How many truly exceptional businesses are there?

The number is arguable.

But what’s not arguable?

The fact that there are truly exceptional businesses out there.

And as an investor, it’s your job to fill your portfolio with as many of them as you can find.

That’s a job I’ve taken very seriously as I’ve gone about building my FIRE Fund.

Jason Fieber's Dividend Growth PortfolioThe Fund is my six-figure dividend growth stock portfolio.

It produces enough five-figure dividend income for me to live off.

I’ve filled the portfolio with high-quality dividend growth stocks.

That’s because dividend growth investing tends to focus an investor on those truly exceptional businesses.

After all, it takes a special kind of business to be able to consistently hand out ever-larger dividend payments to shareholders year after year, for decades on end.

You can see what I mean by checking out the Dividend Champions, Contenders, and Challengers list.

That list contains invaluable information on hundreds of US-listed dividend growth stocks.

Focusing on these stocks helped me to retire in my early 30s, as I share in my Early Retirement Blueprint.

But an investor’s job goes beyond just finding truly exceptional businesses.

There’s also the important matter of valuation.

Price only 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. 

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.

Investing in truly exceptional businesses, and doing so at advantageous valuations, will serve you very well over the long run.

Fortunately, discerning whether or not a valuation is advantageous isn’t a difficult task.

Fellow contributor Dave Van Knapp, with his Lesson 11: Valuation, has made that process much easier.

That lesson is part of an overarching series of “lessons” on dividend growth investing, and it lays out a fantastic valuation model that you can apply to almost any dividend growth stock.

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…

Home Depot Inc. (HD)

Home Depot Inc. (HD) is the world’s largest home improvement retailer.

Founded in 1978, the company is now a $278 billion (by market cap) retailing juggernaut that employs 500,000 people.

They operate nearly 2,300 stores across the US, Canada, and Mexico. More than 90% of net sales occur in the US.

The typical store averages 105,000 square feet and offers more than 35,000 products. Their e-commerce channel offers one million products.

A huge trend has been playing out for about a year now in the US.

People have been moving out of smaller, urban apartments in favor of larger, suburban homes.

Undoubtedly, the pandemic and related lockdowns caused this trend to explode.

Large cities like NYC effectively being abruptly and indefinitely shut down lit a fire under people and strongly motivated them to move on.

But I’d argue there was already plenty of kindling there before the pandemic.

Many people aging out of apartments had put off homebuying for economic reasons.

To that point, low interest rates only served to add more fuel to the fire. Cheap money has made the purchasing of a house more affordable and enticing.

All of this plays right into the hands of Home Depot.

As the world’s largest home improvement retailer, they will directly benefit from more homeownership.

After all, all of those houses have to be maintained and repaired over time. And that’s before getting into improvement projects.

All of this will almost certainly translate into more sales, higher profits, and bigger dividends.

Dividend Growth, Growth Rate, Payout Ratio and Yield

As it sits, Home Depot has increased its dividend for 12 consecutive years.

In fact, they just announced a 10% dividend increase near the end of February.

While that’s not nearly as high as their 10-year dividend growth rate of 20.0%, a lot of that prior growth was coming off of a near-zero payout.

But with a payout ratio of 55.3%, even after all of that massive dividend growth, the dividend remains highly secure.

And you’re getting this continued double-digit dividend growth on top of the stock’s market-beating yield of 2.56%.

This yield, by the way, is more than 30 basis points higher than the stock’s own five-year average yield.

I consider the “sweet spot” for a dividend growth stock to be a yield of between 2.5% and 3.5%, paired with high-single digit (or better) dividend growth.

This stock is right there.

Revenue and Earnings Growth

As great as these dividend metrics are, though, they are looking at what was.

However, investors are risking today’s capital for tomorrow’s reward.

It’s those future dividends we care most about.

As such, I’ll now built out a forward-looking growth trajectory for the business, which I’ll later use to estimate the intrinsic value of the stock.

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

I’ll then 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 come to a reasonable conclusion about where the company is going.

Home Depot increased its revenue from $70.395 billion in FY 2011 to $132.110 billion in FY 2020.

That’s a compound annual growth rate of 7.25%.

I usually look for a mid-single-digit top-line growth rate from a mature business like this, but Home Depot knocked it out of the park. This growth is especially impressive when you see that they started this prior decade from a rather large sales base.

Meanwhile, earnings per share grew from $2.47 to $11.94 over this period, which is a CAGR of 19.13%.

Truly exceptional.

