One of things I’d love to do before I get old is visit Rome.
It’s been kind of a lifelong dream of mine.
Many people (including yours truly) are fascinated by the ancient Roman Empire, and being able to walk along the same paths that great emperors once strolled seems quite enchanting.
But the crazy thing is, when you really sit down and think about it, regular people these days live far better lives than those emperors did.
Refrigeration, food delivery, smartphones, modern-day HVAC, antibiotics, access to the Internet, etc.
The amenities that billions of people have low-cost access to these days would be otherworldly magic to a Roman emperor.
And one of the greatest luxuries an emperor would have had was financial independence – something everyday Romans could only dream of.
Yet, this too, is accessible to regular people (again, including yours truly).
One of the most effective ways to access it is via dividend growth investing.
This is a long-term investment strategy that involves buying and holding shares in high-quality businesses paying safe, growing dividends to shareholders – safe, growing dividends which can cover one’s bills and unlock financial independence.
You can find many examples of such high-quality businesses by studying the Dividend Champions, Contenders, and Challengers list, which has compiled data on hundreds of US-listed stocks that have raised dividends each year for at least the last five consecutive years.
I’ve been employing this strategy over the last 15 years to build the FIRE Fund.
That’s my real-money portfolio, and it generates enough five-figure passive dividend income for me to live off of.
I’ve actually been able to live off of this since I quit my job and retired in my early 30s – something, again, 99.9% of Romans back in the day could not fathom.
By the way, if you’re curious as to how such an early retirement is possible, my Early Retirement Blueprint lays it out.
Now, building the FIRE Fund over those years has involved not only investing in great businesses but also investing at great valuations.
See, 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.
Systematically buying undervalued high-quality dividend growth stocks and building a portfolio that can generate enough growing dividend income to live off of sets you up for a lifestyle that even ancient Roman emperors would blush at.
Of course, taking advantage of undervaluation first means one already knows how to spot it.
Well, that’s where Lesson 11: Valuation comes in.
Written by fellow contributor Dave Van Knapp as part of a series of “lessons” designed to teach the dividend growth investing strategy, it explains the concept of valuation using simple terminology and even provides readers with a valuation template they can easily apply on their 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…
Lithia Motors, Inc. (LAD)
Lithia Motors, Inc. (LAD) is an American automotive dealership group.
Founded in 1946, Lithia is now a $6 billion (by market cap) car dealership aggregator that employs approximately 30,000 people.
Lithia operates more than 450 dealerships representing more than 50 OEM brands across the US, the UK, and Canada.
About 75% of annual revenue comes from Import and Luxury brands, with its top two brands (by annual sales) being Toyota and Honda.
The company reports results across five categories: New Vehicle Sales, 50% of FY 2025 revenue; Used Vehicle Sales, 36%; Aftersales, 11%; and Finance & Insurance, 3%.
The interesting thing is that the two smallest categories by revenue are actually the main profit drivers, as service/parts and finance/insurance combine to comprise about 70% of annual gross profit.
And that brings me to the crux of the investment thesis.
The dealership business model is ingeniously lucrative due to a self-reinforcing ecosystem.
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 high-margin financing and insurance opportunities.
Once a customer actually owns a vehicle after financing, a long-lasting, sticky relationship is immediately cemented due to the fact that the customer must return to the dealership for maintenance and repairs.
Only OEM-backed dealerships are allowed to provide warranty updates/repairs, further reinforcing 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 high-margin work on these vehicles – even after expired warranties.
Vehicle owners become beholden to the dealership.
It’s a self-perpetuating flywheel that nearly guarantees sticky clientele and repeat business for the dealership.
Lithia takes all of this goodness and cranks it up a notch by employing the serial acquirer model to slowly acquire competitors (acquiring something like 100 stores over the last two years alone).
An individual dealership is a money machine, but Lithia is building itself a global empire of these machines.
This is why Lithia is positioned incredibly well to continue growing its revenue, profit, and dividend for years to come.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Already, Lithia has increased its dividend for 16 consecutive years.
Its 10-year dividend growth rate of 11.1% is very solid, although the last few dividend raises have been well below trend as the company has sought to recalibrate after the pandemic period pulled forward a lot of demand for vehicles.
I think the 10-year dividend growth rate is more indicative of Lithia’s longer-term dividend growth trajectory than recent dividend raises that have temporarily suffered from a post-pandemic hangover.
In exchange for that double-digit dividend growth, the stock’s lowish 0.9% yield is the trade-off.
It’s pretty common to see a yield in this range when there’s double-digit growth to be had.
That said, the yield trade-off isn’t as bad as it usually is, as this yield is 30 basis points higher than its own five-year average (giving us an early sign of some possible undervaluation).
And one thing that you definitely don’t have to sacrifice here is safety.
The payout ratio is only 6.8%, which is one of the lowest payout ratios I know of, meaning Lithia can afford to (and likely will) be generous with dividend raises over the coming years.
For those looking for a coiled spring positioned to explode with compounding dividends, this stock is beautiful.
Revenue and Earnings Growth
As beautiful as it may be, though, a lot of this is based on what’s already transpired.
However, investors must always be thinking about 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 be incorporated into the valuation process.
I’ll first show you what the business has done over the last five years 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 way should give us enough information to make a call on where the business could be going from here.
