One of the biggest mistakes investors can make is selecting an investment strategy that doesn’t align with their temperament.
That means it all gets abandoned at the first sign of trouble.
If you can’t stick with something, even the best strategy in the world will be ineffective.
This is why I think dividend growth investing is so universally applicable.
It’s a long-term investment strategy involving the buying and holding of shares in high-quality businesses sending out ever-larger cash dividends to shareholders.
This strategy is so easy for almost anyone to warm up to and align with, making adherence more likely.
After all, who doesn’t love steadily collecting totally passive income which is consistently getting bigger all by itself?
You can find hundreds of businesses that qualify for the strategy by giving the Dividend Champions, Contenders, and Challengers list a look.
This list contains invaluable information on US-listed stocks that have raised dividends each year for at least the last five consecutive years.
I’ve been faithfully adhering to this strategy for more than 15 years now, and it’s been very rewarding.
It’s guided me as I’ve gone about building the FIRE Fund – my real-money portfolio generating enough five-figure passive dividend income for me to live off of.
Now, while investing in the right businesses will get you far, there’s also the matter of investing at the right valuations.
And that’s because price only tells you what you pay, but 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.
The ease of sticking with dividend growth investing due to the positive reinforcement of ever-growing passive dividend income makes it a fantastic long-term investment strategy for building wealth, passive income, and financial freedom.
Of course, the preceding information on valuation is only insightful if it’s fully understood.
This is where Lesson 11: Valuation comes in.
Written by fellow contributor Dave Van Knapp as part of a series of “lessons” designed to teach dividend growth investing, it does a great job of breaking down what valuation is all about and how to go about estimating the fair value of almost anything 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…
Sonic Automotive, Inc. (SAH) is a US-based automotive dealership group.
Founded in 1997, but with roots dating back to the 1960s, Sonic is now a $2.5 billion (by market cap) major dealership player employing more than 10,000 people.
Sonic operates more than 100 franchised dealerships across 18 states, mostly focused on luxury and import brands (such as BMW and Honda).
FY 2025 revenue breaks down as follows: New Vehicle Sales, 47%; Used/Wholesale Vehicle Sales, 34%; Parts, Service, and Collision Repair, 14%; and Finance, Insurance, and Other, 5%.
However, because of the high-margin nature of back-of-the-house operations, Parts, Service and Collision Repair actually comprised an outsized 43% of FY 2025 gross profit.
The automotive dealership business model is brilliant (and that’s coming from someone who personally worked in the space for years).
Its lucrative nature comes down to a self-reinforcing ecosystem.
Only OEM-backed dealerships are permitted to sell new vehicles.
Better yet, an OEM typically allows just one branded dealership per geographic area, which creates a localized monopoly with no competitive threats.
This creates the sales funnel.
From there, since most people don’t have enough liquid capital to buy a car in cash, that leads straight to high-margin financing and insurance opportunities.
Thereafter, once a customer takes ownership of a vehicle after financing, a long-lasting, sticky relationship is created due to the fact that the customer must return to the dealership for maintenance and repairs.
Only OEM-backed dealerships can provide warranty updates/repairs.
Furthermore, because of how complex vehicles have become(they’re almost 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 high-margin work on these vehicles – even after warranties have expired.
And that’s not event to mention that extended warranties tend to tie customers back to the origin dealership.
It’s a self-perpetuating flywheel that nearly guarantees sticky clientele and repeat business for the dealership.
Sonic has taken this idea and flown with it, steadily growing its revenue, profit, and dividend along the way.
Dividend Growth, Growth Rate, Payout Ratio and Yield
To date, Sonic has increased its dividend for 11 consecutive years.
Its 10-year dividend growth rate is 30.5%, which is obviously incredible and one of the highest I’ve yet come across.
The rate is so high because Sonic tends to hand out smaller dividend increases multiple times per year, and these smaller raises add up in a hurry.
Now, more recent dividend growth has slowed, but its three-year dividend growth rate is still 18%.
That yield is 30 basis points higher than its five-year average.
And when paired with the double-digit dividend growth, it’s a compelling package.
Since the payout ratio is only 26.2%, even after all of the large dividend raises, I’m seeing nothing to indicate the status quo can’t or won’t be maintained.
Seeing as how the status quo is amazing, that’s good news.
Revenue and Earnings Growth
As amazing as it has been, though, much of what we’re seeing here is largely rooted in the past.
However, investors must always be anticipating the future, as today’s capital gets risked for tomorrow’s rewards.
This is why I’ll now build out a forward-looking growth trajectory for the business, which will come in handy when the time comes to estimate fair value.
I’ll first show you what the business has done over the last ten years in terms of its top-line and bottom-line growth.
And I’ll then reveal a professional prognostication for near-term profit growth.
Amalgamating the proven past with a future forecast in this manner should give us the ability to reasonably assess where the business could be going from here.
Sonic advanced its revenue from $9.7 billion in FY 2016 to $15.2 billion in FY 2025.
That’s a compound annual growth rate of 5.1%.
Solid top-line growth.
That said, the dealership industry across the US is slowly consolidating as major players buy up smaller groups, and Sonic has been opportunistically acquiring stores.
