“It was the best of times, it was the worst of times…”
A very famous line by Charles Dickens.
It certainly wasn’t referring to investing, but I think it can be reappropriated and applied toward investing.
What do I mean?
The best times to invest are during the worst times.
It’s precisely when things look bleak that you tend to get the big discounts on assets.
Look, the future is always uncertain.
It’s just that widespread pessimistic sentiment, often prompted by a confluence of negative events, prices more of that uncertainty in.
On the other hand, the worst times to invest are during the best times.
This is a mantra I’ve lived by over the years, building out my FIRE Fund in the process.
That’s my real-money portfolio, which produces enough five-figure passive dividend income for me to live off of.
Indeed, I live off of dividends.
And I’m still in my 30s.
In fact, I retired at only 33 years old.
I share exactly how I did that in my Early Retirement Blueprint.
Now, a pillar of the Blueprint is the investing strategy I’ve used (and still use).
That strategy is dividend growth investing.
This is a strategy that advocates for investing in world-class businesses that pay reliable, rising dividends to their shareholders.
Of course, only great businesses can engage in this virtuous circle for years on end.
Dividend growth stocks represent equity in these businesses.
You can find hundreds of examples of these stocks on the Dividend Champions, Contenders, and Challengers list.
As great as these stocks are, though, valuation at the time of investment is critical.
Price only tells you what you pay. It’s value that tells you what you 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.
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.
Seeing the worst of times as the best of times to invest, and putting capital to work with undervalued high-quality dividend growth stocks, sets you up to ride the wave higher as the sentiment tide inevitably turns in your favor.
Of course, spotting undervaluation does require one to have an understanding of valuation in the first place.
Fortunately, forging this understanding is not that difficult.
Fellow contributor Dave Van Knapp has made it much easier.
His Lesson 11: Valuation, which is part of an overarching series of “lessons” on dividend growth investing, puts forth a simple-to-understand valuation template that you can apply toward almost 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) is a multi-channel retailer of high-quality home products and furnishings.
Founded in 1956, Williams-Sonoma is now a $10 billion (by market cap) retail beast that employs more than 16,000 people.
The company’s reporting segments break down by brand: Pottery Barn, 37% of FY 2020 sales; West Elm, 25%; Williams Sonoma, 18%; Pottery Barn Kids and Teen, 15%. Other, which includes international franchise operations, accounted for 4%.
Almost all of the company’s sales are US-based.
In my opinion, today’s retailer needs two things to thrive.
First, they must properly implement and communicate differentiation.
Second, they must have a successful, cohesive omnichannel strategy.
Regarding the first point, Williams-Sonoma does this through unique brands within a niche space.
They’re not trying to be all things to all people.
Instead, they provide attractive home furnishings that still offer a great value proposition relative to the quality.
Regarding the second point, Williams-Sonoma has been, perhaps, better than any other retailer on the omnichannel front.
Here’s what the company has to say about this in their most recent annual report: “Our e-commerce channel has been our fastest growing business over the last several years and represented more than 70% of our net revenues and profits in fiscal 2020.”
By the way, this isn’t new. It’s not a pandemic story. Williams-Sonoma has clocked in 50%+ of sales through e-commerce for years.
Simultaneously, they showcase their products in beautiful retail stores that convey a sense of attainable luxury.
With the sharp rise in the work-from-home trend playing out, and with home renovations being all the rage, Williams-Sonoma has found their planning and hard work over the years paying off even more than usual.
But make no mistake about it.
Williams-Sonoma, because of the two points I touched on, has been thriving for a long time. And I think they’ll continue thriving for a long time to come.
That should translate to them increasing their revenue, profit, and dividend for years into the future.
Dividend Growth, Growth Rate, Payout Ratio and Yield
As it sits, the company has increased its dividend for 16 consecutive years.
The 10-year dividend growth rate is 13.9%.
If you think that’s impressive, their most recent dividend increase was a monstrous 20.3%.
This market-beating yield is close to its own five-year average.
And with a very low payout ratio of 21.4%, the company has plenty of room to continue aggressively increasing the dividend.
Very healthy dividend metrics.
The yield might not be super high here, but the high dividend growth rate offers an appealing compounding proposition.
Revenue and Earnings Growth
As healthy as these dividend metrics might be, though, these dividend metrics are mostly looking backward.
Since investors risk today’s capital for tomorrow’s rewards, it’s the future growth and dividend increases that matter.