Lithia grew its revenue from $8.7 billion in FY 2016 to $37.6 billion in FY 2025.
That’s a compound annual growth rate of 17.7%.
Excellent top-line growth, although Lithia’s employment of the serial acquirer model means that much of its top-line growth has been acquired rather than organic.
Looking at profit growth on a per-share basis should give us a better idea of what’s really going on here.
Earnings per share increased from $7.72 to $32.32 over this period, which is a CAGR of 17.3%.
Highly impressive.
It’s clear that management has been prudent with acquisitions, with almost no drag from the top line to the bottom line.
Speaking of management, 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).
Since dividend growth has trailed EPS growth over the last decade, helping to explain the compressed payout ratio, and since the DeBoer family are direct beneficiaries of the dividend, this likely sets the dividend up for big upward movement ahead.
Looking forward, CFRA is calling for Lithia to compound its EPS at an annual rate of 13% over the next three years.
As good as 13% is, and as much as a lot of companies out there would love to have that, it would represent a modest slowdown relative to what occurred over the prior decade.
Still, it’s quite strong, and I think it’s a good baseline expectation to work with.
CFRA notes that Lithia’s own long-term goal of $75 billion to $100 billion in revenue and $131.25 to $200.00 in EPS gets you to that kind of growth in a hurry, and Lithia has thus far made good on its aspirations.
CFRA further notes the various levers Lithia can pull, including a continuation of its serial acquisition strategy and buybacks.
Seeing as how the auto dealership industry is highly fragmented, Lithia is not short on acquisition targets.
Also referenced is the business model’s resilience, largely due to the ecosystem I noted earlier.
That ecosystem is hardened by the high-margin Aftersales segment, which gives Lithia the opportunity to squeeze maximum juice out of every transaction.
When you combine CFRA’s forecast with the low payout ratio, that easily gives Lithia the ability to hand out mid-teens dividend raises for many years into the future.
And that paints a picture of a similar total return profile, which is obviously fantastic.
Since Lithia is
For long-term dividend growth investors who are partial to high-quality compounders, this is a very compelling setup.
Financial Position
Moving over to the balance sheet, Lithia has a challenged financial position.
The long-term debt/equity ratio is 1.2, while the interest coverage ratio is about 2.5.
As the company has made good on its aspirations to consolidate its industry, the balance sheet has become weighed down by leverage.
Against the alternative of issuing equity, this is the superior option, but cash flow hasn’t been enough to acquire all targets.
I see the balance sheet as easily the weakest part of the entire business.
It’s the one chink in the armor.
We can see this weakness in the credit ratings: Ba2, Moody’s; BB+, S&P.
Profitability, on the other hand, is quite good.
Return on equity has averaged 19.4% over the last five years, while net margin has averaged 3.3%.
Lithia generates most of its revenue from low-margin vehicle sales, so it’s unsurprising to see low net margin here.
While returns on capital have historically been strong, Lithia’s numbers here have declined over the last few years as Lithia has actively built out its portfolio.
This is something to keep an eye on, but it’s very possible that the new stores just haven’t had enough time to take on Lithia’s operational tenets.
Overall, other than the balance sheet, there’s a lot to like about Lithia.
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 recently fell from pandemic-induced heights, negatively impacting near-term comps.
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).
There is tariff uncertainty, especially regarding imported inventory.
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.
I certainly see some risks to be aware of here.
But with the stock down 40% from recent highs and the multiples in single-digit territory, I think a lot of risk is already being priced in…
Valuation
The stock is trading hands for a P/E ratio of 7.9.
That is absurdly low for double-digit growth, putting the PEG ratio at about 0.5.
Before the pandemic hit, this stock was hitting a P/E ratio of 20, so it’s gotten wild.
The P/CF ratio of 4.6, which is well below its own five-year average of 5.9, provides further evidence of just how lowly this stock is being valued.
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%.
I’m assuming mid-teens dividend growth for a number of years into the future, which is unusual for me, but I think this is a rare case that justifies it.
I say that because this is a very unusual case where the business growth is high and the payout ratio is in the single digits.
Even without any business growth, a dividend growing at 15%/year results roughly in a doubling of the payout ratio every five years.
After a decade of something like that – which would be nearly impossible for a business growing at well over 10%/year – the payout ratio in this case would only rise to less than 30%.
There’s just such a huge margin of safety with the starting payout ratio.
And the high rate of business growth simply cements the deal.
The DDM analysis gives me a fair value of $361.51.
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 model puts the fair value right about on par with where the stock was priced at only two months ago.
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 5-star “STRONG BUY”, with a 12-month target price of $400.00.
I came out surprisingly low. Averaging the three numbers out gives us a final valuation of $395.84, which would indicate the stock is possibly 36% undervalued.
Bottom line: Lithia Motors, Inc. (LAD) has a near-bulletproof, OEM-backed flywheel in its business model. Each dealership is a money machine. By employing the serial acquirer playbook, the company is creating an empire of money machines. With a market-like yield, double-digit dividend growth, an extremely low payout ratio, more than 15 consecutive years of dividend increases, and the potential that shares are 36% undervalued, long-term dividend growth investors who favor high-quality compounders should have a close look at this name.
-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.
