The U.S. home improvement market is dominated by the two giants Home Depot (HD) and Lowe’s (LOW).
Home Depot is Dividend Challenger, with 6 straight annual dividend increases.
But Lowes is a Dividend Champion, with 53 straight years of dividend increases under its belt.
Lowe’s is A-rated for dividend safety by Safety Net Pro. Under their cash-flow-based method of analyzing a dividend’s reliability, LOW’s dividend is considered to be extremely safe.
Please see this article for an explanation of why cash flow analysis is important.
It’s one thing to have a safe dividend.
[ad#Google Adsense 336×280-IA]But another tenet of dividend growth investing is to buy at good values.
Even the best company is a poor investment if you overpay for its shares.
So let’s see whether Lowe’s is selling for a fair or even favorable price right now.
We will do this by applying my 4-step valuation process.
The outcomes of the 4 steps are summarized at the end of the article.
Step 1: FASTGraphs Default. The first step is to compare the stock’s current price to FASTGraphs’ default estimate of its fair value.
That default estimate is based on a price-to-earnings (P/E) that is selected as being suitable for the company’s growth rate. Faster-growing companies justify higher P/E ratios.
Lowe’s has a recent earnings growth rate of 17.9% per year, which justifies a P/E ratio of 17.9. That provides a logical baseline for evaluating the stock’s current valuation.
On the following graph, LOW’s fair value at a P/E of 17.9 is shown by the orange line, while the company’s actual price is the black line.
As you can see, under this method of valuation, Lowe’s actual price is above fair value at the current time. If you look in the “Fast Facts” panel at the right, you see that LOW’s actual P/E ratio is 20.8,which is 16% above 17.9.
If this were the only step in our valuation process, we would dismiss LOW right now. It is rare that you would want to buy a stock that is 16% overvalued.
But valuations are estimates or appraisals, and different methods can yield different answers. So let’s continue with the other steps.
Step 2: FASTGraphs Normalized. The second valuation step is to compare LOW’s price to its long-term average P/E ratio. This adjustment in the “fair” P/E ratio accounts for the fact that many stocks typically trade at valuations that are higher or lower than the market at large.
Now we get a different picture. The blue line tells us that Lowe’s average P/E ratio is 20.7. Its current ratio – 20.8 – is practically identical. So by this reckoning, LOW is fairly valued.
Let’s look further.
Step 3: Morningstar Star Rating. Morningstar uses a different aproach to valuing companies. Instead of examining P/E ratios, they conduct what is known as discounted cash flow (DCF) analysis.
Here is how they describe their method:
At Morningstar, our analysts estimate a company’s fair value by determining how much we would pay today for all the streams of excess cash generated by the company in the future. We arrive at this value by forecasting a company’s future financial performance using a detailed discounted cash-flow model…that factors in projections for the company’s income statement, balance sheet, and cash-flow statement. The result is an analyst-driven estimate of the stock’s fair value.
Notice again here the importance of cash flow analysis. In its DCF approach, Morningstar makes a projection of all the company’s future profits. The sum of those profits is discounted back to the present to reflect the time value of money. The resulting net present value of all future earnings is considered to be the fair price for the stock today.
Morningstar points out that comprehensive DCF models are quite complex, involving many variables that are themselves inherently uncertain and tough to estimate. When done well, though, valuations based on DCF models are often considered to be the highest and best form of estimating fair value.
Morningstar boils its DCF calculations down to its famous star rating. Here is their rating on Lowe’s.
Morningstar awards 4 out of 5 stars to Lowe’s. That means they believe that the company is undervalued, i.e., available at a bargain price.
Morningstar places a value of $81 on the shares. That means that at its recent price of about $70, Morningstar thinks that LOW is 14% undervalued. That is, the shares are a bargain.
Step 4: Current Yield vs. Historical Yield.
Finally, we compare the stock’s current yield to its historical yield. It is better to be near the top of that range than the bottom. All else equal, we would like to buy our dividend growth stocks when thy are yielding more rather than less.
We can use a FASTGraphs display to see the historical yield.
Just eyeballing this graph, we can see that Lowe’s current yield is not the highest that it has ever been, but it is higher than most of the years since 1996.
If we shorten the graph to the last 10 years, we get, if anything, the impression that LOW’s current yield is in the high end of its historical range.
To me, these two graphs suggest that Lowe’s is a bit undervalued, say by about 10%.
Please notice that these yield comparisons are not based on how large the company’s yield is. At 1.6%, LOW is not a high-yielding stock. But as a basis for valuation, the yield comparisons suggest that it is yielding toward the high end of its historical range.
Valuation Summary:
Using the 4 approaches just described, our valuation summary for LOW looks like this:
My conclusion is that Lowe’s is just a bit undervalued at the present time. Its current price of about $70 is 4% under the fair value price that I calculate, which is $73.
If after due diligence you like the company and it is a good fit for your portfolio, now is a decent time to buy it.
A note on yield
For many dividend growth investors, a 1.6% yield is too low as a starting yield. I require 2.7% myself.
But other investors like the faster dividend growth rates that often come from a lower yielding stock. Here are the last 10 increases for Lowe’s.
As you can see, Lowe’s does indeed have a record of very large percentage increases. Its 3-year dividend growth rate (DGR) is 19% per year; 5-year DGR = 21% per year; and 10-year DGR = 26% per year. If those kinds of growth rates are attractive to you, you might be more interested in a stock like Lowe’s than if you need higher income immediately.
— Dave Van Knapp
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As always, no stock I write about should be construed as a recommendation to buy or hold it. Please do your own due diligence on every company’s business and prospects. I do not own Lowe’s shares.