers.
Starbucks increased its revenue from $10.707 billion in FY 2010 to $26.508 billion in FY 2019.
That’s a compound annual growth rate of 10.60%.
I usually look for a mid-single-digit top-line growth rate from a fairly mature business such as this one.
They obviously knocked it out of the park; however, I think the larger revenue base in FY 2019 makes top-line growth more challenging moving forward.
The company grew its earnings per share from $0.62 to $2.92 over this same period, which is a CAGR of 18.79%.
Highly, highly impressive.
The excess bottom-line growth appears to be mostly due to margin expansion. The margin expansion story is pretty incredible, although I think the potential for more expansion moving forward is more limited relative to where things were a decade ago.
Comps are also notable. Global comparable store sales were up 5% for FY 2019 – during a year in which they opened almost 2,000 new stores!
Consumers have not yet had their fill of Starbucks coffee. Not even close.
Looking forward, CFRA is predicting that Starbucks will compound its EPS at an annual rate of 14% over the next three years.
This would be a drop from what the company produced over the last decade. But I think it’s a reasonable assumption, as the starting profit base is much higher and the store count has grown so much.
CFRA believes that continued strong revenue growth should be aided by cost savings and improvements in efficiency, leading to big bottom-line gains.
The China market in particular is a bright spot for Starbucks.
Starbucks is one of the rare US companies to achieve big success in China. They acquired the remaining shares of East China Joint Venture in July 2017, allowing the company to operate all Starbucks stores in mainland China.
That’s obviously a massive market. China has almost 1.4 billion people. And they love coffee.
Starbucks is anticipating the bulk of new store openings in FY 2010 to occur in the International segment, with much of that being focused on China (where they’re anticipating mid-teens growth).
And they’re adapting to local trends, especially in regard to digital and delivery.
In July of this year, the company opened its first Starbucks Now store in Beijing. It’s an express store format that integrates mobile ordering and delivery seamlessly.
There’s also the global retail story playing out in the company’s Channel Development segment.
This was bolstered by a $7.15 billion licensing deal that saw Nestle SA (NSRGY) pay Starbucks for the right to exclusively sell the chain’s packaged coffees and teas around the world. Starbucks now has Nestle’s distribution might working for them.
Moreover, Starbucks has demographics on its side.
Young people are preferring to spend money on experiences instead of products.
Starbucks offers both. You get the high-quality coffee product, and the stores offer a rich environment in which to consume it.
Starbucks has positioned itself incredibly well to capture a major chunk of a global megatrend in rising coffee consumption and a preference for experiences.
If the 14% EPS CAGR holds anywhere near true, investors should expect the company to deliver double-digit dividend growth for the foreseeable future.
Moving over to the balance sheet, the long-term debt/equity ratio is N/A due to negative common equity.
However, an interest coverage ratio of over 14 indicates no issues whatsoever with leverage or the ability to cover its interest expenses.
The one thing about the balance sheet I will note is the fact that it has deteriorated in recent years.
This is a common phenomenen across corporate America. A lot of major companies have taken on cheap debt to fuel a number of activities. Starbucks is no different here, but I would like to see them start to take it easy here.
Profitability is definitely a strong suit. Starbucks has long been a very profitable enterprise, but they’ve gone from good to great in this department.
Over the last five years, the firm has averaged annual net margin of 14.27% and annual return on equity of 65.54%.
ROE has been juiced by low (now negative) common equity; however, they’ve done a fantastic job on margin expansion.
Net margin was under 10% a decade ago. We’re talking a big move up here.
Overall, there’s so much to like about Starbucks.
It’s one of the most recognized brands on the planet, offering a unique combination of product and experience that appeals to a global audience.
This brand is a huge competitive advantage. Unrivaled scale is another advantage.
They’ve been successful in a perplexing Chinese market, adeptly adapted to changing trends, and differentiated their value proposition in the marketplace.
And dividend growth investors are set up very nicely for strong dividend raises for years to come.
Of course, there are risks to consider.
Competition, regulation, and litigation are omnipresent risks in every industry.
Input costs (like coffee beans) can wildly fluctuate. In this regard, there’s current pressure to raise wages in the US.
Any kind of global economic slowdown could reduce demand for coffee, which is a discretionary product.
Also, the company’s size could start to work against them due to the law of large numbers.
At the right valuation, though, this could be a fantastic long-term investment.
Down more than 15% from its 52-week high reached earlier this year, the stock looks attractively valued now…
The P/E ratio is 28.74, which is admittedly a heavy number.
But it compares favorably to earnings multiples this stock has often commanded in recent years. That multiple was over 30 less than six months ago.
And I’d argue this high-quality company has earned itself a premium valuation in this market.
Its P/S ratio, at 3.9, is in line with its own five-year average. That’s against the backdrop of a broader market that has relentlessly risen.
Furthermore, the stock’s yield, as shown earlier, is materially higher than its own 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 valued shares using a dividend discount model analysis.
That DGR looks awfully conservative against the long-term dividend and earnings growth rates, respectively.
It’s also much lower than the CFRA forecast for EPS growth looking out over the next three years.
With the payout ratio being where it’s at, I wouldn’t be surprised to see Starbucks continue to hand out low-double-digit dividend raises (on par with the most recent increase) for the foreseeable future.
However, I do believe a flattening out of that dividend growth rate is going to occur sooner rather than later.
But 8% dividend growth as a long-term target is certainly nothing to sneeze at.
The DDM analysis gives me a fair value of $88.56.
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.
It looks to me like a high-quality stock available for a modest discount, which is very nice in this market.
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 SBUX as a 3-star stock, with a fair value estimate of $90.00.
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 $90.00.
We have a pretty tight consensus here. Averaging out the three numbers gives us a final valuation of $89.52, which would indicate the stock is possibly 7% undervalued.
Bottom line: Starbucks Corporation (SBUX) is one of the highest-quality companies in the entire world, with a beloved brand that’s recognized across the planet. The company has brewed up something special and is firing on all cylinders. And a big pullback from its summer highs has made the stock attractive once again. With a market-beating yield, moderate payout ratio, double-digit long-term dividend growth rate, 10 consecutive years of dividend raises, and the potential that shares are 7% undervalued, investors have a rare opportunity to scoop up shares in a world-class enterprise at a discount.
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 67. 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 with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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