This article first appeared on Dividends & Income

Two big trends are playing out in the US right now.

There’s the “work-from-home” trend.

And there’s also the “flight to the suburbs”.

While these trends have some differences in terms of catalysts, both lead to the same end point.

That end point implies that we will see more people in the future living outside of expensive city centers.

Major studies have come out over the last decade or two concluding that our future society will be extremely urban in nature.

And recent demographic trends have been playing out exactly that way, with major cities seeing large influxes of people.

Yet we’re now seeing a sudden and rapid unwinding of all of that.

It’s anyone’s guess as to how sustainable this is over the long run, but investors must always be flexible and willing to adapt.

Moreover, it’s important to hedge your bets in a way that allows you to capitalize no matter what happens.

Jason Fieber's Dividend Growth PortfolioI’ve lived by this methodology as I’ve gone about building my FIRE Fund.

That’s my real-money stock portfolio.

It generates the five-figure passive dividend income that I live off of.

In fact, this portfolio allowed me to retire in my early 30s.

I lay out precisely how I retired so early in my Early Retirement Blueprint.

I’ve used dividend growth investing to amass a small fortune for myself at a very early age.

This investment strategy advocates investing in world-class enterprises that pay reliable and rising cash dividends to shareholders.

These growing dividends are funded by growing profit.

Generally speaking, only the best businesses in the world can afford to pay out large, growing dividends for years on end.

You can find a number of them on the Dividend Champions, Contenders, and Challengers list.

However, not all stocks on that list are great investments at all times.

An intelligent investor always does their homework on a business before putting capital to work.

That homework includes business analysis and valuation.

Valuation is particularly critical.

Whereas price is what you pay, it’s value that you get.

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.

Prospective investment income is boosted 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 quality company naturally 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 lessen a company’s fair value. It’s protection against the possible downside.

Buying a high-quality dividend growth stock when it’s undervalued, especially if it’s taking advantage of big trends, can lead to life-changing wealth and passive income.

Fortunately, the process of valuing a stock isn’t all that difficult.

Fellow contributor Dave Van Knapp has made that process even easier with the introduction of Lesson 11: Valuation.

One of his many “lessons” on dividend growth investing, Lesson 11 provides a valuation guide that can help you estimate intrinsic value on just about 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)

Williams-Sonoma, Inc. (WSM) is a nationwide multi-channel retailer of high-quality home products and furnishings.

Founded in 1956, Williams-Sonoma is now a $6.7 billion (by market cap) company that employs more than 19,000 people.

Their enviable brand portfolio includes Pottery Barn, West Elm, and the eponymous Williams-Sonoma.

The company reports results across two channel segments: E-commerce, 56% of FY 2020 sales; and Retail, 44%.

Roughly 94% of their sales occur in the US.

In order to thrive in today’s retail environment, you need two things.

First, you need a strong brand, or suite of strong brands, to differentiate yourself, maintain a loyal customer base, and protect margins.

Second, you need a coherent and complementary omnichannel strategy, where you take advantage of both e-commerce and physical retail to delight your customers.

Well, Williams-Sonoma excels at both.

They have coveted brands.

And they developed a very effective e-commerce channel in anticipation of a changing retail landscape, as evidenced by their split in sales across channels.

All of this puts them in a great position as the two big aforementioned trends play out in the US. If more people are moving to the suburbs and working from home, that means larger homes and more furnishings to fill those spaces.

This bodes well for increasing profit and dividends for Williams-Sonoma.

Dividend Growth, Growth Rate, Payout Ratio and Yield

As it sits, the company has increased its dividend for 14 consecutive years.

The 10-year dividend growth rate is 14.6%.

This double-digit dividend growth comes on top of the stock’s market-beating yield of 2.12%.

With a payout ratio of only 20.8%, the dividend is easily covered by earnings.

The only criticism here is the skipping of the normal dividend raise cycle back in March. That was when the pandemic was just starting to take hold.

I suspect the company will get back to dividend growth shortly.

And that leads us to where this company might be going, which is what ultimately matters to investors.

We put capital at risk today for tomorrow’s rewards.

Revenue and Earnings Growth

It’s future growth we’re after.

I’ll now put together a forward-looking growth trajectory for the business, which will later help us estimate intrinsic value.

I’ll first show you what the company has done over the last decade in terms of top-line and bottom-line growth.

Then I’ll compare that to a near-term professional prognostication for profit growth.

Blending the proven past with a future forecast in this manner should allow us to reasonably extrapolate out a growth path moving forward.

Williams-Sonoma increased its revenue from $3.504 billion in FY 2011 to $5.898 billion in FY 2010.

That’s a compound annual growth rate of 5.96%.

