Becoming a successful long-term investor isn’t that complicated.
Charlie Munger, Warren Buffett’s right-hand man, likes to solve problems by way of inversion.
Well, becoming an unsuccessful investor would require you to invest in a lot of truly awful businesses.
How do you avoid this fate?
You invest in truly great businesses.
Sounds simple, right?
That’s because it is.
I’ve never heard of anyone going broke after routinely investing in great businesses for years of their life.
It just doesn’t happen.
So how do you make sure you’re sticking to truly great businesses?
I’d argue you do that by accumulating high-quality dividend growth stocks.
These stocks represent equity in world-class businesses that pay reliable, rising dividends to their shareholders.
They’re able to pay those reliable, rising dividends because they’re producing reliable, rising profits.
Of course, only truly great businesses can reliably increase their profits, year in and year out.
You can see what I mean by taking a look at the Dividend Champions, Contenders, and Challengers list.
This list contains invaluable data on hundreds of US-listed stocks that have increased their dividends each year for at least the last five consecutive years.
I’ve been personally accumulating these stocks for years.
I built my FIRE Fund by doing so.
That’s my real-money portfolio, and it produces enough five-figure passive dividend income for me to live off of.
Indeed, dividend income covers my bills.
By sticking to high-quality dividend growth stocks – and, by extension, truly great businesses – I was able to retire in my early 30s.
My Early Retirement Blueprint shares the ins and outs of how I achieved this feat.
As critical as it is to focus solely on truly great businesses, we can’t lose sight of the importance of valuation.
While price is what you pay, it’s value that you actually end up 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.
Buying high-quality dividend growth stocks at low valuations means you’re not buying low-quality stocks at high valuations, naturally setting you up to become a successful long-term investor.
This idea does, of course, require you to understand valuation in the first place.
Fortunately, this is easier than you might think.
My colleague Dave Van Knapp put together Lesson 11: Valuation, which is part of a comprehensive series of “lessons” designed to teach the A-Z of DGI.
This lesson provides an easy-to-follow valuation process that can be applied toward 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…
Starbucks Corporation (SBUX)
Starbucks Corporation (SBUX) is the world’s leading retailer of high-quality, specialty coffee products. These products are sold in 34,000 stores across 80 different markets, in addition to multi-channel retail.
Founded in 1971, Starbucks is now a $90 billion (by market cap) global coffee titan that employs nearly 400,000 people.
Company-owned stores accounted for approximately 84% of FY 2021 revenue, while licensed stores accounted for approximately 10% of FY 2021 revenue. Other sales made up the remainder.
The company splits its revenue across two primary geographical segments: North America, 70% of FY 2021 revenue; and International, 24%. Channel Development (retail CPG), as well as Corporate and Other accounted for the remainder of revenue.
The U.S. is by far the company’s largest single market, comprising 45% of the global store count. China is their most important international market, comprising 16% of the company’s total global store count.
This venerable company has one of the world’s best-known and most-respected brands.
How did they build this?
I think it comes down to the fact that they’re selling a cheap, simple luxury that anyone can attain.
And they’re doing this by way of both a product and an experience all wrapped up into one.
Sure, you could make a cheap cup of coffee at home.
But Starbucks offers a higher-level drink attached to an elevated, socialized experience within their lounges.
And consumers are all too happy to take them up on the offer.
As someone who is personally in a coffee shop almost every day creating content and managing investments, I can attest to the appeal of this product-experience combination.
See, a lot of companies try to nail either a great product or a great experience.
Starbucks, on the other hand, has been able to nail both.
While the pandemic did negatively impact the experience side of what Starbucks offers, by way of shutting down the lounges, this was temporary.
Moreover, Starbucks may have benefited permanently more than it suffered temporarily.
That’s because many small, independent coffee shops lacked the financial wherewithal necessary to survive the pandemic.
Starbucks was already a world-class enterprise heading into the pandemic, with its leading market share built on global acclaim and recognition.
It could end up even more dominant on the other side, as competition has been almost certainly reduced.
This sets them up to slingshot to greater heights than ever, growing their revenue, profit, and dividend for years to come.
Dividend Growth, Growth Rate, Payout Ratio and Yield
As it stands, Starbucks has increased its dividend for 12 consecutive years.
The 10-year dividend growth rate of 20.7% shows what a strong start they’re off to.
That said, I do see the more recent dividend increases, which have been in the high-single-digit range, as more indicative of their long-term dividend growth capacity.
The stock’s market beating 2.5% yield even offers a respectable income story.
By the way, that’s 60 basis points higher than the stock’s own five-year average yield.
And with the payout ratio sitting at 52.4%, the dividend is comfortably covered.
You’re slaying two dragons here.
The yield beats the market, and the dividend growth rate beats inflation.
I always 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.
The yield is admittedly on the low end of that range, but the high growth rate more than makes up for it.
Great dividend metrics here.
Revenue and Earnings Growth
As great as these dividend metrics are, though, they’re largely looking backward.
However, investors are always risking 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 of immense help when it comes time to estimate intrinsic value.
I’ll first show you 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.
Lining up the proven past with a future forecast in this way should give us the framework necessary to gauge where the business may be headed.
Starbucks increased its revenue from $13.3 billion in FY 2012 to $29.1 billion in FY 2021.