Consistent acquisitions have helped to drive some of this top-level growth.
Meanwhile, earnings per share rose from $2.03 to $6.60 (adjusted) over this period, which is a CAGR of 14%.
I used adjusted EPS for FY 2025 due to some one-time charges which inaccurately skews things.
We can now see where all of that double-digit dividend growth came from: Sonic’s double-digit EPS growth has been fueling much of it.
It’s a strong number boosted by buybacks, with the outstanding share count down by nearly 25% over the prior decade.
It’s also clear that Sonic has been excellent with capital allocation, seeking out stores that are accretive to the bottom line.
Looking forward, CFRA believes that Sonic will deliver a 12% compound annual growth rate in its EPS over the next three years.
That’s not far off from what Sonic has been doing for quite a while, so we could be looking at more of the same – and the same has been quite good.
CFRA sees a better environment for dealerships ahead, driven by a combination of easing interest rates and improving vehicle affordability (after a pandemic-related spike).
That last portion is of particular relevance, as Sonic is more reliant than some competitors on luxury brands (accounting for half of Sonic’s total new vehicle revenue).
Sonic is one of the biggest and best players in its industry, so it already stands to capture a large portion of any benefits that accrue from positive changes, but its focus on luxury can disproportionately aid it.
Moreover, its opportunity set in terms of acquisition targets remains rich.
I’d also note that the founding Smith family continues to run Sonic and control the company through a 30%+ ownership stake, providing plenty of “skin in the game” and alignment with common shareholders.
As someone who seeks out out family-led/founder-led businesses, this gets a giant nod of approval from me.
I see nothing to indicate that Sonic can’t or won’t be able to support its low-teens type of EPS growth profile.
And when you layer that on top of the starting yield, that creates a credible path toward a mid-teens annualized total return.
It’s pretty fabulous.
Financial Position
Moving over to the balance sheet, Sonic has a tenuous financial position.
Its long-term debt/equity ratio is 1.8, while the interest coverage ratio is approximately 2.
This is, in my view, by far the weakest part of the whole business.
While large dealership groups tend to take on a lot of debt in order to pursue acquisitions and consolidate the industry, this is an aggressive stance.
Its BB credit rating from Fitch further demonstrates the lack of financial strength.
Since family-led businesses are, in my experience, conservative with leverage (preferring everlasting staying power above almost all else, which leverage can work against), Sonic’s balance sheet is somewhat surprising, but I think it just speaks to the capital-intensive nature of the business (i.e., managing inventory) and the buyouts of expensive stores.
Profitability is respectable.
Return on equity has averaged 19.9% over the last five years, while net margin has averaged 1.4%.
It’s only due to the back-of-the-house operations that Sonic has any margins at all, frankly.
Also, ROE is boosted by the leverage.
ROIC is typically in a low-double-digit range, which is quite good.
Overall, Sonic is employing the dealership flywheel extremely effectively and generating great results over time.
And with economies of scale in a fragmented industry, localized franchise monopolies, established OEM relationships, and OEM-backed warranties which ensure repeat business, the company does benefit from durable competitive advantages.
Of course, there are risks to consider.
Competition, regulation, and litigation 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 fallen from pandemic-induced heights which negatively impacts near-term comps but offers an increased demand counterbalance.
The high degree of leverage will likely constrain the company’s ability to be aggressively acquisitive in the future, which could cut off a major source of growth.
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 required for daily life in the US).
The serial acquirer model introduces risks around capital allocation, execution, and integration.
Interest rates remain elevated, harming 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.
Overall, these risks have largely been in place for as long as Sonic has been doing business, so I’m not seeing any new issues here.
What is relatively new, however, is the stock’s ~30% drawdown that started only weeks ago and has brought the valuation down to a reasonable level…
Valuation
The P/E ratio of 12.9 is very undemanding for a business that has consistently shown an ability to generate mid-teens EPS growth.
That puts the PEG ratio at 1 or less.
This is obviously well below where the broader market (and almost everything else out there) is at now.
The cash flow multiple of 6.8 is almost absurdly 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 10-year dividend growth rate of 12%, and a long-term dividend growth rate of 7%.
I’m basing the near-term dividend growth rate on CFRA’s forecast for near-term EPS growth, which aligns well with where I see the business going from here.
The payout ratio is still quite low, so some payout ratio expansion (as well as outperformance from the business itself) could lead to this 12% number being quite conservative in hindsight.
However, I keep coming around to the balance sheet, which leads me to being more cautious than usual.
Over the longer term, I’d expect Sonic to deliver high-single-digit growth, which doesn’t seem unrealistic at all for the business model.
The DDM analysis gives me a fair value of $88.17.
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.
The valuation looks attractive 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 SAH as a 4-star stock, with a fair value estimate of $98.00.
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 SAH as a 3-star “HOLD”, with a 12-month target price of $105.00.
I think my balance sheet concern caused me to come in low. Averaging the three numbers out gives us a final valuation of $97.06, which would indicate the stock is possibly 17% undervalued.
-Jason Fieber
Note from D&I: How safe is SAH‘s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is unrated. 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.
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 SAH.