A global pandemic.
War in Europe.
Unfortunately, this sounds a bit like the world 100 years ago.
History might not completely repeat itself, but it does often rhyme.
This can teach investors a valuable lesson.
See, there is consistent repetitiveness in our world.
And this repetitiveness is ingrained in many aspects of society.
For investors, this can be a great thing.
It makes it easier to find sustainable, repetitive, long-term trends for investment.
By extension, it makes it easier to find sustainable, repetitive, long-term profits.
And this leads to sustainable, repetitive, long-term dividends.
I’ve used this thought process while building up my FIRE Fund.
That’s my real-money stock portfolio, which produces enough five-figure passive dividend income to live off of.
Indeed, I do live off of it.
I was actually able to retire in my early 30s.
I describe in my Early Retirement Blueprint exactly how I achieved that.
But it’s not just dividend income that I live off of.
It’s growing dividend income.
The FIRE Fund is based on the tenets of dividend growth investing.
It’s an investment strategy that advocates investing in world-class businesses that pay reliable, rising dividends.
You can find hundreds of US-listed dividend growth stocks on the Dividend Champions, Contenders, and Challengers list.
The same process that results in consistent profits and dividends can also result in consistently growing profits and dividends.
As you might imagine, high-quality dividend growth stocks are some of the best stocks in the world.
But even when buying the best stocks, valuation at the time of investment is still vital.
The price of a stock 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.
Taking advantage of the repetitiveness that’s inherent in society and business, and doing this when value is on your side, sets you up to do very well over the long run while you collect ever-higher dividends.
While spotting businesses with visible repetitiveness might not be difficult, valuation seems like a more difficult concept to master.
However, it’s really not.
Fellow contributor Dave Van Knapp’s Lesson 11: Valuation has greatly simplified the concept of valuation.
Part of an overarching series of “lessons” on dividend growth investing, it provides a valuation template that you can apply toward just about 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…
Home Depot Inc. (HD)
Home Depot Inc. (HD) is the world’s largest home improvement retailer.
Founded in 1978, the company is now a $330 billion (by market cap) retail monster that employs 500,000 people.
They operate over 2,300 stores across the US, Canada, and Mexico. More than 90% of net sales occur in the US.
The typical store averages approximately 105,000 square feet and offers more than 35,000 products. Their e-commerce channel offers one million products.
Is it 1922 or 2022?
A global pandemic and sad, unnecessary war in Europe has us feeling a bit like it’s the former.
Some say history repeats itself.
I’d argue that it at least rhymes.
There is a rhythm to everyday life.
And this rhythm in people’s thought patterns and actions makes it easier to invest in sustainable trends with a high amount of long-term visibility in terms of repeat business.
One such example is home ownership and home improvement.
Shelter is a basic need in life.
This has been true since the dawn of time, and it’ll remain true until the end of time.
And most people would rather own than rent said shelter.
Going beyond just the basic need is the desire to make a comfortable home out of their shelter.
And this involves customization and improvement, not to mention ongoing maintenance.
Then you up the ante when you factor in that more and more people are working from home, which only reinforces customization and increased maintenance from additional wear and tear.
This plays right into the hands of Home Depot, which should translate to increasing profit and dividends for years to come.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Home Depot has already increased its dividend for 13 consecutive years.
In fact, they just increased the dividend only days ago, marking that 13th straight year.
The 10-year dividend growth rate of 20.3% is highly impressive.
And you’re even getting a solid 2.4% yield to go along with that high growth rate.
This yield, by the way, is 30 basis points higher than its five-year average.
With a payout ratio of 48.9%, the dividend is secure and positioned to continue growing aggressively.
I 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.
We’re on the bubble here with the yield, but the high dividend growth rate more than makes up for it.
Great dividend metrics across the board.
Revenue and Earnings Growth
As great as these metrics are, though, they’re largely looking at what’s already transpired.
However, investors are 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 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 its top-line and bottom-line growth.
And then I’ll divulge a near-term professional prognostication for profit growth.
Amalgamating the proven past with a future forecast should give us a reasonable idea as to where business might be going from here.
Home Depot increased its revenue from $74.8 billion in FY 2012 to $151.2 billion in FY 2021.
That’s a compound annual growth rate of 8.1%.
I usually look for a mid-single-digit top-line growth rate from a mature company. And make no mistake about it, Home Depot is mature.
However, Home Depot blew away my expectations here. Growing revenue at 8%+ annually when you’re coming off of a ~$75 billion base is remarkable.
Meantime, earnings per share expanded from $3.00 to $15.53 over this period, which is a CAGR of 20.0%.
Outstanding.
We can now see where that huge dividend growth came from. Huge EPS growth powered it.
