XL Group's DDM Valuation: Is It Still a Buy?

Author's Avatar
Feb 21, 2014

In a previous article we analyze that Hedge fund guru Donald Smith (Trades, Portfolio) added XL Group plc (XL, Financial). Now we turn our attention to the future direction of the stock. Let's look at the intrinsic value of this company and try to explain to investors the reasons it is a good buy or not.

XL Group is an insurance and reinsurance holding company and is engaged in providing property, casualty and products to industrial, commercial and other firms, insurance companies and other enterprises. The firm's largest competitors include American International Group (AIG), Allianz SE (AZSEY, Financial) and ACE Ltd. (ACE).

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.

03May20171454291493841269.jpg

  • 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:

  • Risk-Free Rate: Rate of return on LT Government Debt: RF = 2.67%
  • Beta: β =1.16
  • 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]

rXL = RF + βXL [GGM ERP]

= 2.67% + 1.16 [11.43%]

= 15.93%

  • 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:

03May20171454291493841269.jpg

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.

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

With the GGM formula and simple math:

03May20171454301493841270.jpg

The growth rates are:

Year Value g(t)
1 g(1) 2.33%
2 g(2) 5.18%
3 g(3) 8.04%
4 g(4) 10.89%
5 g(5) 13.74%

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

  • Calculation of Intrinsic Value
Year Concept Amount Present value
0 Div 0 0.56 Â
1 Div 1 0.57 0.49
2 Div 2 0.60 0.45
3 Div 3 0.65 0.42
4 Div 4 0.72 0.40
5 Div 5 0.82 0.39
5 Terminal Value 42.67 20.38
Intrinsic value   22.53
Current share Price   29.09

Final Comment

When the stock price is higher than the intrinsic value, the stock is said to be overvalued, and it makes sense to sell the stock.

Hedge fund gurus have also been active in the company. Steven Cohen (Trades, Portfolio), Jim Simons (Trades, Portfolio), Louis Moore Bacon (Trades, Portfolio). Richard Snow (Trades, Portfolio), Jeremy Grantham (Trades, Portfolio), Leon Cooperman (Trades, Portfolio), James Barrow (Trades, Portfolio) and the fund Hotchkis & Wiley have sold or reduced the stock.

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

Â

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