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Deere's DDM Valuation Indicates an Urgent Buy

February 20, 2014 | About:
Victor Selva

Victor Selva

9 followers

In a previous article we looked into Deere & Company (DE), the world's biggest producer of farm equipment, which is also a large maker of construction machinery and lawn and garden equipment. We saw that the firm is investing hard (has launched several new tractor products) to increase its market share in Brazil because the value of agricultural production is expected to rise. Deere expects its agriculture and turf sales to grow 20% in South America. The firm's largest competitors include Caterpillar (CAT) and Kubota Corporation (KUBTY).

Now, turning our attention to the future direction of the stock, let's take a look at the intrinsic value of this company and try to explain to investors the reasons it is a good buy or not.

Valuation

In stock valuation models, dividend discount models (DDM) define cash flow as the dividends to be received by the shareholders. Extending the period indefinitely, the fundamental value of the stock is the present value of an infinite stream of dividends according to John Burr Williams.

Although this is theoretically correct, it requires forecasting dividends for many periods, so we can use some growth models like: Gordon (constant) growth model, the Two or Three stage growth model or the H-Model (which is a special case of a two-stage model).

To start with, the Gordon Growth Model (GGM) assumes that dividends increase at a constant rate indefinitely.

a) Required Rate of Return (r)

The capital asset pricing model (CAPM) estimates the required return on equity using the following formula: required return on stock j = risk-free rate + beta of j x equity risk premium

Assumptions:

1. Risk-Free Rate: Rate of return on LT Government Debt: RF = 2.67%

2. Beta: β =1.27

3. GGM equity risk premium = (1-year forecasted dividend yield on market index) +(consensus long-term earnings growth rate) – (long-term government bond yield) = 2.13% + 11.97% - 2.67% = 11.43%[1]

rDE = RF + βDE [GGM ERP]

= 2.67% + 1.27 [11.43%]

= 17.19%

b) Dividend growth rate (g)

The sustainable growth rate is the rate at which earnings and dividends can grow indefinitely assuming that the firm´s debt-to-equity ratio is unchanged and it doesn´t issue new equity.

g = b x ROE

b = retention rate

ROE can be estimated using Dupont formula:

Because for most companies, the GGM is unrealistic, let´s consider the H-Model which assumes a growth rate that starts high and then declines linearly over the high growth stage until it reverts to the long-run rate. A smoother transition to the mature phase growth rate that is more realistic.

c) Dividend growth rate (g) implied by Gordon growth model (long-run rate)

With the GGM formula and simple math:

The growth rates are:

Year

Value

g(t)

1

g(1)

135,24%

2

g(2)

105,04%

3

g(3)

74,83%

4

g(4)

44,62%

5

g(5)

14,42%

G(2), g(3) and g(4) are calculated using linear interpolation between g(1) and g(5).

d) Calculation of Intrinsic Value

Year

Concept

Amount

Present value

0

Div 0

2,04

 

1

Div 1

4,80

4,10

2

Div 2

9,84

7,17

3

Div 3

17,20

10,69

4

Div 4

24,88

13,19

5

Div 5

28,47

12,88

5

Terminal Value

1.176,19

532,23

Intrinsic value

   

580,25

Current share price

   

84,29

Final Comment

When the stock price is lower than the intrinsic value, the stock is said to be undervalued and it makes sense to buy the stock.

Hedge fund gurus have also been active in the company. Jean-Marie Eveillard (Trades, Portfolio), Jim Simons (Trades, Portfolio), David Dreman (Trades, Portfolio), Brian Rogers (Trades, Portfolio), Jeff Auxier (Trades, Portfolio), Paul Tudor Jones (Trades, Portfolio), Francisco Garcia Parames (Trades, Portfolio), Jeremy Grantham (Trades, Portfolio) and John Buckingham (Trades, Portfolio) have also invested in it.

Disclosure: Victor Selva holds no position in any stocks mentioned.

[1] This values where obtained from Blommberg´s CRP function.


Rating: 4.7/5 (9 votes)

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Comments

philtcu
Philtcu - 1 month ago

Sorry to complain, but why do you use commas instead of decimals? Very confusing.

AType007
AType007 premium member - 4 days ago

I think the growth rates you have given are unrealistic and driven by financial leverage (risky). Given DE's market position, I would take market growth numbers as g or better yet use GDP growth numbers and see if the company will turn any profit at all.

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