Undervalued Dividend Growth Stock of the Week: Home Depot (HD)

Successful long-term investing is fairly simple.

But simple doesn’t mean easy.

For example, the concept of repeatedly finding and buying shares of high-quality businesses is not difficult to understand.

On the other hand, it’s easier said than done to actually do that in real life.

I’ll tell you how to how to make it easier.

Stick to the dividend growth investing strategy.

It involves buying and holding shares in world-class businesses that pay reliable, rising dividends.

This strategy takes a lot of guesswork out of investing.

That’s because, by its very nature, it basically filters out low-quality businesses.

How does it do this?

Well, generally speaking, only high-quality businesses can produce the reliable, rising profits necessary to continuously fund reliable, rising dividends.

Thus, a lengthy track record of growing dividends is a great initial litmus test for business quality.

You can see what I mean by perusing the Dividend Champions, Contenders, and Challengers list, which contains 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 in that list countless household names – the companies that figuratively keep the world turning.

I’ve personally been an acolyte of this strategy for more than a decade, building my FIRE Fund in the process.

That’s my real-money stock portfolio.

And it generates enough five-figure passive dividend income for me to live off of.

I’ve been living off of dividends since my early 30s, which is when I quit my job and retired.

Yes.

I retired in my early 30s.

How?

I spill the beans in my Early Retirement Blueprint.

A major aspect of the Blueprint involves using the dividend growth investing strategy to home in on high-quality businesses.

But quality isn’t all that matters.

Valuation at the time of investment is also critical.

Whereas price 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.

Combining the focus of dividend growth investing with the power of undervaluation sets you up to become a successful investor and create immense wealth and passive dividend income over the long term.

Of course, valuation is another concept that is simple on its face but seemingly more challenging to handle in real life.

Fear not.

Fellow contributor Dave Van Knapp has greatly simplified the process.

He’s done this via Lesson 11: Valuation, which part of a comprehensive series of “lessons” on dividend growth investing.

His easy-to-replicate valuation template can be applied 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 $278 billion (by market cap) retail juggernaut that employs almost 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.

We have a lot going on right now.

And much of it, at first glance, seems negative.

China is locking down major cities.

The US may be on the cusp of (or even in the midst of) a recession.

Our global supply chain remains in disarray.

But what do all three of these issues have in common?

They’re all short-term problems.

However, investors must maintain a long-term perspective.

If you ignore the noise and look past short-term bumps in the road, you’ll see that great businesses positioned in secular growth areas of the economy will almost certainly thrive over the long run.

Home Depot is a perfect example.

What could possibly be more secular than the need for shelter?

The global population continues to expand, and these future human beings will all need somewhere to live.

And we’re not talking about just somewhere to live.

People want their shelter to be a home.

Well, that’s precisely where Home Depot comes in, offering thousands of products to improve and beautify one’s abode.

After all, it’s called Home Depot, not “shelter depot”.

Furthermore, homes are physical structures that naturally deteriorate over time.

That means routine trips to the local Home Depot in order to purchase various products for maintenance and repair.

All of this adds up to Home Depot being in a great position to continue growing its revenue, profit, and dividend for many years to come.

Dividend Growth, Growth Rate, Payout Ratio and Yield

As things stand, Home Depot has increased its dividend for 13 consecutive years.

And I think they’re just getting started with that.

The 10-year dividend growth rate is an astounding 20.3%, although more recent dividend increases have been closer to 15%.

Along with the double-digit dividend growth rate, the stock yields a market-beating 2.8%.

This yield, by the way, is 60 basis points higher than its own five-year average.

And with a healthy payout ratio of 46.7%, Home Depot’s dividend is set up to continue growing at least in line with the business, if not faster.

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 higher) dividend growth rate.

This stock gives you both a sweet yield and a very sweet dividend growth rate.

Revenue and Earnings Growth

As sweet as these numbers might be, they’re mostly looking backward.

But investors have to face the reality of 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 great aid when it comes time to estimate the stock’s intrinsic value.

I’ll first present the company’s top-line and bottom-line growth over the last decade.

And then I’ll uncover a near-term professional prognostication for profit growth.

Lining up the proven past with a future forecast like this should help us to formulate an idea about where the business may 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 tend to look for a mid-single-digit top-line growth rate from a mature company like this.

Home Depot blew my expectations out of the water.

Compounding revenue at this kind of rate from a $75 billion base is exceptional.

Meanwhile, earnings per share grew from $3.00 to $15.53 over this period, which is a CAGR of 20%.

Truly extraordinary bottom-line growth.

What’s remarkable here is that EPS growth and dividend growth line up almost exactly over the last decade, demonstrating incredible prudence from management.

A mix of margin expansion and prolific buybacks spurred a lot of the excess bottom-line growth.

For perspective on the buybacks, the outstanding share count is down by 30% over the last decade.

And the company recently authorized a new $15 billion share repurchase program.

Looking forward, CFRA is forecasting that Home Depot will compound its EPS at an annual rate of 4% over the next three years.

CFRA’s forecast for near-term EPS growth is well off of what Home Depot produced over the last decade.

Is this kind of slowdown realistic?

I think it is, albeit with the caveat that I see it as a temporary phenomenon.

