Money.
It’s difficult and time consuming to make it.
Yet, it can be spent very easily and quickly.
This asymmetrical, unfavorable relationship regarding our money can actually be fixed.
How?
By investing.
Investing puts one in a situation where their money makes more money for them.
Money doesn’t sleep or sweat.
It’s way easier for money to make money than it is for you or I to go out and make money ourselves.
Investing puts money to work.
And I’ve found that the very best way for that money to work is through the dividend growth investing strategy.
This is a long-term investment strategy whereby one buys and holds shares in high-quality businesses paying their shareholders reliable, rising dividends.
This strategy literally pays you to own stock in great companies.
It just doesn’t get any easier than simply collecting dividends.
And when those dividends are growing, year after year, that’s even better.
You can see what I mean by taking a look at the Dividend Champions, Contenders, and Challengers list, which has assembled invaluable information on hundreds of US-listed stocks that have raised dividends each year for at least the last five consecutive years.
Some of the world’s best companies are on this list.
For good reason.
After all, it takes a special kind of business to be able to produce the ever-larger profit necessary to afford ever-bigger dividend payouts.
I started applying this strategy 15 years ago, and it’s what has allowed me to build the FIRE Fund.
That’s my real-money portfolio which generates enough five-figure passive dividend income for me to live off.
Actually, I’ve been in the extremely fortunate position of being able to live off of dividend income since I quit my job and retired in my early 30s.
To find out how that was possible, check out my Early Retirement Blueprint.
Now, putting money to work properly involves more than simply investing in the right businesses.
Investing when valuations are right is also extremely important.
That’s because price only represents what you pay, but value represents what you ultimately 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.
Properly putting your money to work by buying undervalued high-quality dividend growth stocks is a great way to fix the disadvantageous nature of earning and spending money, allowing oneself to build significant wealth and passive income over time.
Of course, spotting undervaluation and being in a position to pounce on opportunities requires one to understand the entire concept of valuation.
Well, that’s where Lesson 11: Valuation comes in.
Written by fellow contributor Dave Van Knapp as part of an overarching series of “lessons” designed to teach the entire dividend growth investing strategy, it uses simple terminology to instruct readers on what valuation is all about and how to correctly estimate the fair value of just about any dividend growth stock you’ll run across.
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…
Lithia & Driveway (LAD)
Lithia & Driveway (LAD) is an American automotive dealership group.
Founded in 1946, Lithia & Driveway is now an $8 billion (by market cap) car dealership aggregator that employs approximately 30,000 people.
Lithia & Driveway operates more than 300 dealerships across 25 US states representing 40 different OEM car brands (with its top three brands by revenue being Honda, Toyota, and BMW/Mini).
The company has also started to expand internationally through acquisitions and now operates dealerships in Canada and the UK.
Its 2024 acquisition Pendragon PLC’s UK motor and fleet management divisions through a strategic partnership for a cash consideration of approximately $350 million greatly expanded the geographic footprint and reach of the group, and Lithia & Driveway now operates more than 100 international stores (bringing its total dealership count to nearly 500).
Despite the international expansion efforts, ~80% of the company’s revenue is derived from the US.
The company reports results across five categories: New Vehicle Sales, 48% of FY 2024 revenue; Used Vehicle Sales, 35%; Service, Body & Parts, 11%; Finance & Insurance, 4%; and Fleet & Other, 2%.
By vehicle type, its sales mix for FY 2024 was: Import, 43%; and Luxury, 33%; and Domestic, 24%.
Because higher margins can be found in financing sales and providing parts and services to vehicles (relative to the actual selling of vehicles), the Finance & Insurance and Service, Body, Parts segments combined to account for nearly 65% of FY 2024 gross profit (compared to only 15% of revenue).
This brings me to the crux of the matter.
The dealership business model is ingeniously lucrative.
There’s a self-reinforcing ecosystem in place.
Since it’s nigh impossible to live in a modern-day society without a personal vehicle (excepting a few major metropolises), dealers have captive customers who depend on their products.
Only OEM-backed dealerships are allowed to sell new vehicles.
Better yet, an OEM will only allow one branded dealership per geographic area, which creates a localized monopoly.
This creates the initial sales opportunity.
And since most people don’t have enough liquid capital to buy a car in cash, that leads right to the financing opportunity (which, as I just noted, has incredibly high margins for the dealer).
Once a customer buys a vehicle, there’s then a long-lasting relationship put in place, whereby that customer must return to the dealership for maintenance and repairs.
Only OEM-backed dealerships are allowed to provide warranty updates/repairs, so that further reinforces the relationship between the customer and the dealership.
Moreover, because of how complex vehicles have become over the years (they’re practically computers on wheels nowadays), it’s often only OEM-backed dealerships that have the technological know-how (via trained technicians, access to certain factory information, and specialized machinery) necessary to perform work on these vehicles.
Put simply, vehicle owners become beholden to the dealership.
