The stock market seems like a crazy, scary place to those who are new to it.
I’ve found that it can be as crazy and scary as you want to make it.
There are “pockets” of crazy where you’ll find the speculative trading, momentum chasing, etc.
All the same, though, the market can seem like a pretty orderly way to make money over time for those who approach things with a clear, rational mind.
This is why I’m such a fan of dividend growth investing.
It might just be the most rational way to approach the market.
This is a long-term investment strategy that involves buying and holding shares in high-quality businesses that reward shareholders with reliable, rising dividends.
Those reliable, rising dividends practically require reliable, rising profits.
Well, it’s awfully hard for terrible businesses to reliably put up rising profits.
As such, the strategy tends to funnel investors almost automatically into some of the world’s best businesses, giving better odds of great outcomes over the long run.
Sounds pretty rational to me.
You’ll find hundreds of stocks that qualify for the strategy by looking over the Dividend Champions, Contenders, and Challengers list – a list with important metrics on US-listed stocks that have raised dividends each year for at least the last five consecutive years.
I’ve followed this strategy for nearly 15 years now.
To say that it’s changed my life would be greatly understating it.
It guided me as I’ve gone about building the FIRE Fund, which is my real-money portfolio that generates enough five-figure passive dividend income for me to live off of.
This dividend income became enough to cover my bills when I quit my job and retired in my early 30s, and I lay out in my Early Retirement Blueprint how that happened.
Now, a key feature of any rational dividend growth investor is their relentless focus on valuation whenever they’re considering an investment.
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.
Taking a rational approach to the market by utilizing the dividend growth investing strategy and routinely buying shares in high-quality businesses at attractive valuations can yield amazing results over time and even lead to financial independence.
Of course, everything I just laid out does depend on a basic understanding of valuation already being in place.
If that’s not the case for you, no worries.
Fellow contributor Dave Van Knapp’s Lesson 11: Valuation, which is part of an overarching series of “lessons” designed to teach dividend growth investing, lays out the whole concept of valuation in simple-to-understand terms and even provides a valuation template that you can easily apply on your own.
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…
D.R. Horton, Inc. (DHI) is an American home construction company.
Founded in 1978, D.R. Horton is now a $47 billion (by market cap) homebuilding leader that employs nearly 15,000 people.
By volume, D.R. Horton is the largest homebuilder in the United States.
The company operates in 118 different markets across 33 states.
D.R. Horton is the 800-pound gorilla in a lucrative industry poised to do incredibly well over the coming years.
It comes down to extremely favorable dynamics around supply and demand.
First of all, homeownership is part of the “American Dream”.
Most households desire to own their abode.
There’s a base level of demand for homes – a base which rises alongside the population and formation of new households.
Well, D.R. Horton is suited particularly well to help this dream come true for those Americans forming new households.
That’s because the company specializes in starter homes for first-time homebuyers who prioritize affordability.
Approximately 70% of its homes close at under $400,000.
D.R. Horton has no issues whatsoever with demand.
At the same time, against this strong demand backdrop, limited supply gives the company a further boost.
For a variety of reasons, it’s been difficult to bring new supply to market, leading to a structural imbalance between supply and demand.
Stretching back to the GFC, US homebuilders have seen construction activity curtailed.
Key challenges to new construction activity include red tape, land acquisition, NIMBYism, and labor shortages.
Annual US home production has been steadily short of what’s necessary to meet demand, and it’s been estimated that the US has a supply deficit of somewhere around six million homes.
This cumulative deficit, which has been years in the making, is now huge.
And it won’t be an easy or fast fix.
Even if new home construction volume were to suddenly materially increase, it’ll take many years of overproduction just to close the existing gap – before factoring in the rising demand from new households being formed in the interim.
Better yet for D.R. Horton (albeit not for those looking to buy homes), because there’s a consistent and ongoing stream of young adults entering the market for the first time and trying to buy single-family homes at low price points, the structural imbalance between supply and demand is most acute around those affordable homes that the company specializes in.
