Do high-quality dividend growth stocks offer the best of both worlds?

Well, they’ve been shown to outperform the broader market over long periods of time.

And then they also tend to hold up better during periods of extreme volatility.

This year is a perfect example.

While the S&P 500 is down ~18% YTD, the S&P 500 Dividend Aristocrats index is only down ~11% this year.

High-quality dividend growth stocks represent equity in world-class businesses that pay reliable, rising dividends to their shareholders.

So it’s not just dividends.

It’s dividends that are consistently increasing.

Jason Fieber's Dividend Growth PortfolioAnd the only way a business can pay ever-larger cash dividends to shareholders is to produce ever-higher profits.

By its very nature, dividend growth investing usually filters out low-quality businesses.

You can find more than 700 US-listed dividend growth stocks stocks on the Dividend Champions, Contenders, and Challengers list.

That list contains invaluable data on stocks that have raised dividends each year for at least the past five years.

Dividend Aristocrats, however, kick it up a notch.

They are arguably the crème de la crème of all dividend growth stocks.

These are stocks that have consistently increased their dividends for at least the last 25 consecutive years.

It shouldn’t be a surprise that dividend growth stocks, in general, and Dividend Aristocrats, in particular, are holding up so well in a very volatile market.

When things get scary, investors look for safety.

Well, these are some of the best businesses in the world.

There’s relative safety in that quality.

I’ve been writing about, and personally implementing, the dividend growth investing strategy for more than a decade.

And it’s radically changed my life for the better.

I built my FIRE Fund using the tenets of this strategy.

This real-money portfolio generates enough five-figure passive dividend income for me to live off of.

I actually started living off of dividends years ago.

I was able to retire in my early 30s, thanks largely to this strategy.

By the way, my Early Retirement Blueprint delves into all of the details on how I was able to do that.

Growing dividends, which is often a good sign of quality, is a big part of the equation here.

But valuation is also critical.

Whereas price tells you what you’re paying, value tells you what you’re getting.

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.

With heightened market volatility creating a gravitational pull toward safety, buying undervalued high-quality dividend growth stocks for the long term, which always strikes me as intelligent, could be especially intelligent right now.

But this does require one to first understand valuation.

Fortunately, it’s not all that difficult.

Fellow contributor Dave Van Knapp’s Lesson 11: Valuation makes it even easier.

This is part of a series of “lessons” designed to provide a detailed overview of the dividend growth investing strategy, and it explicitly lays out a valuation system that can be applied toward 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…

VF Corp. (VFC)

VF Corp. (VFC) is a worldwide apparel and footwear company.

Founded in 1899, VF is now an $18 billion (by market cap) apparel heavyweight that employs more than 27,000 people.

The company reports results across three segments: Outdoor, 45% of FY 2022 revenue; Active, 46%; and Work, 9%.

The company is geographically diversified. Half of the company’s revenue is sourced from the US; the other 50% comes from International sales.

Channels are also diversified. Wholesale accounted for 54% of FY 2022 revenue, while the other 46% came from DTC (direct-to-consumer) sales.

Approximately 85% of the company’s revenue is derived from four major brands: Vans, The North Face, Timberland, and Dickies. Supreme, which was acquired by VF in late 2020 for $2.1 billion, is set to become another key brand for the company going forward.

Apparel is a great business model that’s very easy to understand.

It’s everywhere.

We’re talking about a basic product that’s so ubiquitous because people literally can’t walk around without wearing clothes.

The structure of modern-day society builds in automatic and recurring demand for apparel from captive consumers.

And because apparel is usually a small portion of one’s budget, it’s easy to pay up for quality, individualized clothing that outwardly expresses one’s personality.

Further bolstering recurring demand for apparel is the way fashion trends change from season to season, which encourages consumers to frequently upgrade and rotate their wardrobe.

While consumers certainly aren’t forced in any way to buy VF’s products specifically, their brand strength in various categories gives them an advantage over many of their competitors.

