Warren Buffett has correctly noted many times how one doesn’t need to have a high IQ in order to become a successful investor over time.
Finding great investment opportunities doesn’t require one to be a genius.
In fact, these opportunities are all around us.
Many of the world’s best businesses are household names that are extremely visible in day-to-day life.
Want to see what I mean?
Take 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 many, many household names on this list – companies that provide the products and/or services you probably use on a regular basis.
And by providing those products and/or services, these companies make a lot of money.
The profit tends to regularly increase, which allows these same companies to regularly send rising cash dividend payments back to shareholders.
This is why I love the dividend growth investing strategy.
The strategy is all about buying and holding shares in high-quality businesses that pay safe, growing dividends to shareholders.
Growing dividends must be underpinned by growing profit in order to be sustainable, and growing profit is a pretty good sign that a business is doing something right.
By its very nature, this strategy can almost automatically funnel one right into terrific businesses.
I’ve been using this strategy for nearly 15 years now, and it’s guided me as I’ve gone about building the FIRE Fund.
That’s my real-money portfolio, and it generates enough five-figure passive dividend income for me to live off of.
This passive dividend income has been enough to cover my bills for years, even allowing me to retire in my early 30s.
My Early Retirement Blueprint spells out how I was able to do all of that.
Now, while dividend growth investing can easily tilt you toward the great investment opportunities out there, you must still carefully consider valuation.
Price is only what you pay, but it’s value that you actually 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.
Repeatedly buying undervalued high-quality dividend growth stocks can lead to enormous wealth and passive income over time, and this simple process proves that you don’t need a particularly high IQ in order to become a successful investor.
Of course, this assumes you already have a basic understanding of valuation.
If you don’t already have this, I’d recommend giving Lesson 11: Valuation a read.
Penned by fellow contributor Dave Van Knapp, it provides a primer on valuation and a helpful template that can be used to estimate the fair value of almost 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…
Domino’s Pizza, Inc. (DPZ)
Domino’s Pizza, Inc. (DPZ) is a multinational pizza restaurant chain.
Founded in 1960, Domino’s is now an $11 billion (by market cap) QSR giant that employs almost 9,000 people.
FY 2023 revenue can be broken down across three main segments: Supply chain, 61%; U.S. stores, 32%; and International Franchise, 7%.
Domino’s is the largest pizza restaurant chain in the world, with nearly 21,000 stores located across more than 90 different markets.
Approximately 2/3rds of all stores are located in international markets.
Almost all stores globally are franchised.
At its heart, Domino’s is a global chain of restaurants selling pizza.
Nothing complex about this, yet there’s beauty in the simplicity.
Pizza is a timeless, affordable food staple that travels well and never loses appeal.
Almost everyone loves pizza, and Domino’s is able to flexibly adapt the product to local markets and tastes (e.g., seafood toppings across many Asian countries).
In addition, because Domino’s is able to quickly make and deliver pizza right to customers, the convenience factor is off the charts.
If that’s all there was, Domino’s would almost certainly be a great business and investment.
But Domino’s has taken this simple idea and made it even more powerful through franchising.
By franchising the vast majority of its stores, Domino’s has created a capital-light business model with a steady stream of royalty revenue.
In addition, Domino’s has been quick to adapt to technology and incorporate innovation into its processes, creating even stickier customers through tracking technology and loyalty programs.
There’s also the near-infinite scalability at work here, because of both the nature of the product (a timeless food product that needs to be purchased again once consumed) and the company’s “fortressing” strategy – the shortening of delivery radiuses by putting in new stores in the same markets, as close to customers as possible, resulting in shorter delivery times and lower costs per delivery.
More scales means more stores being able to sell more food at lower prices and higher levels of convenience.
It’s very difficult to mess up what Domino’s has created, and the company almost can’t help but to sell more products at higher prices over time.
That should translate to more revenue and profit, which leads to higher dividends to shareholders.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Already, Domino’s has increased its dividend for 12 consecutive years.
