The global pandemic has been a terrible experience for most of the world.
Health costs, social costs, and economic costs have all been tremendous.
However, some businesses stumbled into a bonanza, seeing their profits – and their stocks – skyrocket.
But if you thought you missed out on the bonanza, think again.
Many “pandemic darlings” have fallen dramatically in recent months and are now back to pre-pandemic pricing.
This seems strange.
After all, benefits have surely accrued to these businesses.
And two years of growth must count for something.
Yet plenty of these stocks are back to early 2020 in terms of pricing.
It’s as if the last two years didn’t even happen for them.
Of course, this is advantageous for long-term investors who can see past the short-term volatility.
That’s especially true for investors using the dividend growth investing strategy.
This strategy espouses buying and holding shares in world-class enterprises that pay reliable, rising dividends to their shareholders.
Those reliable, rising dividends are, needless to say, funded by reliable, rising profits.
Can’t have the former without the latter.
Not for long, anyway.
The Dividend Champions, Contenders, and Challengers list contains invaluable data on more than 700 US-listed stocks that have raised dividends each year for at least the past five years.
Many of those are household names. And for good reason.
I’ve personally used this strategy for more than 10 years now, building my FIRE Fund in the process.
That’s my real-money portfolio, and it produces enough five-figure passive dividend income for me to live off of.
Indeed, I do live off of dividends.
Been doing it for years now.
In fact, I retired in my early 30s.
And my Early Retirement Blueprint details exactly how I was able to accomplish this.
If you’re spotting the incongruity of a two-year bonanza and 2020 pricing, you’re on to something very important.
It comes down to valuation.
Price is only what you pay. But 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 with today’s value at yesterday’s price, and doing this repeatedly, is nearly a surefire way to build outsized wealth and passive dividend income over time.
Now, this does require one to understand how valuation works.
The good news is, it’s not that difficult.
Fellow contributor Dave Van Knapp put together a series of “lessons” on dividend growth investing so as to instruct prospective investors on how to properly utilize the strategy.
His Lesson 11: Valuation specifically dissects valuation, greatly simplifying it.
One can use the information in this lesson to estimate the fair value of 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…
Domino’s Pizza, Inc. (DPZ)
Domino’s Pizza, Inc. (DPZ) is a multinational pizza restaurant chain.
Founded in 1960, Domino’s is now a $14 billion (by market cap) QSR giant that employs more than 10,000 people.
FY 2021 revenue can be broken down as follows: Supply chain, 59%; U.S. franchise royalties and fees, 12%; U.S. Company-owned stores, 11%; U.S. franchise advertising, 11%; and International franchise royalties and fees, 7%.
Domino’s is the largest pizza company in the world. The company has more than 18,000 stores located across 90 different markets. Approximately 1/3 of the global store base is located in the US. Almost all stores are franchised.
One of my investing heroes, Peter Lynch, advocated for keeping things simple and investing in what you know.
This is a classic example of that.
We all know pizza. Domino’s has an easy-to-understand business model.
But that doesn’t make it any less effective.
If anything, it’s the opposite.
Domino’s has been, and remains, wildly successful.
And the last two years, in particular, have been a bonanza for the business.
With pandemic-induced shutdowns causing people to do more from home, the popularity of pizza delivery has gone into overdrive.
As a result, Domino’s has seen its profits – and its stock – skyrocket higher.
But this “pandemic darling” has recently crashed back to earth.
The stock’s price is now back to where it was in February 2020 – before the pandemic gripped the world.
So it’s as if the benefits accrued to the business over the last two years count for nothing.
Now, the pandemic undoubtedly caused a temporary surge in business.
However, what separates Domino’s from a lot of other businesses in the same boat is that pizza sales can’t be “pulled forward”.
Once you eat the pizza you bought, it’s gone.
I’d argue the company’s foundational base is as strong as ever.
And that augurs well for revenue, profit, and the dividend to all continue heading higher for years to come.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Domino’s has already increased its dividend for 10 consecutive years.