It’s a self-perpetuating flywheel nearly guarantees sticky clientele and repeat business for the dealership (much of which is extremely profitable).
Well, Lithia & Driveway cranks this up a notch by employing the serial acquirer model to slowly acquire competitors.
An individual dealership is a money machine.
Lithia & Driveway is assembling an army of these money machines, building itself a global empire of car dealerships.
This explains why the company has been so successful over the years, and it’s also why it’s positioned so well to continue growing its revenue, profit, and dividend for years to come.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Indeed, the company has increased its dividend for 15 consecutive years.
Its 10-year dividend growth rate is 13.1%, and some years have been especially strong, although a post-pandemic normalization of business (along with the temporary diversion of resources toward the UK expansion) has regulated in more recent dividend raises being in a high-single-digit range.
With the stock’s yield sitting at just 0.7%, one really does need to see that 13%+ dividend growth rate return in order to make sense of things.
First of all, this yield is 10 basis points higher than its own five-year average, so the market has adjusted the yield higher in order to compensate for the slowdown in growth (although this adjustment has been slight, as the market likely sees the slowdown as temporary).
Second of all, and more importantly, the payout ratio is only 7.2%.
This is one of the lowest payout ratios I’ve ever come across.
And that’s in the face of so much dividend growth, indicating the business itself has also been growing quickly (which is true, as I’ll soon show).
The payout ratio being so low gives the company the ability to grow its dividend briskly, even absent commensurate EPS growth, as a tripling of the payout ratio would still result in a healthy number.
However, because the company is growing nicely over time, I suspect a big expansion of the payout ratio will prove to be unnecessary.
Instead, what seems likely here is that a combination of business growth and some flexibility around the payout ratio will result in strong dividend growth (say, a mid-teens rate or so) over the foreseeable future.
If one is hungry for yield today, this idea isn’t palatable.
However, if one is a younger dividend growth investor who tilts toward high-quality compounders (the stock has a 15%+ CAGR, with reinvested dividends, over the last 10 and 20 years, respectively), this could be a fantastic long-term investment candidate.
Revenue and Earnings Growth
As fantastic as it may be, though, this candidacy is based on numbers that are largely in the past.
However, investors must always be considering the future, as the capital of today gets put on the line and risked for the rewards of tomorrow.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will be foundational for the valuation process.
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 way should give us the information we need to make a judgment call on where the business might be going from here.
Lithia & Driveway increased its revenue from $7.9 billion in FY 2015 to $36.2 billion in FY 2024.
That’s a compound annual growth rate of 18.4%.
Incredible top-line growth, but Lithia & Driveway’s acquisitive nature means a lot of this revenue growth has been inorganic.
So how did all of this translate over to the bottom line?
Well, earnings per share grew from $6.91 to $29.65 over this period, which is a CAGR of 17.6%.
Really strong result here.
We can see that Lithia & Driveway’s management has been destroying capital through poor acquisitions.
Speaking of this, I’d like to point out that Lithia & Driveway is a family-run business.
The DeBoer family founded and still owns more than 1% of the company, and it retains key positions: Bryan DeBoer is CEO, while Sidney DeBoer (the son of the original founder) is the Chairman.
The DeBoer family has both the control and incentive necessary to execute, run the business well, and create value for all shareholders (which includes the family).
Profitability (which I’ll touch on later) has been a bit bumpy in recent years, but I attribute that to an extremely volatile period for the industry (rather than anything to do with acquisitions).
High-teens growth like this is usually reserved for fast-growing technology firms, and I think this just goes to show how lucrative this business model is and how terrifically Lithia & Driveway is applying the business model.
Looking forward, CFRA is projecting a 4% CAGR for Lithia & Driveway’s EPS over the next three years.
I’ll parse this forecast in a moment, but I want to first highlight a passage from CFRA that I think excellently sums up the long-term investment thesis: “[Lithia & Driveway] will likely continue to grow through acquisition as it progresses toward its long-term goal of $75B-$100B in revenue and $131.25-$200.00 in EPS, and buybacks will help boost EPS growth. We think auto sales and margins could improve further in the coming quarters in tandem with declining interest rates and resilient results from their high-margin Aftersales (Parts and Service) segment. We believe [Lithia & Driveway] has one of the industry’s best management teams. The automotive retail industry is large and fragmented, which offers the potential for growth via acquisition. [Lithia & Driveway] has proven adept at growing EPS through accretive acquisitions and buybacks over time.”
So we have one of the best management teams in the industry running one of the most lucrative business models out there, taking cash flows from individual money machines to acquire more individual money machines.
And $200 in EPS makes the current stock price look silly cheap.
That’s the long-term picture.
Circling back around to CFRA’s near-term forecast, I don’t really have a problem with the 4% number.
Although this badly belies Lithia & Driveway’s long-term potential, the next year or two could be a bit rocky.
Interest rates remain very high (making it more expensive to finance new and used vehicles), margins are under pressure (car prices are coming off of historic highs), and possible tariffs are an unwelcome wrinkle.
