Want a nearly foolproof rule of thumb for successful investing well over the long run?
It’s simple.
Invest in above-average businesses at below-average valuations.
That’s it.
And implementing the proper investment strategy makes it even easier to stick to this rule of thumb.
I’m talking about dividend growth investing.
This investment strategy espouses buying and holding shares in world-class enterprises that pay reliable, rising dividends to their shareholders.
And how are companies able to fund reliable, rising dividends?
By producing reliable, rising profits.
This strategy funnels you right into above-average businesses, as only great businesses can manage this kind of economic activity for years on end.
You can see what I mean by taking a look at the Dividend Champions, Contenders, and Challengers list.
This list has compiled invaluable information on hundreds of US-listed stocks that have raised dividends each year for at least the last five consecutive years.
You’ll notice a lot of household names on this list.
They’ve become household names by becoming some of the best businesses on the planet.
I’ve personally used this strategy to great effect, building my FIRE Fund in the process.
This real-money portfolio produces enough five-figure passive dividend income for me to live off of.
I’ve actually been living off of dividends for years, which has been a dream come true.
In fact, I quit my day job and retired in my early 30s.
I explain exactly how I was able to achieve this feat in my Early Retirement Blueprint.
Of course, following the tenets of dividend growth investing, which compelled me to invest in above-average businesses, is a key pillar of the Blueprint and my success.
But there’s a second part to this rule of thumb.
Valuation.
Price only 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.
Following the dividend growth investing strategy by investing in above-average businesses at below-average valuations is a nearly foolproof way to successfully invest over the long run.
The good news, identifying below-average valuations is not terribly difficult.
It just requires one to understand valuation in the first place.
Fellow contributor Dave Van Knapp’s Lesson 11: Valuation can help with this in a big way.
Part of a comprehensive and holistic series of “lessons” designed to teach the dividend growth investing strategy, it lays out a simple-to-follow valuation template that can be applied to just about 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…
Williams-Sonoma, Inc. (WSM)
Williams-Sonoma, Inc. (WSM) is a multi-channel retailer of high-quality home products and furnishings.
Founded in 1956, Williams-Sonoma is now an $8 billion (by market cap) retail barbarian that employs over 16,000 people.
The company’s reporting segments break down by brand: Pottery Barn, 38% of FY 2021 sales; West Elm, 27%; Williams Sonoma, 16%; Pottery Barn Kids and Teen, 14%. Other, which includes international franchise operations, accounted for 5%.
Almost all of the company’s sales are US-based.
In my view, the modern-day retailer needs to master two abilities.
Differentiation is one of those abilities.
And a coherent and cohesive omnichannel strategy is the other.
Williams-Sonoma excels at both of these.
First, Williams-Sonoma sets itself apart by providing unique brands within a specialized niche.
The company sells a range of high-end home furnishings that still offer a great value proposition relative to the quality.
Second, Williams-Sonoma has been, arguably, better than any other retailer out there in terms of managing channels.
Here’s what the company has to say about this in their 2021 annual report: “Our e-commerce channel has been our fastest growing business over the last several years and represented more than 65% of our net revenues and profits in fiscal 2021.”
This isn’t some new, pandemic-related story, either.
Williams-Sonoma has been generating 50%+ of its sales through their e-commerce channel for years.
The fact that Williams-Sonoma has been so prolific at managing their channels is what positioned them so favorably for the pandemic.
At the same time, the company uses beautiful physical retail stores to showcase their products in their best light.
With the sudden rise in the work-from-home trend playing out, and with home renovations still occurring at a rapid clip, Williams-Sonoma has seen their foresight and planning over the years paying off.
Because the company has mastered the two abilities I touched on earlier, Williams-Sonoma is thriving in an environment where many traditional retailers are struggling to survive.
And I think they’ll continue to thrive, which should allow the retailer to continue growing its revenue, profit, and dividend for decades to come.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Already, the company has increased its dividend for 16 consecutive years.
Notably, that time period runs through the Great Recession, which severely impacted the US housing market.
I think this shows just how durable this business and its dividend is, which bodes well since another serious slowdown in the US housing market is upon us.
The 10-year dividend growth rate is 13.6%.
And there’s been no marked deceleration in dividend growth, either.
Along with this double-digit dividend growth rate, the stock offers a market-beating yield of 2.5%.
This yield, by the way, is 10 basis points higher than its own five-year average.
With a payout ratio of only 19.5%, this appears to be an extremely secure dividend – even in the face of a tough housing market.
I like dividend growth stocks in what I call the “sweet spot” – a yield of between 2.5% and 3.5%, supported by high-single-digit (or better) dividend growth.
The yield barely qualifies, but the double-digit dividend growth rate more than makes up for that.
It’s hard to find anything to complain about here regarding the dividend metrics.
Revenue and Earnings Growth
As likable as these metrics are, though, they’re largely looking in the rearview mirror.
However, investors must risk today’s capital for the rewards of tomorrow.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will later serve us when it comes time to estimate the stock’s fair value.
I’ll first show you what this company has done over the last decade in terms of its top-line and bottom-line growth.
And then I’ll uncover a near-term professional prognostication for profit growth.
Combining the proven past with a future forecast in this way should allow us to draw a reasonably logical conclusion about where the business might be going from here.
Williams-Sonoma raised its revenue from $4 billion in FY 2012 to $8.2 billion in FY 2021.
That’s a compound annual growth rate of 8.3%.
Strong top-line growth, but I think we have to keep in mind that the last two fiscal years have seen an explosion in sales.