What a start they’re off to.
The five-year dividend growth rate is a blistering 19.9%.
No signs of a major slowing, either: The most recent dividend increase came in at 17.0%.
Of course, the stock’s lowish yield of 1.1% basically requires a high rate of dividend growth in order to make sense of the numbers.
By the way, that yield is 30 basis points higher than its own five-year average.
And with a payout ratio of only 32.5%, the company has plenty of room for many more double-digit dividend raises.
Obviously, this is more of a compounder than an income play, making it highly suitable for younger investors who have the time to let that compounding process play out over the long term.
The yield is on the low side, but the dividend growth has been terrific.
Revenue and Earnings Growth
As terrific as it’s been, though, it’s in the past.
Investors have to risk today’s capital for tomorrow’s rewards.
It’s the future growth we care most about.
As such, I’ll now build out a forward-looking growth trajectory for the business, which will later be used to help estimate the stock’s fair value.
I’ll show you first what this company has done over the last decade in terms of top-line and bottom-line growth.
And then I’ll reveal a professional prognostication for near-term profit growth.
Combining the proven past with a future forecast should allow us to extrapolate in a way that tells us where the business might be headed from here.
Domino’s revenue has increased from $1.7 billion in FY 2012 to $4.4 billion in FY 2021.
That’s a compound annual growth rate of 11.1%.
Very, very strong top-line growth here.
Meanwhile, earnings per share moved up from $1.91 to $13.54 over this period, which is a CAGR of 24.3%.
Extremely impressive. This is breathtaking growth.
A combination of remarkable margin expansion and extensive share buybacks helped to drive a lot of excess bottom-line growth.
For perspective on the latter point, the company’s outstanding share count is down by 36% over this 10-year stretch.
Looking forward, CFRA is forecasting that Domino’s will compound its EPS at an annual rate of 12% over the next three years.
While it’s hard to imagine complaining about a 12% CAGR for EPS – that’s a growth rate many companies would love to have – it would represent a noteworthy slowdown relative to what’s occurred over the last decade.
I do think some moderation in growth is likely and should be expected.
I say that because the company did see a recent demand boost from pandemic-induced developments. Due to personal preferences or outright closures, many consumers avoided restaurants in favor of cooking at home and ordering delivery/takeout.
Some of this boost in demand is likely temporary. Many consumers are naturally excited to go to restaurants again. And so it’s not irrational to expect the company’s growth to moderate.
However, I see three important caveats to point out here.
First, you can’t “pull forward” pizza sales. Pizza isn’t the same as, say, a new couch.
Second, it seems quite plausible that the company will see a lasting benefit. Domino’s was handed a golden opportunity to meaningfully expand their customer base. I suspect there’ll be some “stickiness” to the new customer base.
Third, Domino’s sported excellent growth well before the pandemic hit. For the five-year period between FY 2012 and FY 2016, EPS had a CAGR of 22.5%.
There’s also the inflation issue. But I think some of this can actually play right into the company’s hands.
One, inflation being such a big story gives the company cover to raise its prices. Domino’s won’t stand out when everything is going up.
Two, higher grocery prices can end up making takeout/delivery pizza look more attractive as an alternative. When prices go way up, consumers sometimes trade down. If it’s cheaper and/or easier to just order pizza for dinner, plenty of people will choose the path of least resistance.
Even if the company does only manage 12% annual EPS growth over the next three years, which would still be great by most measures, the low payout ratio positions the dividend to grow even faster.
Suffice it to say, double-digit annual dividend growth is almost certainly here to stay for some time to come.
And so the company’s stock, which is up nearly 1,000% over the last 10 years, should remain a remarkable compounder for years to come.
Financial Position
Moving over to the balance sheet, the company’s financial position is good but could be improved.
Negative common equity means there is no long-term debt/equity ratio. But long-term debt of nearly $5 billion for a company with a market cap of $14 billion shows a somewhat high degree of indebtedness. The interest coverage ratio is also uncomfortably low, at slightly over 4.