But wait.
There’s more.
High interest rates have created a tight resale market, which leads many would-be buyers right into new homes.
What we have here is favorability on steroids.
This helps to explain the explosive business and stock performance over the last decade – exemplified by the stock’s 500%+ return over this period.
And with the imbalance between supply and demand being structural in nature, I don’t see why the next decade can’t also be phenomenal for D.R. Horton and its ability to meaningfully grow its revenue, profit, and dividend.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Indeed, D.R. Horton has increased its dividend for 11 consecutive years.
That dates back to the aftermath of the GFC, which was a time of great turmoil in the US housing industry and homebuilders with far worse financials than what we see now.
The five-year dividend growth rate is 14.9%, which is splendid.
And there’s been no signs of any kind of slowdown, either, as even the most recent dividend raise came in at a monstrous 33.3%.
However, the stock’s lowish yield of 1.1% is the trade-off one must make in order to get access to the growth.
This yield isn’t a surprise, although I’d note that it is 20 basis points higher than its own five-year average.
To the contrary, it’d be silly to expect a high yield when the dividend growth rate is well into the double digits.
Still, for older investors who might be more sensitive to yield and income, this idea might not be super compelling.
On the other hand, for younger dividend growth investors, or even investors who already have enough income and are more interested in long-term growth, D.R. Horton is cooking.
The payout ratio is only 11.2%, so the throttle is likely to remain wide open when it comes to dividend raises over the coming years.
Put simply, D.R. Horton is turning into a powerful dividend growth machine.
Revenue and Earnings Growth
As powerful as it might be, though, many of the dividend metrics we see above are looking backward.
However, investors must always be looking forward, as the capital of today ultimately gets risked for the rewards of tomorrow.
As such, I’ll now build out a forward-looking growth trajectory for the business, which will be of use 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.
Lining up the proven past with a future forecast in this manner should allow us to gauge where the business could be going from here.
D.R. Horton advanced its revenue from $10.8 billion in FY 2015 to $36.8 billion in FY 2024.
That’s a compound annual growth rate of 14.6%.
Exceptional.
I’m usually wanting to see a mid-single-digit (or better) top-line growth rate from a mature business like this.
D.R. Horton blew well past my expectations.
Meanwhile, earnings per share grew from $2.03 to $14.34 over this period, which is a CAGR of 24.3%.
It’s hard to overstate how impressive this is.
I mean, we’re talking about tech-like growth out of a homebuilder.
It’s bananas.
A combination of margin expansion and share buybacks helped to fuel excess bottom-line growth.
Regarding the latter point, the outstanding share count has been reduced by approximately 10% over the last decade.
Looking forward, CFRA currently has no three-year forecast for D.R. Horton’s EPS CAGR.
This is unfortunate, as I do like to compare the proven past with a future forecast.
I’ll note that I last looked at CFRA’s report on D.R. Horton back in April, and it had its forecast for D.R. Horton’s EPS CAGR at 9% for the next three years.
Seeing as how there’s really not much that’s changed over the last few months, I’m sticking with that.
Also, there is much to glean from recent remarks.
CFRA notes that D.R. Horton “…benefits from a tight resale market leading home buyers to engage in homebuilding transactions.”
CFRA also highlights D.R. Horton’s “favorable lot position, strong balance sheet, and benefits of scale to offset margin pressure.”
That point on lot position refers to D.R. Horton’s majority ownership of Forestar Group Inc. (FOR), a publicly-traded residential lot development company.
Through this stake, D.R. Horton has the ability to acquire and develop its own lots.
In addition, D.R. Horton owns its own title agency and provides financing directly to buyers.
This is a vertically-integrated homebuilder.
From lot acquisition and development all the way to providing and financing a finished product, D.R. Horton is a “one-stop shop”.
It’s a juggernaut.
I find it hard to believe that D.R. Horton will be unable to muster a HSD-LDD EPS growth rate over the next few years, lining up fairly well with CFRA’s last forecast.