Strong. I usually like to see a mid-single-digit top-line growth rate from a business like this. They’re delivering.

Notably, there wasn’t a single year over the last decade in which the company didn’t grow its revenue YOY. There’s clearly secular growth here.

Meanwhile, earnings per share compounded from $1.83 to $4.49 over this period, which is a CAGR of 10.49%.

Very impressive.

Buybacks helped to propel much of this excess bottom-line growth; the outstanding share count is down by approximately 28% over the last decade.

Looking forward, CFRA believes Williams-Sonoma will compound its EPS at an annual rate of 9% over the next three years.

They cite the ongoing WFH dynamics, a digitally-led business model, the vertically-integrated supply chain, and favorable demographics as reasons to have a positive view.

Regarding that last point, while unemployment remains chronically high in the USA due to the shutdowns, the demographic that Williams-Sonoma targets has not been as impacted.

I actually think CFRA’s forecast is conservative.

There’s a lot of economic uncertainty at this moment. That is sure.

However, Williams-Sonoma could disproportionately benefit from WFH and urban flight.

Moreover, Williams-Sonoma has grown its EPS much faster than 9% over the last decade.

If CFRA’s 9% EPS growth projection is realized, the dividend is positioned to grow at least this fast, if not faster, due to the modest payout ratio. But we could be looking at a much better scenario here.

Financial Position

Moving over to the balance sheet, the company has a phenomenal financial position.

The balance sheet is a fortress with no long-term debt.

This gives the company more flexibility, and it also allows for more capital returns to shareholders.

Profitability is fairly robust for a retailer, bolstered by the value of their brands.

Over the last five years, the firm has averaged annual net margin of 5.81% and annual return on equity of 25.96%.

Overall, I think Williams-Sonoma is an underrated way to play two big trends playing out in the US.

Even before these trends arrived, this company was doing incredibly well.

Yet they’re in a position to do better.

With sought-after brands, a successful omnichannel strategy, scale, and vertical integration, the company does have competitive advantages.

Of course, there are risks to consider.

Litigation, regulation, and competition are omnipresent risks in every industry.

Regarding competition, the home furnishings industry is particularly competitive.

The lack of switching costs is also a risk.

The company has direct exposure to housing. If home sales fall, demand for luxury home furnishings will naturally decline.

And while they’ve moved faster than most of the competition in terms of their omnichannel strategy, there’s always the possibility of some erosion of this timing advantage.

With these risks known, I still think this looks like a great long-term investment.

But the stock has to be bought at the right price.

Well, I think the valuation here is actually pretty attractive…

Stock Price Valuation

The stock is trading hands for a P/E ratio of 17.37.

That’s much lower than the broader market.

It’s also slightly lower than the stock’s own five-year average P/E ratio.

Unlike some other stocks that feature low P/E ratios right now because their stock prices have collapsed, this is a different story.

The stock is up well over 200% from its 52-week low. On the other hand, earnings have also been strong. The FY 2021 Q2 report showed diluted EPS that doubled YOY.

The P/CF ratio of 8.3 is below its three-year average of 9.0.

And the yield, as noted earlier, is better than what the broader market is offering.

So the stock does look cheap based on basic valuation metrics. 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 8%.

That DGR is on the high end of what I normally allow for.

But I think this is a business that deserves it.

There’s no debt, the payout ratio is very low, the omnichannel strategy is about as good as it gets, the positioning is excellent, trends are working to their advantage, and there’s a high amount of brand value here.

The long-term EPS growth rate is much higher than what I’m accounting for here. As is the near-term EPS growth projection.

I think Williams-Sonoma can continue delivering.

The DDM analysis gives me a fair value of $103.68.

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 after the blistering run this stock has been on, it still looks undervalued to me.

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 3-star stock, with a fair value estimate of $81.00.

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 4-star “BUY”, with a 12-month target price of $115.00.

I came out roughly in the middle here. Averaging the three numbers out gives us a final valuation of $99.89, which would indicate the stock is possibly 10% undervalued.

Bottom line: Williams-Sonoma, Inc. (WSM) is a high-quality stock that’s perfectly positioned to disproportionately benefit from two major trends playing out in the US right now. They’ve solved a lot of problems that plague the competition, including the e-commerce paradigm shift. With a market-beating yield, double-digit long-term dividend growth, a very low payout ratio, and the potential that shares are 10% undervalued, this skyrocketing dividend growth stock still looks like a great long-term investment.

-Jason Fieber

P.S. If you’d like access to my entire six-figure dividend growth stock portfolio, as well as stock trades I make with my own money, I’ve made all of that available exclusively through Patreon

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 60. 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 Borderline Safe with a moderate risk of being cut. Learn more about Dividend Safety Scores here.

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Source: Dividends and Income