Vans is one of the biggest brands in everyday apparel and footwear. The North Face is a leading outerwear brand. Timberland is a major player in boots.

Because of continued global population growth, VF should benefit from an ability to sell ever-more branded apparel at ever-higher prices to an ever-expanding pool of captive consumers.

That should lead to the company being able to grow its revenue, profit, and dividend for years to come.

Dividend Growth, Growth Rate, Payout Ratio and Yield

VF has already increased its dividend for 49 consecutive years.

That easily qualifies them for their elite status as a Dividend Aristocrat.

The 10-year dividend growth rate is 12.4%, which is rather strong.

Admittedly, recent dividend increases have been comparatively tame.

But a lot of that near-term deceleration in dividend growth can be traced back to impacts from the pandemic.

I would expect a big bounce back in the size of dividend increases once the economy and business fully normalizes, but it’ll take some time.

Compensating investors for that near-term dividend growth slowdown is the stock’s yield of 4.3%.

That’s three times higher than the broader market’s yield.

It’s also 190 basis points higher than the stock’s own five-year average yield, which is a remarkable spread.

VF’s stock almost never offers a yield this high.

I’ve been investing for more than a decade, and this is the first time that I could actually classify this as a “high-yield” stock.

The good news, if you can call it that, is that the yield isn’t high because the dividend is too big for the company to handle.

Instead, the high yield is a result of a falling stock price.

Indeed, based on midpoint guidance for this fiscal year’s EPS, the payout ratio is a comfortable 59.7%.

This is a utility-like yield from a Dividend Aristocrat.

For income-oriented dividend growth investors, there’s a lot to like here.

Revenue and Earnings Growth

As likable as these dividend metrics are, though, they’re largely looking backward.

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

And so I’ll now build out a forward-looking growth trajectory for the business, which will later be very helpful during the valuation process.

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

I’ll then unveil a professional prognostication for near-term profit growth.

Amalgamating the proven past with a future forecast like this should give us a good idea as to where the business might be going from here.

VF increased its revenue from $10.9 billion in FY 2012 to $11.8 billion in FY 2022.

That’s a compound annual growth rate of 0.9%.

Meanwhile, earnings per share moved up from $2.43 to $3.10 over this period, which is a CAGR of 2.7%.

I’d usually be disappointed by this kind of low top-line and bottom-line growth.

However, we have to keep three things in mind.

First, VF spun off its jeans business in 2019.

The spin-off, which is Kontoor Brands Inc. (KTB), is a $1.9 billion company in its own right. VF’s revenue and net income were both reduced in a material way by this move.

Second, and more germane, the pandemic severely and negatively impacted the company.

Net income for FY 2021 was approximately 1/3 that of what it was in FY 2019. But a once-in-a-century global event that is outside the company’s control makes it difficult for me to judge VF too harshly. And as severe and negative as the impact was, it’s also temporary.

Third, it’s the coming growth that ultimately matters most here.

We investors are risking today’s capital for future returns. It’s less about what VF was growing at 10 quarters ago and more about what VF will be growing by 10 quarters from now.

Looking forward, CFRA forecasts that VF will compound its EPS at an annual rate of 61% over the next three years.

I had to check my eyes to make sure I was reading that correctly.

Yes. It’s 61%.

It’s actually not a totally outlandish number.

The company did report 242% YOY EPS growth for FY 2022.

Now, I do think that VF’s growth over the next 3-5 years will be substantially higher than what it’s been over the last few years.

On the other hand, I would be surprised to see that kind of otherworldly pace to be sustained over a multiyear period.

Still, either way you slice it, the expectation is for a lot of bottom-line growth over the foreseeable future.

I see VF as a coiled spring in some ways.

This spring can only remain coiled for so long, before it explosively uncoils.

Recent results have been poor not because of a bad business but because of extraneous shocks such as the pandemic.

But these extraneous shocks aren’t permanent.

Once our world gets back to something that looks more like normal, VF should see its profit explosively move higher as the business fully normalizes.

That near-term profit growth is not likely to completely bleed down to the dividend, however.

