This article first appeared on Dividends & Income

The stock market is just like any other market.

It’s a store.

A store filled with merchandise.

Some of that merchandise is cheap, while other merchandise is expensive.

It’s our duty as investors to “treasure hunt” for deals. 

Just the same as wasting money on clothes or food is a bad idea, it’s never good for investors to pay too much for stock.

At the same time, you have to maintain a certain quality standard.

That’s why I’m an ardent supporter of the dividend growth investing strategy.

This strategy advocates buying and holding shares in world-class enterprises that pay reliable and rising cash dividends.

You buy these shares at attractive valuations, reinvest your growing dividends, and watch the wealth and passive income pile up.

The Dividend Champions, Contenders, and Challengers list contains invaluable data on hundreds of dividend growth stocks.

I used this strategy to go from below broke at age 27 to financially free at 33.

I lay out in my Early Retirement Blueprint exactly how I did that.

My six-figure dividend growth stock portfolio, which I call the FIRE Fund, generates enough five-figure passive dividend income for me to live off of.

This portfolio was built by focusing on both quality and value.

The latter aspect can have a major impact on the success of your investments.

Price tells you what you pay. Value tells you what you get.

An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk. 

Jason Fieber's Dividend Growth PortfolioThis 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.

Treasure hunting for quality merchandise in the stock market can yield tremendous results over the long term.

Fortunately, this endeavor is easier than ever.

Fellow contributor Dave Van Knapp’s Lesson 11: Valuation is one reason why.

Part of an overarching series of “lessons” on dividend growth investing, Lesson 11 teaches the importance and application of valuation in a very easy-to-understand way.

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…

Walgreens Boots Alliance, Inc. (WBA)

Walgreens Boots Alliance, Inc. (WBA) is one of the world’s largest pharmacies, with more than 18,000 stores across the world.

Founded in 1901, this is now a $32 billion (by market cap) pharmacy giant that directly employs more than 275,000 people.

Some of their major brands include Walgreens, Duane Reade, Boots, and Alliance Healthcare.

The company’s revenue is split across three reportable segments: Retail Pharmacy USA, 75% of FY 2019 sales; Pharmaceutical Wholesale, 16%; and Retail Pharmacy International, 9%.

Walgreens is primarily a retail pharmacy operator. And the retail pharmacy business is largely a US-based one.

Their 2018 acquisition of nearly 2,000 Rite Aid Corporation (RAD) stores for ~$4.2 billion doubles down on that strategy.

However, the company also owns approximately 26% of AmerisourceBergen Corp. (ABC).

This equity ownership in AmerisourceBergen exposes Walgreens to pharmaceutical distribution, as AmerisourceBergen is one of the largest wholesale drug companies in the US.

Their big bet on the US retail pharmacy business is a double-edged sword.

On one hand, they’re a leader in the largest economy in the world. And with Americans getting older, the need for pharmaceutical products is sure to rise. Aging wealthy people will pay to access quality medicine.

A world that’s growing bigger, older, and richer means demand for and access to quality medical care is only going to rise.

On the other hand, the US is a mature market. And the rise of e-commerce makes the thin-margin retail business even more competitive, while also allowing for the shipment of pharmaceuticals. The pandemic isn’t helping, either.

Still, Walgreens has scale where scale matters.

They’re an integral link in the complex supply chain that makes up the US healthcare system, and that bodes well for their ability to grow their profit and dividend.

Dividend Growth, Growth Rate, Payout Ratio and Yield

The company has already increased its dividend for 45 consecutive years.

That’s getting near Dividend King status, which would be 50 or more consecutive years of dividend raises.

Basically, it’s dividend royalty.

However, while the 10-year dividend growth rate of 13.6% looks fantastic, recent dividend raises have been anemic.

And that’s because business growth has been anemic of late.

On the other hand, the payout ratio of 39.5% (against TTM adjusted EPS) indicates no issue with the dividend’s sustainability.

Indeed, Walgreens notably increased the dividend by 2.2% back in July – during a pandemic.

This growth comes on top of the stock’s mouth-watering yield of 5.0%.

That yield, by the way, is 280 basis points higher than the stock’s five-year average yield.

Revenue and Earnings Growth

A lot to like about the dividend in terms of the yield and growth track record.

But it’s ultimately those future dividend raises we care about.

Today’s investors are putting capital at risk for tomorrow’s rewards.

And it’s that future growth that determines what we should pay for the stock.

I’ll now build out a forward-looking growth trajectory for Walgreens.

This trajectory will partially rely on 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 draw a conclusion about where the business might be going, which will in turn help us to estimate intrinsic value.

Walgreens increased its revenue from $72.184 billion in FY 2011 to $139.537 billion in FY 2020.

That’s a compound annual growth rate of 7.60%.

This looks great at first glance.

However, much of this came from a big bump in revenue in FY 2015, following the merger between Walgreens and Alliance Boots.

