One of the many things about investing that I love is its approachability.
I don’t have a genius IQ, which rules out a lot of pursuits in life.
And I’m not particularly tall or athletic, which cuts off many other avenues.
But investing is something that almost anyone can participate in and achieve great success with.
This is particularly true when talking about the dividend growth investing strategy.
That’s a long-term investment strategy whereby one buys and holds shares in high-quality businesses paying out reliable, rising cash dividends to shareholders.
You can find hundreds of examples of what I mean by perusing the Dividend Champions, Contenders, and Challengers list – a compilation of US-listed stocks that have raised dividends each year for at least the last five consecutive years.
I’d argue this strategy is even more approachable than the average strategy, as it tends to funnel investors right into great businesses and encourage patience via steadily rising cash payments.
By employing this strategy myself, I’ve been able to build the FIRE Fund.
That’s my real-money portfolio generating enough five-figure passive dividend income for me to live off of.
In fact, this allowed me to quit my job and retire in my early 30s.
Now, while investing in the right businesses will get you far, there’s also the matter of investing at the right valuations.
Price is simply what you pay, but value is 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.
Steadily acquiring undervalued high-quality dividend growth stocks is a very approachable way to invest, and it can lead to financial independence over time for almost anyone.
And if anything regarding valuation comes across as confusing, be sure to give Lesson 11: Valuation a read.
Written by fellow contributor Dave Van Knapp, it describes the broad strokes of valuation using very simple terminology.
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…
Lowe’s Companies, Inc. (LOW)
Lowe’s Companies, Inc. (LOW) is an American home improvement retailer.
Founded in 1921, Lowe’s is now a $117 billion (by market cap) major retailer employing 300,000 people.
Lowe’s operates more than 1,700 home improvement and hardware stores in the US.
The typical store averages around 112,000 square feet in size and offers 40,000 different products.
In addition, the company offers hundreds of thousands of products via their special order system and e-commerce channel.
This level of scale in this particular niche is highly advantageous.
It means the company is a dominant force in the homeownership ecosystem within a country that makes homeownership synonymous with success and happiness (i.e., the “American Dream”).
Most Americans desire homeownership.
And since houses are buildings that slowly and steadily deteriorate over time, requiring constant upkeep and maintenance, this desire plays right into the hands of Lowe’s.
Also, because most people want their house to be a home, which involves personal customization, ongoing modifications get layered on top of the basic maintenance requirements.
Plus, as the US population continues to grow, new houses continuously get built and come to market in order to provide shelter.
That’s even more housing stock which will deteriorate over time.
All of this adds up to Lowe’s selling ever-more products and/or services, to ever-more customers, at ever-higher prices.
And that leads to the company maintaining its ability to grow its revenue, profit, and dividend.
Dividend Growth, Growth Rate, Payout Ratio and Yield
To date, Lowe’s has increased its dividend for 64 consecutive years.
Incredible.
It’s one of the longest dividend growth streaks in the world, making Lowe’s a Dividend Aristocrat and a Dividend King.
The 10-year dividend growth rate of 16.5% is super impressive considering how that started coming after more than 50 consecutive years of dividend increases already – although more recent dividend raises have been stuck in a mid-single-digit range while Lowe’s deals with a “frozen” US housing market in the face of higher interest rates and subdued new starts.
However, the stock’s yield of 2.5% has been adjusted upward by the market in the face of the pressured dividend growth.
The yield is now 70 basis points higher than its five-year average, which is a remarkable spread on a Dividend King with an illustrious operating history.
And this rise in yield is due to pressure on growth, not because of sustainability questions, as the payout ratio is only 42.3%.
Quite frankly, Lowe’s is one of the most reliable dividend growers in existence.
It’s dividend royalty.
Revenue and Earnings Growth
As true as that may be, though, this standing is based largely on what’s already happened.
However, investors must always be anticipating what’s to come, as the capital of today gets risked for the rewards of tomorrow.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will come in handy when the time comes later 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.
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 what we need to roughly sketch out where the business could be going from here.
Lowe’s grew its revenue from $65 billion in FY 2017 to $86.3 billion in FY 2026.
That’s a compound annual growth rate of 3.2%.
It’s been a mixed decade for Lowe’s.
The first five years featured fast top-line growth, followed by five years of stagnation.
High interest rates and new starts not keeping up with demand have conspired to “freeze” the US housing market, keeping a lot of existing homeowners in place and keeping would-be homeowners out of the market altogether.
This has worked against Lowe’s.
Meanwhile, earnings per share rose from $3.47 to $11.85 over this period, which is a CAGR of 14.6%.
A massive 40% reduction in the outstanding share count over this period helped to drive substantial excess bottom-line growth.
That said, EPS growth exhibited a similar pattern of rapid growth met with stagnation.
Looking forward, CFRA currently has no three-year EPS growth forecast for Lowe’s.