The 10-year dividend growth rate is an astounding 19.7%, which is just incredible, and the amazing thing is that it hasn’t really slowed.
For example, Domino’s most recently increased its dividend by nearly 25%!
And with a payout ratio of only 37.2%, the company has plenty of room for more of this double-digit dividend growth.
Now, one does have to sacrifice some yield here in order to access that high growth.
That’s the trade-off, but I think it’s a very reasonable one to make.
That said, the stock’s 1.4% yield is decently respectable and actually quite a bit higher than it usually is.
For perspective, this yield is 50 basis points higher than its own five-year average.
It’s a terrific dividend profile, bolstered by the very impressive rate of dividend growth.
It might not work for income-oriented investors, but younger dividend growth investors who have time for compounding to work its magic could have a marvelous long-term opportunity here.
Revenue and Earnings Growth
As marvelous as it may be, though, many of the dividend metrics here are looking backward.
However, investors must always be trying to look forward, because today’s capital gets put on the line for the rewards of tomorrow.
As such, I’ll now build out a forward-looking growth trajectory for the business, which will be of aid when the time comes to estimate intrinsic value.
I’ll first show you what the business has done over the last decade in terms of its top-line and bottom-line growth.
And I’ll then reveal a professional prognostication for near-term profit growth.
Blending the proven past with a future forecast in this manner should give us enough information to roughly gauge where the business might be going from here.
Domino’s moved its revenue from $2 billion in FY 2014 to $4.5 billion in FY 2023.
That’s a compound annual growth rate of 9.4%.
Strong top-line growth.
I’m usually looking for a mid-single-digit (or better) top-line growth rate from a fairly mature business like this, but Domino’s is growing much faster.
Meanwhile, earnings per share grew from $2.86 to $14.66 over this period, which is a CAGR of 19.9%.
Tremendous bottom-line growth.
Domino’s is growing like a tech company… with pizza.
Hard to overstate how impressive this is.
A combination of margin expansion and share buybacks helped to drive so much excess bottom-line growth.
Domino’s has been prolific when it comes to the buybacks, with the outstanding share count down by nearly 40% over this 10-year period.
Looking forward, CFRA believes that Domino’s will compound its EPS at an annual rate of 10% over the next three years.
This would represent a material slowdown relative to what’s transpired over the last decade.
CFRA notes the elephant in the room that caused Domino’s stock to crash by nearly 20% after its Q2 results were released on July 18.
That report included the disappointing news that Domino’s now expects international expansion efforts to fall short by 175 to 275 stores (original goal 925+ net new international stores in 2024), due to DPE (Domino’s Pizza Enterprises), a master franchisee, experiencing some issues after aggressive marketplace growth.
CFRA sums up their view with this: “In our view, while [Domino’s]’s U.S. sales are encouraging, we still have concerns about margins and recent issues abroad.”
Fair enough.
The international expansion slowing, which is a linchpin to the overall growth story for Domino’s.
It’s discouraging.
However, I think the post-earnings selloff was way overdone, and the quarter was actually phenomenal in almost every other way.
US same-store sales growth came in at nearly 5% YOY.
Revenue increased 7.1% YOY.
Most impressively, EPS came in at 30.8% higher YOY.
Yes, DPE will have to digest its current footprint and roll out new stores a bit more slowly than it had planned on.
But that’s certainly not the end of the world, and Domino’s is still putting up world-class numbers anyway.
Simply put, Domino’s is running one of the world’s very best QSRs.
In light of this recent quarter, along with what’s been consistently happening for years, CFRA’s forecast looks awfully pessimistic to me.
However, even if Domino’s were to “only” grow its bottom line at 10%/year over the next few years, that would still open up the door to low-double-digit dividend growth (by virtue of the low payout ratio).
Since I think 10% is sandbagging it, mid-teens dividend growth seems like a very reasonable expectation over the next several years – not far off from the 10-year dividend growth rate.
And that sets long-term shareholders up for a juicy, double-digit annualized total return.
I like that very much.
