Stocks are a funny thing.

When they go way down and become way cheaper, it seems like nobody wants them.

And when they shoot higher and become much more expensive, everyone wants to jump in.

This is the opposite of almost anything else in life – demand usually rises when prices are lower.

If you can simply operate in a “counterclockwise” fashion to this and find yourself generally more enthusiastic about stocks after they’ve heavily dropped, you stand to do well over the long run.

I’ve operated in a counterclockwise way for years.

And I combined that contrarian mentality with what I’d argue is the ultimate long-term investment strategy.

I’m talking about dividend growth investing.

This strategy prescribes buying and holding shares in world-class enterprises that pay reliable, rising dividends to their shareholders.

Those reliable, rising dividends are, of course, funded by reliable, rising profits.

And only world-class businesses can consistently produce more and more profits.

You can find hundreds of examples of stocks that fit this strategy in the Dividend Champions, Contenders, and Challengers list.

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

The combination I just spoke of helped me to build significant wealth and passive income at a young age.

Simply put, I’ve applied dividend growth investing even more aggressively when stocks were cheaper.

You can see just how much wealth and passive income I’ve built by taking a look at my FIRE Fund.

This is my real-money portfolio.

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

Since the bills are covered by dividends, I was able to quit my job and retire in my early 30s.

I explain in my Early Retirement Blueprint exactly how I was able to achieve that.

So why does it make sense to be generally more enthusiastic about stocks after they’ve dropped in price and become cheaper?

It all comes down to valuation.

Whereas price 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.

Combining dividend growth investing with a contrarian mindset sets you up to perform well over the long run, as you’ll be more enthusiastic about buying high-quality dividend growth stocks when they’re cheaper and offer so much more for your money.

Now, understanding the valuation part of this does mean that you first have to develop your process.

Fortunately, my colleague Dave Van Knapp has made that a lot easier.

His Lesson 11: Valuation, which is part of an extensive series of “lessons” designed to teach the A-Z of DGI, lays out a valuation process that can be easily applied to most dividend growth stocks.

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 $16 billion (by market cap) retail giant that employs approximately 100,000 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 2022 revenue; and International, 8%.

The company’s revenue mix has five major categories: Computing and Mobile Phones, 42% of Q4 FY 2022 Domestic revenue; Consumer Electronics, 34%; Appliances, 13%; Entertainment, 8%; and Services, 3%.

Best Buy has surprised a lot of industry watchers over the last 10 years, thriving in an environment in which a lot of old-school brick & mortar retailers have struggled or closed up shop altogether.

Retail in the US has been devoured and commoditized by mass merchandisers intent on taking maximum market share at all costs.

With the US arguably being oversaturated with B&M retail, in general, a decade ago, and the e-commerce space still being relatively nascent at the time, the retail landscape was ripe for change.

Best Buy, as a legacy B&M retailer in a world becoming increasingly digital, could have easily turned into yet another cautionary tale.

Instead, they turned into a success story.

Making matters even more impressive, Best Buy has largely done this by selling consumer electronics – prime products for mass merchandisers to take market share in and sell online.

How did this happen?

Well, I believe that leaning into the niche accounts for some of the success.

A consumer knows exactly what to expect from Best Buy, and it’s top of mind for a lot of consumers when they’re in the market for electronics.

But something far bigger is at play here.

Best Buy has thrived by adopting an omnichannel retail approach, which means they meet the customer wherever the customer is.

They built up a potent e-commerce platform before the pandemic hit, putting them in a position to compete against the online onslaught.

This proved to be prescient, as the pandemic severely curtailed in-store interactions.

To offer some perspective on just how critical this was, digital sales as a percentage of Domestic sales have gone from 19% in FY 2020 to 39% in FY 2022.

Selling the specific products consumers want at the price points they demand across the various channels they frequent has been a longstanding recipe for Best Buy’s success, and I think that’ll remain so.

That should translate to the company being able to continue growing its revenue, profit, and dividend for years to come.

Dividend Growth, Growth Rate, Payout Ratio and Yield

As it sits, Best Buy has increased its dividend for 19 consecutive years.

