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Is 3M Fairly Valued? A Look at Fundamental Value

February 25, 2014 | About:
Victor Selva

Victor Selva

9 followers

3M Company (MMM) is a global company that operates as a diversified technology company with manufacturing operations around 70 countries. It was admirable how the company survived to 2008/09 recession, reducing working capital to increase free cash flow and remaining profitable. A key driver of the company is the ability to innovate or acquire new pillars and leverage technology across industries. The firm's competitor includes Johnson & Johnson (JNJ).

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 why 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.

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 =1.2
  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]

r3M = RF + β3M [GGM ERP]

= 2.67% + 1.2 [11.43%]

= 16.39%

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.

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)

17.11%

2

g(2)

16.33%

3

g(3)

15.56%

4

g(4)

14.78%

5

g(5)

14.01%

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

  1. Calculation of Intrinsic Value

Year

Concept

Amount

Present value

0

Div 0

2.76

 

1

Div 1

3.23

2.78

2

Div 2

3.76

2.78

3

Div 3

4.34

2.76

4

Div 4

4.99

2.72

5

Div 5

5.69

2.66

5

Terminal Value

272.33

127.52

Intrinsic value

   

141.21

Current share price

   

132.20

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. Additionally. Zacks Investment Research ranked the company to a Zacks Rank #2 (Buy).

Hedge fund gurus have also been active in the company. Paul Tudor Jones (Trades, Portfolio). Mario Gabelli (Trades, Portfolio). Jim Simons (Trades, Portfolio). Steven Cohen (Trades, Portfolio). Ken Fisher (Trades, Portfolio) and Jeremy Grantham (Trades, Portfolio) have also invested in it in Q4 2013.

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

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


Rating: 5.0/5 (4 votes)

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