Financial Position
Moving over to the balance sheet, on the surface, Domino’s has a mediocre financial position.
The long-term debt/equity ratio is N/A (due to negative common equity), while the interest coverage ratio is just over 4.
Domino’s ended last fiscal year with $4.9 billion in long-term debt, which isn’t overly concerning against the size of the enterprise (about 1/3 the amount of the market cap).
It’s far from a fantastic balance sheet.
However, Domino’s operates within an asset-light framework built around franchises, which creates a centralized revenue collector with minimal overhead costs.
With that context in mind, the financial situation isn’t as bad as it might first appear to be.
Still, I’d like to see a better balance sheet, and I certainly would not be interested in any kind of further deterioration.
Profitability, on the other hand, is strong.
Return on assets has averaged 31.3% over the last five years, while net margin has averaged 11.3%. Due to negative common equity, there is no ROE.
Franchising a timeless food staple with very predictable and repeatable sales has created a phenomenal business that steadily collects royalties without employing much capital.
And the company does benefit from durable competitive advantages that include economies of scale, brand power, and a global franchise footprint.
Of course, there are risks to consider.
Competition, regulation, and litigation are omnipresent risks in every industry.
I see regulation and litigation risks as being relatively low for Domino’s.
On the flip side, they operate in a fiercely competitive QSR industry.
Helping to stave off competition is the aforementioned “fortressing” strategy, which makes Domino’s the most convenient option in the marketplace.
The stretched balance sheet is a mild concern.
Inflation has created challenges in regard to input costs.
The company has been facing labor shortages, especially regarding delivery drivers.
The global footprint is an advantage, but a larger absolute footprint is harder to grow in relative terms.
There are some risks to consider, but they have to be measured up against the quality and growth of this business.
And the valuation, which currently looks quite reasonable after a 20% drop in the stock price, has to be part of the equation…
Valuation
The stock is trading hands for a P/E ratio of 26.
That’s actually low for this stock, as it usually commands a very healthy premium.
It’s far lower than its own five-year average of 30.9.
The cash flow multiple of 23.4 is also quite a bit lower than its own five-year average of 26.7.
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 two-stage dividend discount model analysis.
I factored in a 10% discount rate, a 14% dividend growth rate for the next 10 years, and a long-term dividend growth rate of 8%.
If the near-term dividend growth rate looks aggressive to you, it’s really not.
Domino’s has grown both its dividend and EPS at far faster rates than this over the last decade.
The last quarter showed extremely strong EPS growth, and the last dividend raise was nearly 25%.
With CFRA’s three-year EPS forecast being at 10% (which I think is too pessimistic), and with the payout ratio being as low as it is, Domino’s could easily grow the dividend at a mid-teens rate over the coming years.
Domino’s has been a growth monster for a long, long time, and I just don’t see anything that’s gonna change this.
The DDM analysis gives me a fair value of $540.08.
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 came up with a price that’s similar to where the stock was at just a few weeks ago, so the recent drawdown looks excessive to me.
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 DPZ as a 2-star stock, with a fair value estimate of $425.00.
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 DPZ as a 3-star “HOLD”, with a 12-month target price of $434.00.
I came out high, but I think there’s too much conservatism with the other two. Averaging the three numbers out gives us a final valuation of $466.36, which would indicate the stock is possibly 9% undervalued.
Bottom line: Domino’s Pizza, Inc. (DPZ) is a terrific business, taking advantage of an asset-light, royalty-rich business model that has franchised out the convenient selling of a timeless food staple with highly repeatable purchases. With a respectable yield, double-digit dividend growth, a low payout ratio, more than 10 consecutive years of dividend increases, and the potential that shares are 9% undervalued, younger dividend growth investors less sensitive to income should take a good look at this high-quality compounder while it’s on sale.
-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 DPZ’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 55. 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, DPZ’s dividend appears Borderline Safe with a moderate risk of being cut. Learn more about Dividend Safety Scores here.
Disclosure: I’m long DPZ.