Successful long-term investing is, in some ways, a self-fulfilling prophecy.

What would you do if you believe that you’ll build enough wealth and passive income to become financially independent?

Well, you’d take actions in accordance with that belief.

You’d live below your means, intelligently invest, and remain persistent.

And taking those actions would likely lead to building enough wealth and passive income to become financially independent.

Belief turns into action.

Action turns into results.

Results reinforce belief.

I had this same belief, took these same actions, and experienced these same results.

And my Early Retirement Blueprint recounts much of it, detailing how I was able to retire in my early 30s.

Let’s home in on the intelligent investing part for a moment.

I’d argue that the most intelligent way to invest is to employ dividend growth investing.

This is a long-term investment strategy that advocates buying and holding shares in world-class enterprises that pay reliable, rising dividends to their shareholders.

Simply put, these are some of the best companies in the world.

And that gets proven by consistently growing profits… and consistently growing dividends.

I’ve personally used the dividend growth investing strategy to build my FIRE Fund.

This is my real-money portfolio, and it produces enough five-figure passive dividend income for me to live off of.

Dividend growth investors are never short on ideas.

The Dividend Champions, Contenders, and Challengers list contains invaluable data on hundreds of US-listed stocks that have raised their dividends each year for at least the last five consecutive years.

As great as these stocks can be, though, valuation is always a critical factor.

Jason Fieber's Dividend Growth PortfolioPrice is what you pay. But value is what you actually get for your money.

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 can be a very intelligent way to invest for the long term, and it can help you to execute a self-fulfilling prophecy toward financial independence.

Of course, this would require one to first be able to understand valuation.

Fortunately, it’s not that hard.

Fellow contributor Dave Van Knapp’s Lesson 11: Valuation can make it much simpler.

Part of his comprehensive series of “lessons” that are designed to teach dividend growth investing, it lays out a valuation process that can be easily replicated and used 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…

Lowe’s Companies Inc. (LOW)

Lowe’s Companies Inc. (LOW) is a large home improvement retailer based in the United States.

Founded in 1921, Lowe’s is now a $124 billion (by market cap) retailing behemoth that employs 270,000 people.

They directly operate nearly 2,000 home improvement and hardware stores in the US and Canada.

The typical store averages around 112,000 square feet in size and offers 40,000 different products. In addition, they offer hundreds of thousands of products via their special order system and e-commerce channel.

What is the American Dream?

A complex question with no simple answer.

But I think we can all agree that homeownership is part of it.

Many people aspire to own their own home.

We saw this play out in a big way over the last two years.

Sales and prices for houses have gone parabolic across the country.

While the explosive nature of this shift was undoubtedly stimulated by the pandemic, a combination of low supply and pent-up demand was bound to result in something akin to this at some point anyway.

All of this plays right into the hands of Lowe’s.

It’s more people in more homes.

And these homes will slowly deteriorate and become outdated over time, which leads to increased demand for the very products that Lowe’s provides.

All of that bodes well for the company to continue growing its revenue, profit, and dividend for many years to come.

Dividend Growth, Growth Rate, Payout Ratio and Yield

Already, Lowe’s has increased its dividend for 59 consecutive years.

This is a Dividend Aristocrat.

In fact, it’s been increasing its dividend for so long, it could be a Dividend Aristocrat more than twice over.

The 10-year dividend growth rate of 18.8% is very strong.

Remarkably, there hasn’t been a deceleration from that high level.

In fact, it’s been the opposite – their most recent dividend increase came in at 33.3%.

However, you do have to give up some yield to get that growth.

The stock’s yield is only 1.7%.

This is obviously more of a compounder than an income play, but that yield does slightly beat the market.

It’s also 10 basis points higher than its own five-year average.

And with the payout ratio sitting at only 26.6%, the dividend has plenty of room to head higher.

This is a very safe, fast-growing dividend with a terrific history behind it.

There’s a lot to like about these dividend metrics, particularly if you have time to let those dividend raises compound over time.

Revenue and Earnings Growth

As great as these dividend metrics might be, though, they’re largely looking backward.

But investors have to risk today’s capital for tomorrow’s rewards.

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

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 unveil a professional prognostication for near-term profit growth.

Lining up the proven past against a future forecast in this manner should give us a reasonable idea as to where the business might be going from here.

Lowe’s has advanced its revenue from $50.5 billion in FY 2012 to $96.3 billion in FY 2021.

That’s a compound annual growth rate of 7.4%.

Impressive top-line growth for a fairly mature business like this. It’s not easy to compound at a high rate when you’re starting off with a sales base north of $50 billion.

Meanwhile, earnings per share grew from $1.69 to $12.04 over this period, which is a CAGR of 24.4%.

Monstrous bottom-line growth. This clearly shows how the company has been able to support such monstrous dividend growth.

A combination of margin expansion and prolific share buybacks have combined to propel a lot of this excess bottom-line growth.

For perspective on the latter, the company has reduced its float by 39% over this time frame.

Looking forward, CFRA is forecasting that Lowe’s will compound its EPS at an annual rate of 4% over the next three years.

24.4% to 4%? What gives?

Lowe’s undoubtedly experienced a lot of pull-forward in sales over the last two years, as the pandemic and certain restrictions created a surge in demand for home improvement products.