If we back things up a bit, we can see that Williams-Sonoma was compounding its revenue at an annual clip of approximately 6%.
Still solid.
Just not quite as impressive.
Meantime, earnings per share grew from $2.58 to $14.75 over this period, which is a CAGR of 21.4%.
Truly exceptional.
Who would have predicted a home furnishings company would put up tech-like earnings growth?
Again, though, if we back up to just before the pandemic, EPS was compounding at an annual rate of between 9% and 10%.
And that’s where I’d be baselining my growth expectations for the business.
Margin expansion and copious share repurchases helped to drive this excess bottom-line growth.
For context around the repurchases, the outstanding share count has been reduced by approximately 25% over the last decade.
Looking forward, CFRA is projecting that Williams-Sonoma will grow its EPS at a CAGR of 20% over the next three years.
In my estimation, that’s an awfully aggressive forecast.
Then again, Williams-Sonoma’s most recent quarterly report – Q2 FY 2022 – showed 20.6% YOY EPS growth.
So there’s no apparent slowdown in this train.
On the other hand, we haven’t seen the full effects of rising rates and the related softening in the US housing market work its way into the company’s results.
There is a lag here.
Now, I’m not forecasting doom and gloom.
To the contrary, Williams-Sonoma is a wonderful business that is poised to do very well over the coming years.
It’s just that I’m not sure if they can keep up the torrid growth rates of the last couple of years.
I’d be (pleasantly) surprised if Williams-Sonoma compounds its EPS at a 20% annual rate over the next three years.
But even if they fall far short of this level and come in closer to something that resembles their pre-pandemic norm, that would still be enough to power the kind of dividend growth that’s roughly in line with what’s transpired over the last decade.
And coupling a double-digit dividend growth rate with a 2.5% starting yield is a highly compelling mix.
Financial Position
Moving over to the balance sheet, Williams-Sonoma has a pristine financial position.
The company has no long-term debt.
Management has been a great steward of capital.
This gives the company a lot of financial flexibility in terms of funding internal growth, buybacks, possible M&A, and dividend increases.
Also, Williams-Sonoma’s lack of debt what could otherwise be a headwind from rising rates.
Profitability is robust, especially for a retailer.
Over the last five years, the firm has averaged annual net margin of 8.3% and annual return on equity of 43%.
Coming back around to the margin expansion story I touched on earlier, the company was printing net margin in the 6% range 5-10 years ago.
Fundamentally speaking, this is an extremely high-quality business.
And with brand strength, a successful omnichannel strategy, economies of scale, and vertical integration, 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.
While I see regulation and litigation risks as relatively low in this particular industry, Williams-Sonoma has to deal with fierce competition.
The lack of switching costs is a risk, although the company’s brand recognition around quality products does mitigate this risk somewhat by creating a more loyal customer base.
There is exposure to the housing market and the cyclicality that brings. If home sales fall, demand for luxury home furnishings should decline.
Ongoing kinks in the global supply chain could weigh on near-term results.
The company also faces volatility around input costs.
I think it’s important to carefully consider these risks, but quality and valuation should also be carefully considered.
That latter point is key, with the stock looking attractively valued after seeing its price crater by more than 40% from its 52-week high…
Stock Price Valuation
The stock’s P/E ratio is 8.
Yes, it’s a single-digit P/E ratio.
That’s significantly lower than the broader market’s earnings multiple.
It’s also meaningfully lower than its own five-year average P/E ratio of 15.4.
The P/CF ratio of 7.3 is also noticeably lower than its own five-year average of 9.
And the yield, as noted earlier, is 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%.
Now, this is as high as I’ll go with a long-term dividend growth rate.
But I think a company of this caliber deserves the benefit of the doubt.
This rate is lower than the demonstrated long-term growth across both EPS and the dividend.
And with the expectation of more double-digit EPS growth to come, I don’t see my mark as aggressive.
We also have to keep in mind that there’s no long-term debt on the balance sheet.
Plus, the payout ratio is low.
If anything, Williams-Sonoma is positioned to exceed this model’s dividend growth rate.
But I’d rather be pleasantly surprised than surprisingly disappointed.
The DDM analysis gives me a fair value of $168.48.
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 believe my valuation model was very fair, yet the stock comes out looking quite 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 WSM as a 5-star stock, with a fair value estimate of $230.00.
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 WSM as a 2-star “SELL”, with a 12-month target price of $135.00.
It’s odd to see Morningstar and CFRA so far apart. It’s also odd that CFRA takes this stance with a rosy growth forecast and a target price that’s higher than the current price of the stock. Nonetheless, I came out somewhere in the middle. Averaging the three numbers out gives us a final valuation of $177.83, which would indicate the stock is possibly 39% undervalued.
Bottom line: Williams-Sonoma, Inc. (WSM) is an extremely high-quality business with excellent fundamentals, including a pristine balance sheet. It’s about as good as a retailer can get. With a market-beating yield, double-digit dividend growth, a low payout ratio, more than 15 consecutive years of dividend increases, and the potential that shares are 39% undervalued, this is a gem 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 D&I: How safe is WSM’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, WSM’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
Motley Fool Stock Advisor's average stock pick is up over 350%*, beating the market by an incredible 4-1 margin. Here’s what you get if you join up with us today: Two new stock recommendations each month. A short list of Best Buys Now. Stocks we feel present the most timely buying opportunity, so you know what to focus on today. There's so much more, including a membership-fee-back guarantee. New members can join today for only $99/year.
Source: Dividends & Income