That’s a compound annual growth rate of 9.1%.
Impressive.
I’m usually looking for mid-single-digit top-line growth from a mature business like this, but Starbucks obviously did much better than that.
Earnings per share grew from $0.90 to $3.54 over this 10-year period, which is a CAGR of 16.4%.
Again, just super impressive stuff here.
We can now see how the business has been able to afford handing out double-digit dividend raises over the last decade – the underlying business has been growing in kind.
A combination of margin expansion and share buybacks helped to drive this excess bottom-line growth.
Regarding the latter point, the outstanding share count has been reduced by 23% over the last decade.
Looking forward, CFRA anticipates that Starbucks will compound its EPS at an annual rate of 13% over the next three years.
This growth forecast isn’t that far off from what Starbucks demonstrated over the last decade.
I see two sides to the growth coin here.
On one hand, Starbucks is a revered brand that commands a large amount of mind share and market share.
I suspect that Starbucks has taken, and will continue to take, even more market share by virtue of less competition in a post-pandemic world.
In addition, Starbucks is keeping its foot on the gas pedal by expanding its global footprint. The company is expected to open approximately 2,000 new stores this fiscal year, most of which will be across international markets.
At the same time, they’re posting up terrific comps – up 7% globally YOY for Q2 FY 2022, even after factoring in China lockdowns.
On the other hand, it’s that last point that brings me to the other side of the coin.
And it really is the elephant in the room: The pandemic-related lockdowns in China will weigh on the business.
However, the dark side of the coin is a short-term problem.
The other side of the coin offers up long-term solutions.
In my view, it’d be silly to expect a significant slowdown from Starbucks relative to their performance over the last decade.
If anything, it’s possible that the next decade is even better.
It begs a question: If the company did what they did with a smaller footprint and a global pandemic, what might they do with a larger footprint and no global pandemic?
Using CFRA’s EPS growth forecast as our base case, Starbucks is primed for at least high-single-digit dividend growth over the foreseeable future.
I think that would be a splendid outcome when also considering the 2.5% starting yield.
Financial Position
Moving over to the balance sheet, the company has a very good financial position.
Negative shareholders’ equity means there is no long-term debt/equity ratio.
But an interest coverage ratio of over 12 shows us that the company is having no difficulties with servicing its debt.
To add further context, their $13.6 billion in long-term debt is relatively small in relation to the company’s $90 billion market cap.
Profitability is robust.
Over the last five years, the firm has averaged annual net margin of 12.4%. ROE is N/A because of negative equity.
Starbucks is running a world-class enterprise that is getting bigger and, arguably, better.
Whether the consumer wants to spend more on products or experiences, Starbucks is poised to benefit.
And brand value, pricing power, economies of scale, a global distribution network, and a competent omnichannel strategy are durable competitive advantages that defend the business.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
While I see regulation and litigation as somewhat limited risks compared to many other industries, the QSR space is notoriously competitive.
Input costs are volatile and rising, especially in terms of labor. Adding further pressure and uncertainty in their labor story is a growing unionization drive across stores.
Being a global company, they’re exposed to macroeconomic issues and broad economic slowdowns. The pandemic, and its shutdowns (especially in China), are emblematic of this.
Perhaps the biggest risk to long-term growth in relative terms is the law of large numbers. Their massive size could start to work against them in the near future.
It’s important to carefully think over these risks, but I do see the quality and valuation of the business as overcoming these risks.
With the stock down nearly 40% from its 52-week high, the valuation looks very compelling right now…
Stock Price Valuation
The stock is trading hands for a P/E ratio of 21.1.
That’s not terribly low in absolute terms, but it is a lot lower than its own five-year average of 47.4.
Now, this comparison is difficult to make. Starbucks has often printed lumpy GAAP results.
But if we go straight to cash flow, the P/CF ratio of 17.5 is well off of its own five-year average of 27.4.
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 8%.
This 8% mark is as high as I’ll go, but I believe that Starbucks is worthy.
I see nothing to indicate that they can’t clear this hurdle.
The company has clearly proven itself as capable of producing double-digit EPS and dividend growth over the long term.
And it appears that the near term is full of the same.
While the company could do quite a bit better than my number over the medium term, I also think we should expect a moderation in dividend growth when looking out beyond five or so years.
Averaging things out, though, I’m comfortable with this model.
The DDM analysis gives me a fair value of $105.84.
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 find my valuation as being aggressive, yet the stock looks to be worth a lot more than its current price would suggest.
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 SBUX as a 4-star stock, with a fair value estimate of $100.00.
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 SBUX as a 3-star “HOLD”, with a 12-month target price of $80.00.
I came out very close to where Morningstar is at. Averaging the three numbers out gives us a final valuation of $95.28, which would indicate the stock is possibly 21% undervalued.
Bottom line: Starbucks Corporation (SBUX) is a world-class institution that is becoming bigger than ever, and a clear case could be made that it’s also becoming better than ever. It has the rare distinction of mastering both a product and an experience for consumers all over the world. With a market-beating yield, double-digit dividend growth, a moderate payout ratio, more than 10 consecutive years of dividend increases, and the potential that shares are 21% undervalued, this is a fantastic investment idea for long-term dividend growth investors to strongly consider.
— 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 SBUX’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 67. 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, SBUX’s dividend appears Safe with an unlikely 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