It’s a bump in a road that is otherwise nearly flawless.

Indeed, Home Depot’s own FY 2022 guidance calls for mid-single-digit EPS growth.

This comes down to what’s been a pull-forward in sales over the last two years.

Home Depot has been a beneficiary of certain pandemic-related events.

Some people decided to flee cities because of health concerns, lockdowns, and/or family/space needs.

Many of these people bought larger homes in suburban markets.

Simultaneously, the work-from-home trend took off in a big way, partially out of a need for businesses to adapt to the pandemic, which left people craving more space at home with office setups.

It’s not hard to see how this was a perfect storm, leading to an explosion in demand for Home Depot’s products.

And it’s important to keep in mind that Home Depot disproportionately benefits from favorable industry dynamics.

The company operates within a powerful duopoly – Lowe’s Companies Inc. (LOW) is the only serious competitor.

Now, let’s be clear.

While some of the pandemic-induced trends are apparently behind us, the desire to own one’s home isn’t a trend.

Homeownership is a lifelong dream for many Americans.

In addition, the work-from-home situation seems to be “sticky”.

That said, it’s unreasonable to expect the results over the last two years to persist indefinitely.

Once certain home improvements have been completed, that’s it.

There are only so many kitchens to remodel, decks to build, and home offices to fashion at one time.

Even if we accept CFRA’s forecast as a base case, I still believe Home Depot offers a lot to like.

Expanding the payout ratio ever so slightly could support high-single-digit dividend growth in an environment where the company’s EPS is only growing at a mid-single-digit rate.

Keep in mind, this is only a near-term situation.

If we widen our aperture and look at Home Depot’s growth profile before the pandemic hit, they were doubling EPS roughly every five years.

The earnings power here is special.

I don’t see why they couldn’t return to this kind of growth once the world fully normalizes, which would set the dividend up to grow at least in the high-single-digit range over the long run.

Coupling that with a 2.8% yield is awfully appealing.

Financial Position

Moving over to the balance sheet, Home Depot has a great financial position.

The long-term debt/equity ratio is N/A.

Buybacks have led to a high amount of treasury stock, which has created negative shareholders’ equity.

However, total long-term debt of under $40 billion is not concerning for a company with a market cap of nearly $280 billion.

Moreover, an interest coverage ratio of over 17 shows no issues whatsoever with servicing debt.

Profitability is impressive, especially considering the fact that retailing is typically a low-margin industry.

Over the last five years, the firm has averaged annual net margin of 10%. There is no measurable ROE because of negative common equity.

To offer some context to the margin expansion story that’s played out, net margin was routinely coming in at between 6% and 7% at the start of the last decade.

Home Depot is a terrific business.

And with large economies of scale, pricing power, brand value, product specialization, and a differentiated workforce that guides consumer purchases, 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.

Retailing, in particular, is an extremely competitive industry, but Home Depot’s status as the clear leader within an entrenched duopoly mitigates competition.

The company has exposure to economic cycles, as spending on homes and home improvement is partially reliant on economic confidence, strength, and expansion.

Housing supply/affordability remains an ongoing issue in the US, but people living in older homes actually bodes well for the company.

Pent-up demand for services in a post-pandemic world could lead to less 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 has been cooling of late, which would likely negatively impact the demand for general spending on homes.

It’s worth bearing these risks in mind, but the quality and promise of the business should also be considered.

And after the stock’s jaw-dropping 35% drop from its 52-week high, the valuation is more attractive than it’s been in years…

Stock Price Valuation

The stock is trading hands for a P/E ratio of 16.7.

This is a stock that has usually commanded an above-market earnings multiple, but it’s now flipped to a below-market earnings multiple.

This is also well off of the stock’s own five-year average P/E ratio of 22.9.

We can also see that the P/S ratio of 1.8 is measurably lower than its own five-year average of 2.3.

And the yield, as noted earlier, is significantly 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’s as high as I’ll go with a long-term dividend growth rate, but a business of Home Depot’s caliber deserves this designation.

The company has clearly shown an ability to grow both EPS and the dividend at a higher rate than this over a long period of time.

While a pull-forward in sales seems to be causing a temporary slowdown in growth, I don’t see anything here that indicates a permanent impairment.

With a moderate payout ratio, the company should be able to sustain high-single-digit dividend growth until the business normalizes.

After that, there could be an acceleration in dividend growth.

I like to err on the side of caution, but I think this is the rare kind of business that can actually exceed lofty expectations over the long run.

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.

I believe my valuation took a balanced stance, yet the stock still looks highly undervalued.

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 3-star stock, with a fair value estimate of $267.00.

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 $365.00.

I came out high this time around, which surprises me. Nonetheless, none of us view it as expensive. Averaging the three numbers out gives us a final valuation of $347.47, which would indicate the stock is possibly 28% undervalued.

Bottom line: Home Depot Inc. (HD) is a world-class retailer taking advantage of secular growth and benefiting from being the clear leader within a powerful duopoly. With a market-beating yield, double-digit long-term dividend growth, a moderate payout ratio, more than 10 consecutive years of dividend increases, and the potential that shares are 28% undervalued, long-term dividend growth investors should seriously consider buying the drop on this high-quality dividend growth stock.

— 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 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.