How does an investor achieve spectacular results over the long term?

Well, I’d argue there are two main factors to consider.

What you buy.

And when you buy it.

It’s all about investing in great businesses at opportune moments.

When thinking about great businesses, my mind immediately races toward high-quality dividend growth stocks.

These stocks represent equity in world-class enterprises paying reliable, rising dividends.

They’re able to pay reliable, rising dividends because they’re producing the reliable, rising profits necessary to sustain those payments.

Of course, the reliable, rising profits only come about when a company is doing all the right things.

There are hundreds of these stocks listed on the Dividend Champions, Contenders, and Challengers list.

Jason Fieber's Dividend Growth PortfolioThat list contains invaluable data on US-listed stocks that have raised dividends each year for at least the last five consecutive years.

Simply put, these are some of the best stocks in the world because they’re shares in some of the best businesses in the world.

I’ve personally invested in these stocks myself, building the FIRE Fund in the process.

That’s my real-money dividend growth stock portfolio.

And it generates enough five-figure passive dividend income for me to live off of.

Indeed, investing in these stocks allowed me to retire in my early 30s – even after growing up on welfare and getting a late start.

My Early Retirement Blueprint shares exactly how I made that happen.

So that’s the what, but the when is the other important factor.

This comes down to valuation at the time of investment.

Price is only what you pay. It’s value that you actually 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 high-quality dividend growth stocks when they’re undervalued positions investors to achieve spectacular results over the long term.

Now, investing at a point of undervaluation requires an investor to be able to understand valuation in the first place.

Fortunately, this isn’t as difficult as you might think.

Fellow contributor Dave Van Knapp has made it even easier, via Lesson 11: Valuation.

Part of a larger, more comprehensive series of “lessons” on dividend growth investing, it lays out an easy-to-understand valuation process that can be used to value almost 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…

Best Buy Co., Inc. (BBY)

Best Buy Co., Inc. (BBY) is a North American consumer electronics and appliances retailer.

Founded in 1966, Best Buy is now a $25 billion (by market cap) retail giant that employs nearly 80,000 people.

The company operates over 1,100 stores across their North American footprint, most of which are in the United States.

Results are broken down across two business segments: Domestic, 92% of FY 2021 revenue; and International, 8%.

The company’s revenue mix has five major categories: Computing and Mobile Phones, 45% of Q3 FY 2022 revenue; Consumer Electronics, 30%; Appliances, 15%; Entertainment, 5%; and Services, 5%.

Best Buy has done something that a lot of people thought would be impossible.

They’ve survived – no, thrived – as a niche retailer in an environment where retailing is being gobbled up and commoditized by megaretailers hell-bent on market share at all costs.

With Best Buy being a legacy brick & mortar retailer in a digital world, they could have easily turned into a cautionary tale.

Instead, they turned into a success story.

Even more impressively, Best Buy has largely done this with products – consumer electronics – that are prime candidates for those aforementioned megaretailers to e-retail.

Best Buy has thrived by adopting an omnichannel retail approach, meeting the customer wherever they want to be.

Since the pandemic curtailed physical retail interactions over the last two years, this pivot proved to be critical. Digital accounted for slightly over 43% of sales in FY 2021 for Best Buy, compared to 19% of sales in FY 2020.

With the pivot out of the way, Best Buy can focus on being the best omnichannel retailer they can be.

And since consumer electronics are showing no signs of letting up in terms of demand, the company should be able to grow its revenue, profit, and dividend for years to come.

Dividend Growth, Growth Rate, Payout Ratio and Yield

Best Buy has already increased its dividend for 18 consecutive years.

The 10-year dividend growth rate is a very stout 15.8%.

Along with that double-digit dividend growth, the stock yields a market-beating 2.7%.

This yield, by the way, is 20 basis points higher than the stock’s own five-year average yield.

And the low payout ratio of only 27.1% easily covers the dividend.

Good yield, great dividend growth, and a low payout ratio.

The dividend checks the right boxes.

I like dividend growth stocks in what I refer to as the “sweet spot” – a yield of between 2.5% and 3.5%, paired with a high-single-digit (or better) dividend growth rate.

While the yield is on the low end of that sweet spot, the dividend growth more than makes up for it.

Revenue and Earnings Growth

As sweet as the dividend is, much of this is looking backward.

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

It’s future growth and future dividend raises that matter.

As such, I’ll now build out a forward-looking growth trajectory for the business, which will later help us to estimate the stock’s 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.

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

Lining up the proven past against a future forecast in this way should give us a pretty good idea as to where the business is going from here.

Best Buy saw its revenue decline slightly from $50.7 billion in FY 2012 to $47.3 billion in FY 2021.

This decline, though, is not a symptom of a struggling business.

In some ways, it’s actually the complete opposite.

Best Buy initiated a program they called “Renew Blue” in late 2012. It was designed to improve margins and comparable store sales.

This program resulted in a slate of changes, including the sale of non-core assets. A major sale was the Five Star business in China, which led to Best Buy completely exiting the Chinese market.