This is unfortunate, as I do like to compare the proven past with a future forecast.
CFRA does note that it’s modeling $12.30 in EPS for FY 2027, slightly ahead of where Lowe’s itself is guiding for, which would represent 3.8% YOY EPS growth.
That model then has $13.15 for FY 2028 EPS, which would show an acceleration to 6.9% YOY growth.
CFRA also highlights the recent acquisitions of Artisan Design Group and Foundation Building Materials, which provide Lowe’s with a more balanced profile, resilient revenue, and countercyclical commercial exposure.
These acquisitions helped Lowe’s to build out a homebuilding platform, targeting more commercial/contractor business as the US continues to suffer through a home supply shortage.
As supply attempts to meet demand over the coming years, Lowe’s has an opportunity to capitalize on that activity – in addition to the core home improvement retailing business.
If we extrapolate out recent growth, along with CFRA’s number for this coming year, that paints a picture of mid-single-digit near-term EPS growth.
However, I think the longer-term growth story here remains fully intact and quite strong.
While the entire housing space is clearly going through a temporary lull, Lowe’s is still a high-quality business positioned as one of the largest forces in an industry with nearly endless demand.
There is no imaginable future in which Americans en masse will stop chasing homeownership, and there’s a direct line from that to the likes of Lowe’s.
The next couple of years may feature more modest growth out of Lowe’s, but it’s hard to see how or why the business can’t get back to at least high-single-digit EPS growth over the longer run.
And that would easily set up like dividend growth.
Pairing the two together can get one to a 10% or so annualized total return from here, even before assuming any kind of multiple recovery.
Coming out of a Dividend King, that’s not bad at all.
Financial Position
Moving over to the balance sheet, Lowe’s has a good financial position.
Because of negative common equity from extensive buybacks, there is no long-term debt/equity ratio.
However, the $37.5 billion long-term debt load is not egregious relative to the $117 billion market cap.
The interest coverage ratio is approximately 7.
And Lowe’s does have investment-grade credit ratings: Baa1, Moody’s; BBB+, S&P.
Profitability is strong.
Although ROE is N/A (again, due to negative common equity), net margin has averaged 8.1% over the last five years.
For a retailer, Lowe’s is putting up world-class margins.
Furthermore, ROIC is routinely over 30%, which is very impressive for any business – let alone a retailer.
Overall, despite a temporary lull in the housing space, Lowe’s remains a top-tier, well-placed business within the broader housing ecosystem.
And with economies of scale, pricing power, brand recognition, product specialization, an expert workforce that guides consumer purchases, and a sizable commercial arm, 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.
Retailing is notoriously competitive, making competition a standout risk.
Higher interest rates are keeping existing homeowners in place, limiting turnover and upgrades, although there’s still probably a floor under maintenance/repairs.
New starts remain below what’s necessary to meet demand, which further limits the company’s opportunities to sell products.
Inflation has recently been an issue, pressuring overall consumer spending.
A large-scale recession would almost certainly impact the business.
And the company’s US-centric footprint eliminates international growth opportunities.
I don’t see any extreme risks here.
But the valuation may have become somewhat extreme, pushed down to a decade low after a recent 30% drop in the stock’s price…
Valuation
The P/E ratio has dropped to 16.9.
That’s as low as I’ve seen it over the last 10 years.
It compares favorably to its own five-year average of 19.1.
The P/CF ratio of 10.8 is also well below its own five-year average of 13.
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 7.5%.
I’m basically splitting the difference here between the longer-term growth and the shorter-term growth being demonstrated out of Lowe’s.
Although the next year or two may feature more modest dividend raises, I would be very surprised to see Lowe’s fail to get back to something closer to high-single-digit growth soon thereafter.
There’s just nothing to indicate that anything is fundamentally wrong with Lowe’s or its industry.
Rather, it’s just a confluence of temporary challenges conspiring to hold the business back.
I remain confident in the US housing market long term, and that bodes well for Lowe’s.
The DDM analysis gives me a fair value of $215.00.
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.
From where I’m sitting, this stock has been punished way too much.
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 LOW as a 4-star stock, with a fair value estimate of $255.00.
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 LOW as a 4-star “BUY”, with a 12-month target price of $246.00.
We’re all in the same neighborhood here. Averaging the three numbers out gives us a final valuation of $238.67, which would indicate the stock is possibly 16% undervalued.
Bottom line: Lowe’s Companies, Inc. (LOW) is one of America’s finest retailers. Although its core industry is in a temporary lull, the firm remains firmly positioned to capture outsized growth opportunities from the recovery ahead. With a market-beating yield, double-digit dividend growth, a low payout ratio, more than 60 consecutive years of dividend increases, and the potential that shares are 16% undervalued, long-term dividend growth investors have a great shot at a Dividend King right now.
-Jason Fieber
Note from D&I: How safe is LOW‘s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 80. 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, LOW’s dividend appears Safe with an 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 LOW.