By virtue of the payout ratio being extremely low, that would open up the dividend for much faster growth.
Even putting aside the most recent 30%+ dividend raise for a moment, there’d be nothing challenging about a mid-teens or even high-teens dividend growth rate ahead for this business.
And that would line up quite well with the demonstrated dividend growth over the last several years.
Boiling it all down, it’s a compounding machine set to continue compounding at a fairly high rate.
Financial Position
Moving over to the balance sheet, D.R. Horton has a stellar financial position.
The long-term debt/equity ratio is just 0.2.
As low as that is, it belies how strong the balance sheet actually is.
I say that because D.R. Horton ended last fiscal year with a net cash position.
This is completely different to how things were around the time of the GFC (when D.R. Horton had net debt), showing just how much the homebuilder space has improved.
Profitability is outstanding.
Return on equity has averaged 25.9% over the last five years, while net margin has averaged 14.1%.
Pretty amazing to see a homebuilder put up tech-like growth and returns on capital.
It’s clear to me that D.R. Horton is running a terrific business.
And with economies of scale, high barriers to entry, leading market share, vertical integration, and industry know-how, the company does benefit from durable competitive advantages.
Of course, there are risks to consider.
Litigation, regulation, and competition are omnipresent risks in every industry.
The homebuilding industry, in general, is highly cyclical and very sensitive to economic slowdowns, but the shortage of housing supply in the US provides a buffer.
Building on that last point, the way in which D.R. Horton leans into first-time, entry-level homebuyers makes the business particularly sensitive to the US economy (seeing as how those on the lower end of the socioeconomic strata can be financially fragile).
D.R. Horton is strongly and directly exposed to interest rates, as interest rates affect demand for mortgages and housing.
Interest rates are currently elevated off of recent levels, which makes it more expensive and difficult for consumers to purchase homes.
This is a capital-intensive business model, meaning the company must intelligently manage its pace and inventory in every market.
The company has a variety of input costs which are largely out of its control, and inflation has resulted in upward pressure on these costs.
A major source of input costs is labor, and skilled labor shortages in the construction industry across the US is a headwind for the business.
I certainly see some risks present, but the structural shortage of housing supply offsets many of them.
Another key offset is the valuation, which looks attractive after the stock’s 30% fall from recent highs…
Valuation
The stock is trading hands for a P/E ratio of 9.8.
A lowly single-digit P/E ratio for a company that has put up double-digit growth?
Seems quite strange to me.
The sales multiple of 1.3 is also very undemanding and roughly in line with its own five-year average.
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 two-stage dividend discount model analysis.
I factored in a 10% discount rate, a 10-year dividend growth rate of 16%, and a long-term dividend growth rate of 8%.
The last time I valued this business, I actually used an 18% 10-year dividend growth rate, but I’m adjusting this downward just slightly in response to the company’s recent 33.3% dividend raise which pulled forward some growth.
Still, this would be a very healthy dividend growth rate over the next decade.
And it lines up well with what I noted earlier about the company’s easy ability to continue growing the dividend at a mid-teens rate.
If the business can grow at a HSD-LDD rate, a slow expansion of the low payout ratio clearly sets up the dividend for a growth rate at well into the double digits.
I just don’t see anything unreasonable here, although I would expect the dividend growth rate to slow a bit after that payout ratio expansion plays out (and this is reflected in the model).
The DDM analysis gives me a fair value of $168.63.
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 view is that this stock looks too cheap for the growth and quality it offers.
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 DHI as a 3-star stock, with a fair value estimate of $143.00.
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 DHI as a 3-star “HOLD”, with a 12-month target price of $171.00.
I ended up extremely close to where CFRA is at. Averaging the three numbers out gives us a final valuation of $160.88, which would indicate the stock is possibly 12% undervalued.
-Jason Fieber
Note from D&I: How safe is DHI’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 85. 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, DHI’s dividend appears Very Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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.
Disclosure: I’m long DHI.