Instead, I see a high near-term bottom-line growth rate as the mechanism necessary to lower the payout ratio while simultaneously getting the dividend growth rate back to something more in line with its historical norm – say, a high-single-digit range.

And when you’re already starting off with a 4%+ yield, long-term dividend growth investors ought to like that setup.

Financial Position

Moving over to the balance sheet, VF has a solid financial position.

The long-term debt/equity ratio is 1.3, while the interest coverage ratio is over 12.

Both numbers have improved markedly since only one year ago. And I suspect they’ll continue to improve over the next few years.

Profitability is good, and I think this is another area of the business that can, and will, improve as we advance time.

Over the last five years, the firm has averaged annual net margin of 7.3% and annual return on equity of 23.1%.

The jeans spin-off and the Supreme acquisition (a premier brand featuring higher price points) were both designed to improve margins. We haven’t had a good environment for these moves to play out, but I think management will ultimately be vindicated. For perspective, net margin came in at nearly 12% for FY 2022.

VF has been successfully operating a simple-to-understand business model for more than a century.

I see no reason why the next century would be any different, which should make this a great long-term investment.

And with brand strength, global distribution, a multi-channel strategy, and economies of scale, the company does benefit from durable competitive advantages.

Of course, there are risks to consider.

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

The large Supreme acquisition has integration risk, although VF has a long history of successful acquisitions and integration. Vans, The North Face, and Timberland were all acquired.

VF has some exposure to struggling B&M US retailers through the Wholesale channel.

Brand strength is something that has to be continually managed and marketed, so VF will have to properly maintain these brands moving forward.

Fashion trends can be ephemeral. The company must stay on top of trends to continue growing.

No business is without risks, but I see VF as a relatively low-risk business model.

And with the stock now a breathtaking 45% off of its 52-week high, the valuation makes this a very compelling idea right now…

Stock Price Valuation

The P/E ratio is 15.1.

That would ordinarily be a reasonable, if not attractive, earnings multiple for this business.

But I’d argue it’s absurdly low right now.

The business isn’t even at full strength, and EPS is expected to move materially higher over the next few years.

We can also see that the P/S ratio of 1.6 is well off of its own five-year average of 2.4.

And the yield, as noted earlier, is significantly 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%.

This viewpoint balances tepid dividend growth over the last few years against double-digit long-term dividend growth.

With an anticipation of extraordinary EPS growth over the next few years, VF could easily support high-single-digit dividend growth over that same period.

And then once EPS growth slows down into a normal groove, it should match up better with dividend growth.

So while I suspect that EPS growth over the next decade could look something like a rocket taking off and then coming back down to earth, I don’t see why VF can’t grow the dividend in a more stable way through that arc.

They’ve shown the ability to do this in the opposite way – the dividend continued to grow, albeit very slowly, even when EPS dropped by more than 50% during the pandemic.

I’m giving this Dividend Aristocrat the benefit of the doubt, although this long-term model is slightly cautious.

The DDM analysis gives me a fair value of $71.33.

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 my valuation model was rational, yet the stock still comes out looking extremely 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 VFC as a 4-star stock, with a fair value estimate of $66.00.

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 VFC as a 5-star “STRONG BUY”, with a 12-month target price of $60.00.

I came out slightly high, but we all agree that the stock looks to be worth a lot more than its current price. Averaging the three numbers out gives us a final valuation of $65.78, which would indicate the stock is possibly 41% undervalued.

Bottom line: VF Corp. (VFC) has successfully operated a simple-to-understand business model for more than a century. They have some of the best brands in their industry. Inherent demand is present. And they’re positioned for an e-commerce world, with nearly half of sales coming via their DTC channel. With a 4%+ yield, almost 50 consecutive years of dividend increases, a reasonable payout ratio, a double-digit long-term dividend growth rate, and the potential that shares are 41% undervalued, this Dividend Aristocrat might be one of the most clearly obvious long-term investment opportunities available 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 VFC’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, VFC’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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