A lot of this comes down to one’s time horizon.
If one is a trader, or if someone is looking for a lot of growth over the next six months, this isn’t it.
But if you’re looking for a high-quality compounder to grow your wealth and passive dividend income with over the next, say, 20 years, Lithia & Driveway has the tools it needs to continue compounding the business, stock, and dividend at mid-teens (or so) rates, respectively.
If you have that kind of time horizon, it’s awfully attractive.
Financial Position
Moving over to the balance sheet, the company has a challenging financial position.
The long-term debt/equity ratio is 1.2, while the interest coverage ratio is around 2.5.
Lithia & Driveway’s serial acquirer playbook has resulted in a very successful dealership empire, but it’s come at the expense of a heavily indebted balance sheet.
Long-term debt has exploded higher, now up more than 10 times over the last decade.
And the interest coverage ratio, in particular, is now worrisome.
This is the one blemish on an otherwise extremely impressive enterprise.
It really does depend on how much of a stickler one is regarding debt, but I personally view the balance sheet’s (lack of) health as something that should be seriously mended over the coming years.
Profitability, on the other hand, is fairly solid.
Return on equity has averaged 21.5% over the last five years, while net margin has averaged 3.6%.
Return on equity has been juiced by the balance sheet, and margins suffer from core car sales (it’s really financing and aftermarket services that make this business model so terrific).
ROIC is routinely in the 10% area, so returns on capital are pretty good here.
Other than the balance sheet, Lithia & Driveway has a fantastic business on its hands.
And with scale in a fragmented industry, localized franchise monopolies, OEM-backed inventory, and OEM-authorized warranty servicing that protects the dealership flywheel, 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.
Although the auto industry is extremely competitive at a high level, each individual dealership is insulated and protected by local franchise control.
Vehicle prices have recently fallen from unsustainable heights, negatively impacting near-term comps and profitability.
Until it’s in healthier condition, the stretched balance sheet will likely limit the company’s acquisitive behavior (which is a primary growth engine).
Cars are high-ticket purchases, and any kind of broad economic weakness could reduce demand for auto sales (although this may serve to raise demand for service and parts on an older fleet, as a personal vehicle is practically a necessity in the US).
Tariffs on autos are a new wrinkle that may negatively impact the company.
The serial acquirer model introduces risks around capital allocation, execution, and integration.
High interest rates harms both the company’s income statement (via reduced demand for auto loans) and balance sheet (via higher interest expenses on debt).
Insurance rates have risen significantly in recent years, which could stretch consumers’ ability to afford newer cars.
There are definitely some risks present here with Lithia & Driveway.
But the extremely low valuation appears to be pricing in a lot of risk anyway…
Valuation
The P/E ratio is sitting at a lowly 10.
We’re nearly in single-digit territory on the earnings multiple, despite double-digit revenue, EPS, and dividend growth.
If this were any other business model, and if the balance sheet weren’t marred like it is, I think this multiple would be at least twice as high.
For some reason, car dealerships have never really gotten any respect from the market.
However, many of them have still gone on to be fantastic investments over time, and that’s certainly been true for this name (its been compounding at a mid-teens rate, as I pointed out earlier).
The P/S ratio of 0.2 is also shockingly low, and it’s below even the stock’s own five-year average P/S ratio of 0.3 (which, in and of itself, is extremely low).
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 20-year dividend growth rate of 15%, and a long-term dividend growth rate of 8%.
This is the same model I used when I last analyzed and valued the stock, and I think it remains appropriate.
The payout ratio here is so low that Lithia & Driveway could grow its dividend at a mid-teens rate for a decade or longer even without the corresponding business growth to back it up.
But with the business also growing so nicely, that kind of payout ratio expansion seems unnecessary and unlikely.
The company is growing too quickly, and the payout ratio is too low, that the dividend almost can’t help but to increase rapidly over the coming years.
The DDM analysis gives me a fair value of $348.37.
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.
This stock looks attractively valued 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 LAD as a 4-star stock, with a fair value estimate of $426.00.
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 LAD as a 4-star “BUY”, with a 12-month target price of $450.00.
I’m surprised to see I came out so low, even though my valuation model was somewhat aggressive with the near-term dividend growth. Averaging the three numbers out gives us a final valuation of $408.12, which would indicate the stock is possibly 28% undervalued.
Bottom line: Lithia & Driveway (LAD) has used the serial acquirer playbook to great effect, building itself a car dealership empire. Each individual car dealership is a money machine, protected by localized monopolies and OEM-backed flywheels. With an acceptable yield, an extremely low payout ratio, double-digit dividend growth, 15 consecutive years of dividend increases, and the potential that shares are 28% undervalued, this is a high-quality compounder that looks to be on sale.
-Jason Fieber
Note from D&I: How safe is LAD’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 60. 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, LAD’s dividend appears Borderline Safe with a moderate 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 have no position in LAD.