Meanwhile, earnings per share advanced from $2.94 to (adjusted) $4.74 over this period, which is a CAGR of 5.45%.

This is a more accurate picture of what kind of growth this firm has put out over the last decade.

It’s a solid number. Not outstanding. But pretty good.

Now, I used adjusted EPS for FY 2020. The pandemic and some other issues caused a very messy GAAP EPS picture for the last fiscal year. I think the adjusted number captures a fairly accurate picture of profit, as it’s similar to where FCF is at.

Looking forward, CFRA is forecasting that Walgreens will compound its EPS at an annual rate of -6% over the next three years.

They see headwinds exceeding tailwinds over the next few years.

This primarily relates to the pandemic negatively impacting the business in a variety of ways, including less foot traffic, tightening margins, higher costs, and a weaker cold/flu season.

I don’t disagree with CFRA’s take on the near term.

But it’s important to balance this against both the long-term picture and the valuation – this near-term fragility doesn’t exist in a vacuum.

I think the business is still positioned nicely for the long term. Demographic trends work to their favor, even if the near term looks ugly.

Furthermore, the valuation already prices in terrible performance.

In fact, the valuation prices in terrible performance in perpetuity.

Unless the business totally collapses, which appears unlikely, the low valuation and high yield presents a compelling long-term opportunity.

Financial Position

Moving over to the balance sheet, the company maintains a good financial position.

The long-term debt/equity ratio is 0.59.

There is no applicable interest coverage ratio for FY 2020 because of messy GAAP numbers, but this number came in at over 7 for FY 2019.

Profitability is as one would expect for a business model that counts on thin-margin retail.

Over the last five years (ex FY 2020), the firm has averaged annual net margin of 3.44% and annual return on equity of 15.71%.

To be honest, this isn’t the most attractive business model I’ve ever seen.

But the yield and valuation go a long way toward increasing my enthusiasm.

And with economies of scale, brand power, and its entrenched position in the complex US healthcare chain, there are competitive advantages in place.

Of course, there are risks to consider.

Regulation, competition, and litigation are omnipresent risks in every industry.

Competition is especially brutal – both in retail and on the pharmacy side. With rising risks and costs as it pertains to omnichannel sales (especially e-commerce), this is a concern.

The company’s scale works against them in some ways. It’s the law of large numbers at play. Their large size simply reduces the amount of future growth they can produce in percentage terms.

There’s also political risk, especially on the healthcare front. Any moves toward the nationalization of US healthcare, however unlikely, would impact this business model.

And with competitor CVS Health Corp. (CVS) moving toward a vertically integrated healthcare provider, Walgreen’s decision to double down on the core business model increases their exposure to structural changes in pharmacy retail.

With these risks known, I still think this stock warrants attention here.

It’s down 42% from its 52-week high and deeply into value territory now…

Stock Price Valuation

The stock’s P/E ratio (using adjusted EPS) is sitting at a lowly 7.89.

That’s well off of where the broader market is at. It’s actually one of the lowest P/E ratios I know of.

The P/S ratio of only 0.2 is less than 1/3 of its three-year average of 0.7.

Then there’s cash flow. The P/CF ratio of 6.0 is much lower than the stock’s three-year average P/CF ratio of 9.8.

And the yield, as noted earlier, is substantially higher than its own recent historical average.

So the stock looks cheap when looking at basic valuation metrics. But how cheap might it be? What would a rational estimate of intrinsic value look like?

I valued shares using a dividend discount model analysis.

I factored in a 9% discount rate and a long-term dividend growth rate of 4.5%.

This DGR is materially lower than what the stock has proven out over the last decade.

There’s also the low payout ratio and mid-single-digit long-term EPS growth to be optimistic about.

But with recent dividend raises being small, the pandemic still raging, structural business model concerns, and CFRA’s near-term EPS growth projection being so negative, I think it makes sense to err way on the side of caution in this case.

Walgreens doesn’t have to do much to grow the dividend at a 4.5% annual rate from here.

They basically just have to avoid a complete collapse in the business model. I’m modeling in very low expectations.

The DDM analysis gives me a fair value of $43.43.

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 this extremely conservative valuation, 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 WBA as a 4-star stock, with a fair value estimate of $42.00.

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 WBA as a 3-star “HOLD”, with a 12-month target price of $42.00.

We have a tight consensus here. Averaging the three numbers out gives us a final valuation of $42.48, which would indicate the stock is possibly 14% undervalued.

Bottom line: Walgreens Boots Alliance, Inc. (WBA) is a global business with scale where scale matters, and they’re set to benefit from demographic changes. With a market-smashing 5% yield, 45 consecutive years of dividend raises, a moderate payout ratio, strong dividend growth, and the potential that shares are 14% undervalued, this is a stock that should be on the radar for every dividend growth investor.

-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 WBA’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 79. 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, WBA’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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Source: Dividends and Income