And so I’ll now build out a forward-looking growth trajectory for the business, which will later be part of the value estimation process.
I’ll first show you what the company has done over the last decade in terms of its top-line and bottom-line growth.
I’ll then reveal a near-term professional prognostication for profit growth.
Pitting the proven past up against a future forecast in this way should give us a pretty good idea about where the business might be going from here.
Williams-Sonoma increased its revenue from $3.7 billion in FY 2011 to $6.8 billion in FY 2020.
That’s a compound annual growth rate of 7.0%.
Very solid top-line growth.
Meantime, earnings per share advanced from $2.22 to $8.61 over this period, which is a CAGR of 16.3%.
Really incredible.
Prolific buybacks and margin expansion combined to power a lot of excess bottom-line growth.
Regarding the former point, the company’s outstanding share count is down by 26% over the last 10 years.
Looking forward, CFRA is forecasting that Williams-Sonoma will compound its EPS at an annual rate of 7% over the next three years.
CFRA clearly sees a material drop in Williams-Sonoma’s EPS growth over the next few years, compared to what the last decade has resulted in.
I don’t see CFRA’s position as unreasonable.
That’s because the pandemic likely caused a near-term pull-forward of sales from trends like work-from-home and home renovation suddenly taking off.
I wouldn’t expect the last two years to be indicative of a sustainable, long-term growth rate for the company.
On the other hand, Williams-Sonoma has stated that it’s on a path to $10 billion in revenue by 2024. That would represent a top-line CAGR of 10%. Continued buybacks alone could give the company the ability to grow its EPS at a rate which exceeds that level.
If we take CFRA’s forecast as the base case here, I think there’s still a lot to like.
The low payout ratio means the dividend can be increased at an even higher rate than that 7% mark over the foreseeable future.
In fact, I wouldn’t be surprised to see Williams-Sonoma continue to raise its dividend at a double-digit rate over the next few years, if only to settle down into a more viable higher-single-digit range over the long run.
And with a 2%+ starting yield, that’s a compelling scenario.
Financial Position
Moving over to the balance sheet, the company has the best financial position you could possibly have.
The company has no long-term debt.
They’ve been an excellent steward of capital, in my view.
And they have a lot of financial flexibility in terms of funding internal growth, buybacks, possible M&A, and dividend increases.
Profitability is another strong suit.
Over the last five years, the firm has averaged annual net margin of 7.1% and annual return on equity of 35.1%.
Speaking on the margin expansion I noted earlier, the company is logging double-digit net margin right now. They were routinely printing net margin in the 6% range 5-10 years ago.
In my opinion, Williams-Sonoma is a wonderful business with excellent fundamentals across the board.
And they also benefit from durable competitive advantages, including brand strength, a successful omnichannel strategy, economies of scale, and vertical integration.
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 faces extremely fierce competition in a highly fractured market.
The lack of switching costs is a risk, although the company’s brand recognition does mitigate this risk somewhat.
There is exposure to the housing market and the cyclicality that brings. If home sales fall, demand for luxury home furnishings will naturally decline.
Issues with the global supply chain could weigh on near-term results.
The company also faces volatility around input costs.
These risks should be kept in mind, but the quality of the business still makes it an appealing long-term investment idea.
That’s particularly true after the stock has dropped a stunning 40% from its recent high and now looks significantly undervalued…
Stock Price Valuation
The stock’s P/E ratio is 10.1.
That’s less than half that of the market’s earnings multiple.
It’s also way off of the stock’s own five-year average P/E ratio of 16.1.
We can also see a disconnection in the cash flow multiple.
The P/CF ratio of 7.8 is quite a bit lower than its five-year average of 9.1.
And the yield, as noted earlier, is close to 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 what I ordinarily allow for, but I think this business deserves it.
It’s actually much lower than the demonstrated long-term dividend growth. And EPS growth has been about twice as high as this level over the last decade.
I do see moderation in growth going forward, which will lead to less spectacular results.
But the low payout ratio gives the company a lot of leeway in terms of future dividend raises.
I don’t think this is an aggressive target for the company to meet.
The DDM analysis gives me a fair value of $153.36.
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 view my valuation as sensible, yet the stock looks very 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 $209.00.
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 4-star “BUY”, with a 12-month target price of $225.00.
I came in surprisingly low. Averaging the three numbers out gives us a final valuation of $195.79, which would indicate the stock is possibly 46% undervalued.
— 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.
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