I view the balance sheet as the weakest part of the business. However, they maintain an asset-light business model with a high percentage of franchised stores.
Profitability is robust.
Over the last five years, the firm has averaged annual net margin of 10.8%. ROE is not applicable.
Margin expansion has been a nice story. Domino’s was regularly printing single-digit net margin at the start of the last decade.
Overall, Domino’s offers long-term investors a very simple business model that’s growing at a very high rate.
It’s a timeless food staple with a high degree of sales repeatability and predictability.
I see almost nothing to dislike about it.
And the company does benefit from durable competitive advantages that include economies of scale, brand power, and a global franchise footprint.
Of course, there are risks to consider.
Competition, regulation, and litigation are omnipresent risks in every industry.
I see regulation and litigation risks as being relatively low for Domino’s. On the flip side, they operate in a fiercely competitive industry.
The somewhat heavy debt load is a concern.
It’s difficult to accurately predict how a high rate of inflation will impact Domino’s. They’re positioned well in the marketplace. But wage inflation could weigh on future growth.
The company has been facing labor shortages, especially around drivers.
Domino’s has a global footprint that works to its advantage. Their “fortressing” strategy creates a smaller service radius, shorter delivery times, and lower costs per delivery. However, the bigger the footprint gets in absolute terms, the harder it gets to grow in relative terms.
These risks are worth pondering, but I still think this is a compelling long-term investment candidate for dividend growth investors.
And the stock’s 30% drop from its 52-week high, which has produced an appealing valuation, makes it even more compelling…
Stock Price Valuation
The stock’s P/E ratio is 29.3.
At first glance, that might look like a high earnings multiple.
Admittedly, I rarely look at stocks that have P/E ratios of near 30.
But relative to the business’s growth profile, and relative to its own usual earnings multiple, it’s not unreasonable at all.
Consider that the stock’s five-year average P/E ratio is 35.5.
We’re well below that number.
There’s also a discount in the cash flow multiple.
The P/CF ratio of 22.7 is significantly lower than its own five-year average of 28.8.
And the yield, as noted earlier, is measurably 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 two-stage dividend discount model analysis.
I factored in a 10% discount rate, a 15% dividend growth rate for the next 10 years, and a long-term dividend growth rate of 8%.
Because the growth rate is currently so high, and also because I see this as unsustainable over the very long run, I’m using a two-stage model.
The initial 15% dividend growth rate is lower than the demonstrated 10-year dividend growth rate. The most recent dividend increase was over this mark. And the payout ratio is low.
Even with CFRA’s expectation of 12% near-term annual EPS growth, I don’t see this as difficult to achieve for Domino’s.
Over the long term, though, I think the business will settle into high-single-digit annual growth.
The DDM analysis gives me a fair value of $427.24.
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 think I was being judicious with the valuation, yet the stock still comes out looking 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 DPZ as a 3-star stock, with a fair value estimate of $416.00.
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 DPZ as a 4-star “BUY”, with a 12-month target price of $480.00.
I came out pretty close to where Morningstar is at. Averaging the three numbers out gives us a final valuation of $441.08, which would indicate the stock is possibly 11% undervalued.
Bottom line: Domino’s Pizza, Inc. (DPZ) operates a simple-to-understand business model with a high degree of predictability based on selling a timeless food staple. With 10 consecutive years of dividend increases, a long-term dividend growth rate of almost 20%, a low payout ratio, and the potential that shares are 11% undervalued, long-term dividend growth investors looking for a remarkable compounder ought to seriously consider this stock after a 30% drop.
-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 DPZ’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 55. 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, DPZ’s dividend appears Borderline Safe with a moderate risk of being cut. Learn more about Dividend Safety Scores here.
The goal? To build a reliable, growing income stream by making regular investments in high-quality dividend-paying companies. Click here to access our Income Builder Portfolio and see what we’re buying this month.
Source: DividendsAndIncome.com