That’s actually fairly impressive.

19 years is a long time in Best Buy’s retail world.

The 10-year dividend growth rate is 15.8%.

This is also impressive, in my opinion.

Better yet, there’s been some recent acceleration in the dividend growth rate – the most recent dividend increase came in at over 25%.

Now, I wouldn’t expect that to persist.

Best Buy has been a beneficiary of some pull-forward in demand stemming from pandemic-related trends, which saw people load up on goods like computers and TVs while they stayed and worked at home.

These trends are temporary.

As such, I would expect the near-term dividend growth story here to be somewhat modest as the numbers become right-sized to a new reality.

On the other hand, the market has already adjusted for this.

You see that show up in the stock’s yield, which is now 5%.

That’s three times higher than the broader market’s yield, and it’s 250 basis points higher than its own five-year average.

This high starting yield – twice as high as it normally is – is compensating today’s investors for a possible slowdown in dividend growth over the next year or two.

A payout ratio of 40.5%, based on midpoint guidance for this fiscal year’s adjusted EPS, shows a perfectly healthy dividend, but the payout ratio could rise if Best Buy drops its outlook in the face of tough YOY comps and a deteriorating environment.

For income-oriented dividend growth investors, a well-covered 5% yield is captivating.

Revenue and Earnings Growth

As captivating as it might be, though, the numbers are mostly looking backward.

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

Thus, I’ll now build out a forward-looking growth trajectory for the business, which will later be an integral part of the valuation process.

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

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

Lining up the proven past against a future forecast in this way should give us a good idea of where this business might be going from here.

I almost always use a 10-year snapshot of top-line and bottom-line growth, using a full decade as a proxy for the long term.

I think that gives us a reasonably accurate picture of what a business can do over the long haul, smoothing out short-term fluctuations.

However, in this case, I’ll be using a nine-year period – from FY 2014 to FY 2022.

That’s because Best Buy initiated a program they called “Renew Blue” in late 2012.

It was designed to fix shrinking margins and declining same-store comps.

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.

FY 2014 represented the first full year of their Renew Blue transformation.

Best Buy increased its revenue from $42.4 billion in FY 2014 to $51.8 billion in FY 2022.

That’s a compound annual growth rate of 2.5%.

Meanwhile, earnings per share grew from $1.56 to $9.84 over this period, which is a CAGR of 25.9%.

You sometimes have to “shrink to grow”.

Best Buy clearly did just that.

Their Renew Blue program created a smaller but more focused and faster-growing base.

The transformation has been remarkable.

To wit, comps have gone from -1.7% for FY 2012 (before their program went into full effect) to 10.4% for FY 2022. Net margin went from below 0% in FY 2012 to nearly 5% for FY 2022.

Extensive buybacks have also helped to drive a lot of this excess bottom-line growth.

For perspective, the outstanding share count has been reduced by approximately 28% over this nine-year stretch.

Looking forward, CFRA believes that Best Buy will compound its EPS at an annual rate of 3% over the next three years.

This would represent a severe drop in EPS growth relative to what Best Buy has enjoyed over the better part of the last decade.

I think it’s incredibly difficult to forecast growth in this unique environment, as we have an unprecedented mixture of rising rates, high inflation, looming recessionary risks, and falling demand for consumer electronics after a once-in-a-century pandemic caused a pull-forward in sales.

It’s important to recognize that the last two years do not make for accurate or sustainable measures of the company’s long-term prospects.

All the same, though, I don’t think what will happen over the next two years will be accurate or sustainable measures of the company’s long-term prospects.

The global economy will normalize in time.

And the business will see its numbers right-size themselves as it adjusts to the new reality.

Overall, I think it’s prudent to consider performance before the pandemic hit.

They were growing EPS at a double-digit clip annually, which is why you see the long-term double-digit dividend growth rate.

It’s certainly possible, if not likely, that Best Buy is only able to muster up low-single-digit EPS growth over the next few years.

They’re coming off of a high base, which was supercharged by the pull-forward in sales. And near-term sales will be cooled by that very same pull-forward in sales.