Breaking down the difference between revenue and EPS growth, a combination of margin expansion and aggressive buybacks caused a lot of excess bottom-line growth.
For perspective on the latter point, the outstanding share count is down by 30% over the last decade.
Looking forward, CFRA believes that Home Depot will compound its EPS at an annual rate of 4% over the next three years.
Lining that 4% forecast up against a 20% historical result seems strange. What gives?
Well, I think a lot of it comes down to the likelihood of a severe pull-forward in sales.
Home Depot has benefited from certain pandemic-related events. For instance, people have been fleeing dense cities and more commonly working from home for an extended period of time.
Now, let me be clear. Homeownership isn’t a “trend”. It’s a lifelong goal for many people.
And the work-from-home situation seems to have legs.
That said, it is difficult to expect results over the last, say, 12-24 months to be perpetual.
Once certain home improvements have been completed, they’re done. There are only so many kitchens to remodel, decks to build, and home offices to fashion.
If we take CFRA’s forecast as the base case, I still think Home Depot offers a compelling setup for long-term dividend growth investors.
That’s because a slight expansion in the low payout ratio could support high-single-digit dividend growth, even in the face of low-single-digit EPS growth.
And this is only a near-term situation.
If we take a step back and look at Home Depot’s general trajectory before the pandemic hit, they were doubling EPS roughly every five years.
I see no reason why they couldn’t return to something like that once things normalize, which would set up dividend growth to be at least in the high-single-digit range over the long run.
Pairing that with a 2.4% starting yield is enticing.
Financial Position
Moving over to the balance sheet, the company’s financial position is great.
There is no long-term debt/equity ratio. A substantial amount of treasury stock, due to aggressive buybacks, has led to negative shareholders’ equity.
However, the interest coverage ratio of over 17 tells the more accurate story.
Simply put, Home Depot has no issues whatsoever with debt.
Profitability is robust, especially for a retailer.
Over the last five years, the firm has averaged annual net margin of 9.7%. ROE is N/A because of negative common equity.
This is a fantastic business from top to bottom.
Fundamentally speaking, Home Depot is running one of the world’s greatest enterprises.
And the company does benefit from durable competitive advantages, including economies of scale, pricing power, brand value, product specialization, and a differentiated workforce that guides consumer purchases.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
Retailing is a particularly competitive industry, which pressures margins.
The company is exposed to the broader economy, as spending on homes and home improvement is partially reliant on economic confidence, strength, and expansion.
Any shifts in consumer spending habits can impact the business. An acute concern is the possible pent-up demand for services, which could reduce spending on products.
Most of the company’s stores are located in the United States, limiting growth potential and geographic diversification.
A hot US real estate market could correct at any time, which would likely negatively impact the demand for general spending on homes.
These risks should be carefully thought over, but I still think the quality of the business easily outweighs all of them.
And after a nearly 25% drop from its recent peak, the stock’s attractive valuation makes this idea even more compelling…
Stock Price Valuation
The P/E ratio is 21.1.
This is well below its own five-year average of 23.3.
For a company that’s been growing at 20% per year, that is not a high earnings multiple.
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%.
That dividend growth rate is at the high end of the scale, but there’s no reason why it doesn’t befit Home Depot.
The company has demonstrated its ability to grow its EPS and dividend at a much higher rate than this over a long period of time.
While a pull-forward in sales could cause a near-term growth headwind, the company’s structure is such that the long-term tailwind should gust much stronger.
And with the payout ratio being as moderate as it is, the company can easily sustain high-single-digit dividend growth until such time that the business gets back to a more normalized growth rate.
I don’t see this hurdle as difficult for Home Depot to clear.
The DDM analysis gives me a fair value of $410.40.
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.
My valuation wasn’t imprudent, yet there still appears to be material undervaluation present.
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 HD as a 2-star stock, with a fair value estimate of $244.00.
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 HD as a 4-star “BUY”, with a 12-month target price of $395.00.
I came out pretty close to where CFRA is at. Morningstar’s number looks way too low to me, but they do note that they’ll be increasing their fair value estimate after incorporating Q4 results. Averaging the three numbers out gives us a final valuation of $349.80, which would indicate the stock is possibly 7% undervalued.
Bottom line: Home Depot Inc. (HD) is a high-quality retailer showing tremendous strength across every facet of the business. Catering to the American Dream of homeownership is very profitable, and it’s only become more profitable with the work-from-home trend showing legs. With a market-beating yield, double-digit dividend growth, a moderate payout ratio, 13 consecutive years of dividend increases, and the potential that shares are 7% undervalued, this is a fantastic name for long-term dividend growth investors to consider adding to their stock depots.
— 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 HD’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 87. 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, HD’s dividend appears Very Safe with a very 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