A combination of margin expansion and buybacks greatly aided the bottom-line growth rate.

For perspective, the outstanding share count is down by about 30% over the last decade, which is a significant reduction.

Looking forward, CFRA believes that Home Depot will compound its EPS at an annual rate of 7% over the next three years.

In my opinion, CFRA is being reasonable here.

Contrasting that 7% number with the 19% EPS growth rate that Home Depot has delivered over the last decade might look alarming at first glance.

However, there’s been a recent explosion in growth from the aforementioned pandemic-related trend that cannot persist forever. For instance, their mind-boggling 24.5% comp sales increase for Q4 2020 is just not something investors should expect to continue.

Put simply, the company’s growth will start to normalize over the coming quarters.

That said, I do think Home Depot is seeing long-term, secular tailwinds take shape.

Homes have been purchased, moves have been executed, and customers have been made. Even after the pandemic subsides, all of that can’t suddenly be undone. Their market has expanded.

And further government stimulus gives consumers – many of them new homeowners – more purchasing power.

In addition, Home Depot strengthened its business model for the long haul by acquiring HD Supply Holdings, Inc. for $8 billion in 2020, giving the company a strategic fit in the MRO marketplace and more exposure to the professional side of the business.

With a moderate payout ratio and a high-single-digit EPS growth rate, Home Depot should be able to easily hand out (at least) high-single-digit dividend raises for years to come.

Financial Position

Moving over to the balance sheet, the company has a rock-solid financial position.

The long-term debt/equity ratio looks very high, at 10.86.

But that’s only so high because of low common equity, which in and of itself is so low only because of a high amount of treasury stock (related to those big buybacks).

On the other hand, the interest coverage ratio of over 13 indicates no issues whatsoever with leverage or its debt servicing.

Profitability is extremely robust.

Over the last five years, the firm has averaged annual net margin of 9.19%. ROE is N/A because of frequent negative equity.

Their net margin is extraordinary compared to the competition and retail in general. Retailers usually sport razor-thin margins.

In my view, Home Depot is a wonderful business. Quality is very high across the board.

And with huge scale, pricing power, brand strength, the specialization of their products, and a unique workforce that guides consumer purchases, there are durable competitive advantages in place.

Of course, there are risks to consider.

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

Retailing is one of the most competitive business models out there, limiting margins.

Any major changes in the way consumers spend money can affect the business. Of particular near-term concern is pent-up demand for services and the coming flow away from home improvement spending.

Most of the company’s stores are located in the United States. This greatly exposes them to only one market.

A red-hot US real estate market could correct, which would likely negatively impact the demand for general spending on homes.

I see these risks as minimal relative to the potential of the business over the long run.

And that potential is exacerbated by the valuation.

With the stock 12% off of its 52-week high in the best environment the business has ever seen, I think the stock is attractively valued…

Stock Price Valuation

The stock’s P/E ratio is 21.56.

That’s reasonable when you compare it to a much higher earnings multiple on the S&P 500.

It’s also off of the stock’s own five-year average P/E ratio of 22.9.

There’s also cash flow to look at.

The P/CF ratio of 14.7 is quite a bit lower than its own three-year average of 17.7.

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

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 at the upper end of what I allow for in a DDM analysis, but Home Depot’s fundamentals and quality warrant it. Especially in their advantageous situation.

This rate is lower than the company’s demonstrated long-term EPS growth rate and long-term dividend growth rate.

And I’ll point out that the most recent dividend increase came in at 10%.

With the moderate payout ratio and underlying business growth, I fully believe this company will meet or exceed my expectations.

The DDM analysis gives me a fair value of $356.40.

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.

I don’t see my valuation model as overly aggressive, yet 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 HD as a 2-star stock, with a fair value estimate of $216.00.

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 HD as a 4-star “BUY”, with a 12-month target price of $300.00.

I came out on the high end, but Morningstar’s valuation looks quite low. Averaging the three numbers out gives us a final valuation of $290.80, which would indicate the stock is possibly 13% undervalued.

Bottom line: Home Depot Inc. (HD) is a high-quality company across the board. And they’re positioned to take advantage of the current US housing trend. With a market-beating yield, double-digit dividend growth, a moderate payout ratio, more than a decade of consistent dividend growth, and the potential that shares are 13% undervalued, this is a very compelling long-term idea for dividend growth investors.

-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 HD’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 87. 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, HD’s dividend appears Very Safe with a unlikely risk of being cut. Learn more about Dividend Safety Scores here.

This article first appeared on Dividends & Income

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