What the pandemic giveth, the pandemic taketh away.

However, I don’t see why this business can’t get back to at least high-single-digit bottom-line and dividend growth once we’re out of the woods and the storm clouds pass.

When you’re starting off with a 5% yield, the stock offers plenty of current income to placate long-term dividend growth investors while they wait for sunny skies to return.

Financial Position

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

The long-term debt/equity ratio is 0.4, while the interest coverage ratio is almost 122.

Furthermore, total cash is enough to pay off all long-term debt twice over.

Profitability is robust, and it’s been moving in the right direction.

Over the last five years, the firm has averaged annual net margin of 3.6% and annual return on equity of 44.4%.

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

Simultaneously, they improved the business across the board, which has led to margin expansion and better comps.

And with economies of scale and brand recognition, the company does have durable competitive advantages.

Of course, there are risks to consider.

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

Retail, in particular, is notoriously competitive.

Best Buy competes mostly on price. Margins could be squeezed in the future.

The company will have to continue adapting and pivoting as the constant evolution of retail plays out. The risk is that they find themselves unable to do this at some point.

There’s uncertainty regarding how much of a pull-forward in sales has occurred over the last two years. Investors are operating somewhat blindly over the near term.

Best Buy is largely dependent on sales of electronics that are often discretionary in nature. Any economic downturn would almost certainly reduce demand for these products.

The improvement over the last decade has been impressive, but it could also prove to be an aberration. Comps and margins are both healthy right now, leading to less room for improvement on a go-forward basis.

I think it’s vital to carefully weigh these risks, but the valuation weighs heavier to me.

With the stock down a stunning 50% from its 52-week high, it looks extremely undervalued now…

Stock Price Valuation

The P/E ratio is 7.7.

This is about half that of the stock’s own five-year average P/E ratio of 15.1, which in and itself is undemanding.

A single-digit P/E ratio is usually absurd, but it’s especially so for a company that’s demonstrated an ability to grow at a double-digit rate over a long period of time.

While we can all acknowledge that the E in this ratio will come down in the near term, the P side of the equation has adjusted in advance.

Could earnings drop in half compared to FY 2022?

I suppose that’s possible.

But the stock has already been cut in half.

Indeed, the stock was priced at similar levels to this back in late 2017, when EPS was less than half of what it was for FY 2022.

The sales multiple is also low, with the P/S ratio of 0.3 well off of its own five-year average of 0.5.

And the yield, as noted earlier, is substantially 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 6.5%.

This DGR is very conservative when you compare it to what this retailer has done over the last decade in terms of both EPS growth and dividend growth.

And, as I stated above, I see no reason why Best Buy can’t get back to at least mid-single-digit growth once the world gets back to some semblance of normal.

However, I’m also keenly aware of the the near-term uncertainty.

We’re in an unprecedented environment.

I think it makes sense to err on the side of caution in this kind of environment, but I also think we shouldn’t lose sight of the long-term picture.

It’s easy to be negative in the here and now, but this valuation model is most useful when one broadens their perspective.

I see this as a conservative hurdle for the business to clear, even if the next year or two is difficult, setting up Best Buy to overdeliver when we start looking out over the next 5-10 years and beyond.

The DDM analysis gives me a fair value of $107.11.

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’d argue my valuation was rather cautious, yet the stock still comes out looking outrageously 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 BBY as a 5-star stock, with a fair value estimate of $126.00.

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 $84.00.

I came out almost exactly in the middle this time around. Averaging the three numbers out gives us a final valuation of $105.70, which would indicate the stock is possibly 51% undervalued.

Bottom line: Best Buy Co., Inc. (BBY) is a great business that has thrived in a very challenging and competitive environment. They’ve successfully pivoted into an omnichannel retailer, massively improving along the way. With a market-smashing 5% yield, a healthy payout ratio, nearly 20 consecutive years of dividend increases, double-digit long-term dividend growth, and the potential that shares are 51% undervalued, this could be one of the best deals I’ve ever seen for long-term 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 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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