Three key factors make any FTSE stock an irresistible bargain to me. One is under-pricing to its fair value of at least 30%. This is because any less than that can be negated through high market volatility. To clarify: price is whatever the market will pay for a share, while value reflects the true worth of the underlying business.
Correctly identifying and quantifying the price-value gap is where sustained big profits lie over time, in my experience. This comprises several years as a senior investment bank trader and decades as a private investor.
The second factor is whether it pays an enticing yield, which to me is 7%-plus. Why this number? It is because the ‘risk-free rate’ – the 10-year UK government bond yield – is around 4.6%, and shares are not risk-free.
And the final element is strong earnings growth prospects. It is these that drive gains in any firm’s share price and dividends going forward. The baseline number I want to see here is also 7%+ right now.
Why? Because otherwise the management might as well sell all the firm’s assets and investment in the UK 10-year or 30-year government bonds. The 30-year paper currently yields 5.5%.
How does this firm stack up?
On the positive side, Dunelm (LSE: DNLM) shares generate a current dividend yield of 7.5%, which meets that criterion for me. This includes a special dividend last year, but it has been paying a special dividend every year since 2021.
On the share price, a discounted cash flow analysis shows it is 22% undervalued at the current £10.66. This modelling highlights where any stock should trade, derived from cash flow forecasts for the underlying business.
Therefore, in Dunelm’s case, the fair value of its stock is £13.67. This does not meet my requirements on this criterion.
Finally, on earnings growth prospects, analysts’ forecast 5.1% a year to end fiscal-year 2027/28. Again, this falls short of my requirement here. So the stock is not currently for me, but it could be in the future. This is based on positives I see in its results.
Solid annual results
Dunelm spelt out its key current business risks in its 9 September fiscal-year 2024/25. It said: “We are yet to see signs of a wider consumer recovery, and consumer confidence has remained lacklustre”. These are clear risks for the firm’s earnings outlook and indeed for many firms in the retail sector. But following this, its share price fell 10% on the day.
However, the market reaction failed to reflect either the preceding or subsequent sentence in the results. The former was that Dunelm was reporting another successful year. The latter was that it will continue to raise the bar on its products and the proposition it offers.
On the former, total sales rose 3.8% year on year to £1.771bn, while profit before tax increased 2.7% to £211m.
While on the latter, the firm has put into action growth plans across three strategic pillars. These include elevating its product offer, connecting to more customers and finding more ways to harness its operational capabilities. Together, these aim to extend the firm’s position as a multi-channel, multi-category specialist.
Consequently, although it is not for me right now, I think it may be worth considering by others whose portfolios it suits.