The last two years have been especially successful for the retailer, and some of that surge in demand is temporary.

However, Lowe’s isn’t exactly a new kid on the block.

If we back things up to way before the pandemic hit, the company put up a 19.7% CAGR in its EPS during the five-year period that stretched from FY 2012 to FY 2016.

A 20% annual growth rate is nothing new or surprising here.

Also, CFRA notes that Lowe’s “is in [the] middle innings of transformation, with improved sales execution, inventory controls, and revamped stores”.

Now, what goes up must come down. I would expect some moderation in the company’s growth profile over the next few years.

That said, CFRA’s forecast does pencil in a more meaningful slowdown than I would anticipate, particularly if they’re only in the middle innings of a transformation.

The company’s own guidance for FY 2022 EPS is $13.35 at the midpoint. That would represent 10.9% YOY EPS growth. This would be a pretty large drop in growth, but it’s also more along the lines of what I’d find to be likely over the near term.

Regardless of what may or may not transpire over the next few years, Lowe’s is a very high-quality retailer that is squarely positioned to benefit from the long-term demand for homeownership in the USA.

People aren’t going to suddenly stop wanting to own and upgrade their homes now that we’re moving past the pandemic.

It’s a very simple concept.

Most people want to own their shelter. And they want to occupy a pleasant, suitable space.

I think Lowe’s will continue to grow its EPS at an annual rate that’s well into the double digits, once things fully normalize.

And that easily sets the company up to consistently grow the dividend at a double-digit rate over the coming years.

Keep in mind, this stock has compounded at 22.6% annually over the last decade.

For long-term dividend growth investors who like to double their investment every 3-5 years, this is a compelling idea.

Financial Position

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

Negative common equity means there is no long-term debt/equity ratio.

However, the $23.9 billion in long-term debt they carry on the balance sheet is fairly modest for a company with a $124 billion market cap.

Furthermore, the interest coverage is over 13.

This shows no issues whatsoever with debt or its servicing.

Profitability has been robust, and it’s been continuously improving.

Over the last five years, the firm has averaged annual net margin of 5.7%. ROE is no longer applicable because of negative common equity.

The margin expansion story is real. Lowe’s was routinely printing annual net margin of around 4% between FY 2012 and FY 2016.

This is a high-quality Dividend Aristocrat.

And there are durable competitive advantages protecting the business, including large economies of scale, pricing power, brand recognition, product specialization, and an expert workforce that guides consumer purchases.

Of course, there are risks to consider.

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

I see competition as the biggest risk of those three. Retailing is extremely competitive, pressuring margins.

Any major changes in the way consumers spend money can affect the business. One near-term concern is the possible pent-up demand for services, which could result in consumer spending flowing away from home projects.

It’s currently unknown how much of a pull-forward of sales has occurred, which will weigh on near-term results.

Rising rates and high inflation are likely to hurt demand for new homes.

A large-scale recession could hurt the business. Economic stress would likely see home improvement projects delayed.

The company’s stores are only in North America, which means no international growth potential at this time.

The global supply chain is still not working correctly. It’s difficult to match supply with demand.

These risks should be carefully thought over, but this is a business that has been navigating similar risks for decades.

And with the stock down 29% from its 52-week high, it looks very appealing right now on a valuation basis…

Stock Price Valuation

The stock is trading hands for a P/E ratio of 15.6.

That’s well below the broader market’s earnings multiple.

And it’s significantly lower than its own five-year average P/E ratio of 24.1.

This is a stock that often commands a premium multiple, but it’s now morphed into a discount multiple.

There’s also the P/CF ratio of 13.0, which compares favorably to its own five-year average of 15.6.

And the yield, as noted earlier, is slightly 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 10-year dividend growth rate of 12%, and a long-term dividend growth rate of 8%.

I’m assuming more double-digit dividend growth over the near term, but this is somewhat tame in comparison to what Lowe’s has been producing over the last decade.

This would only be 1/3 that of the company’s most recent dividend increase.

I think it’s fair to respect the uncertainty right now and be conservative with one’s short-term presumptions.

Looking out over the long term, though, I don’t see why Lowe’s can’t make good on high-singe-digit growth.

If anything, there’s a good chance that Lowe’s does quite a bit better than I’m modeling in.

But I would rather err on the side of caution.

The DDM analysis gives me a fair value of $242.30.

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 at all aggressive, but the stock still looks noticeably cheap here.

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 LOW as a 3-star stock, with a fair value estimate of $203.00.

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 LOW as a 4-star “BUY”, with a 12-month target price of $275.00.

I came out roughly in the middle here. Averaging the three numbers out gives us a final valuation of $240.10, which would indicate the stock is possibly 28% undervalued.

Bottom line: Lowe’s Companies Inc. (LOW) is a world-class retailer poised to continue benefiting from the American Dream, just as it’s been benefiting for 100 years. With a market-beating yield, double-digit dividend growth, a low payout ratio, 59 consecutive years of dividend increases, and the potential that shares are 28% undervalued, long-term dividend growth investors would be wise to consider picking up this Dividend Aristocrat here.

-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 LOW’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 93. 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, LOW’s dividend appears Very Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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