So sales in absolute terms did drop temporarily.

On the other hand, the program seems to have had the desired effect.

The first few years of the last decade are messy, largely because of the changes the business undertook.

However, if we look at the last five years, EPS raced higher – from $3.81 in FY 2017 to $6.84 in FY 2021.

That’s a compound annual growth rate of 15.8%.

Whereas comps came in at -1.7% for FY 2012, they were 9.7% for FY 2021. In addition, the company is guiding for between 10.5% and 11.5% in comps for FY 2022.

Plus, margins have noticeably expanded.

And this isn’t simply a pandemic story, either – the company had been showing strong momentum across all areas well before 2020.

Of course, only a retailer with a successful omnichannel strategy could have done so well over the last two years.

I think the numbers speak to that strategy and the company’s positioning.

Meantime, the company is a prolific repurchaser of its own shares.

The outstanding share count is down by nearly 30% over the last decade. And the company is guiding for $2.5 billion in share repurchases for FY 2022, which is ~10% of the company’s entire market cap.

Looking forward, CFRA is projecting that Best Buy will compound its EPS at an annual rate of 4% over the next three years.

This would be a marked drop from the company’s brisk pace of EPS growth over most of the last decade.

I believe that CFRA is taking a cautious stance here because it’s certainly possible that a lot of sales have been pulled forward from pandemic-induced restrictions and the rising work-from-home trend.

That would make recent results better than they should have been, which would then weaken future results.

The caution is, in my view, not a bad idea.

But even if this rather low EPS growth rate were to materialize over the next few years, the low payout ratio gives the company the ability to continue increasing the dividend at a high-single-digit rate.

And with a yield near 3%, that’s a compelling combination of yield and growth.

Financial Position

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

The long-term debt/equity ratio is 0.2, while the interest coverage ratio is over 117.

These numbers would be praiseworthy all by themselves.

However, Best Buy also has enough total cash on the balance sheet to pay off the long-term debt in one fell swoop.

Profitability is fairly robust for a retailer.

Over the last five years, the firm has averaged annual net margin of 3.4% and annual return on equity of 40.7%.

Speaking on the margin expansion I noted earlier, Best Buy was routinely printing net margin below 3% a decade ago.

Best Buy has made the difficult but necessary pivot into a successful omnichannel retailer, meeting the customer wherever they want to be.

This positions them well for the future.

And the company does benefit from durable competitive advantages that include economies of scale and brand recognition.

Of course, there are risks to consider.

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

Regulation and litigation aren’t as intense as what you see in many other industries, but retail is notoriously competitive.

Best Buy competes mostly on price. This will weigh on margins.

The company deserves kudos for thriving in a very difficult retail environment, but they’re unable to rest on their laurels. Best Buy will have to continue adapting and pivoting as retail evolves. There’s a risk that they find themselves unable to do this at some point.

There’s uncertainty regarding how much the pandemic has pulled forward sales, which could be a drag on future quarters.

Best Buy is largely dependent on sales of electronics that are often discretionary in nature. Any economic downturn would likely result in less demand for these discretionary purchases.

The last decade has seen noticeable improvement across the board for the company. There could be less opportunities for internal improvement in the future, which could lead to the last decade being somewhat anomalous in terms of growth.

Overall, even with these risks stated, Best Buy can make a lot of sense as a long-term investment for dividend growth investors.

With the valuation being so appealing after a 28% drop from its recent high, now could be a particularly advantageous time to buy the stock…

Stock Price Valuation

The P/E ratio is 10.0.

That’s less than half that of the broader market’s earnings multiple.

It’s also well off of the stock’s own five-year average P/E ratio of 15.5.

And the yield, as noted earlier, is 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 10% discount rate and a long-term dividend growth rate of 7.5%.

This dividend growth rate might look a bit aggressive at first glance, considering this is a retailer.

But this is quite a bit lower than the demonstrated 10-year dividend growth rate. The recent EPS growth rate is also much higher than this. Plus, the low payout ratio gives them a lot of cushion.

The near-term forecast for EPS growth is sobering, but that’s just a normalization. And even if CFRA’s number were a long-term projection, Best Buy could still grow the dividend at a high-single-digit rate for many years.

The DDM analysis gives me a fair value of $120.40.

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 analysis as being aggressive, yet the stock still looks undervalued.

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 BBY as a 3-star stock, with a fair value estimate of $116.00.

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 BBY as a 3-star “HOLD”, with a 12-month target price of $130.00.

I came in somewhere in the middle. Averaging the three numbers out gives us a final valuation of $122.13, which would indicate the stock is possibly 19% undervalued.

Bottom line: Best Buy Co., Inc. (BBY) is a great retailer that has successfully pivoted and thrived in one of the most difficult environments you could possibly imagine. With a market-beating yield, double-digit dividend growth, nearly 20 consecutive years of dividend increases, a low payout ratio, and the potential that shares are 19% undervalued, this looks like an under-the-radar gem for long-term dividend growth investors to consider for their portfolios.

-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 BBY’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 80. 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, BBY’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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