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Peter Lynch Versus Dividend Discount Model: Why Lexmark Is a Sell?

July 29, 2014 | About:
ovenerio

ovenerio

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Lexmark International Inc. (LXK), a $2.98 billion market cap company, has a P/E ratio that indicates that the stock is relatively undervalued (11.9x versus 31.8x of industry mean).

Now, let´s consider one of the greatest money managers and most famous investors of
all time, Peter Lynch. In his book One Up on Wall Street, he revealed a charting tool that helped him to success. In the chart, he drew the stock price and the earnings per share together and aligned the value of $1 in EPS to $15 in stock price.

The Peter Lynch Chart of Lexmark is below, where the green line is the price and the blue one is the Peter Lynch Earnings Line.

1406595288864.png

When the price is well below the Peter Lynch Earnings Line, the stock is a buy. As we can appreciate in the chart, since September 2013 the stock is a buy according to this.

Now, let's take a look at a model which is applicable to stable, mature, dividend-paying firms and try to find the intrinsic value of the stock. Although the model has a number of characteristics that make it useful and appropriate for many applications, is by no means the be-all and end-all for valuation. The purpose is to force investors to evaluate different assumptions about growth and future prospects.

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). With the appropriate model, we can forecast dividends up to the end of the investment horizon where we no longer have confidence in the forecasts and then forecast a terminal value based on some other method, such as a multiple of book value or earnings.

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

This formula condenses to: V0=(D0 (1+g))/(r-g)=D1/(r-g)

where:

V0 = fundamental value

D0 = last year dividends per share of Exxon's common stock

r = required rate of return on the common stock

g = dividend growth rate

Let´s estimate the inputs for modeling:

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%. This is a very low rate because of today´s context. Since 1900, yields have ranged from a little less than 2% to 15%; with an average rate of 4.9%. So I think it is more appropriate to use this rate.

Beta: β =1.5

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]

rLXK = RF + βLXK [GGM ERP]

= 4.9% + 1.5 [11.43%]

= 22.05%

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 = (Net Income)/Equity= ((Net Income)/Sales).(Sales/(Total Assets)).((Total Assets)/Equity)

The “PRAT” Model:

g= ((Net Income-Dividends)/(Net Income)).((Net Income)/Sales).(Sales/(Total Assets)).((Total Assets)/Equity)

Let´s collect the information we need to get the dividend growth rate:

Financial Data (USD $ in millions)

Dec. 2013

Dec. 2012

Dec. 2011

Cash dividends declared

75,300

78,600

18,000

Net income applicable to common shares

261,800

107,600

275,200

Net sales

3,667,600

3,797,600

4,173,000

Total assets

3,619,500

3,525,300

3,637,000

Total Shareholders' equity

1,368,300

1,281,500

1,391,700

Ratios

     

Retention rate

0.71

0.27

0.93

Profit margin

0.07

0.03

0.07

Asset turnover

1.01

1.08

1.15

Financial leverage

2.73

2.64

2.61

       

Retention rate = (Net Income – Cash dividends declared) ÷ Net Income =

0.71

       

Profit margin = Net Income ÷ Net sales =

0.07

   
       

Asset turnover = Net sales ÷ Total assets =

1.01

   
       

Financial leverage = Total assets ÷ Total Shareholders' equity =

2.65

 
       

Averages

     

Retention rate

0.64

   

Profit margin

0.06

   

Asset turnover

1.08

   

Financial leverage

2.66

   
       

g = Retention rate × Profit margin × Asset turnover × Financial leverage

 
       

Dividend growth rate

10.13%

   
       

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:

g = (P0.r - D0)/(P0+D0)

= ($48.1 ×22.05% – $1.44) ÷ ($48.1 + $1.44) = 18.5%.

The growth rates are:

Year

Value

g(t)

1

g(1)

10.13%

2

g(2)

12.22%

3

g(3)

14.31%

4

g(4)

16.41%

5

g(5)

18.50%

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

Calculation of Intrinsic Value

Year

Value

Cash Flow

Present value

0

Div 0

1.44

 

1

Div 1

1.59

1.30

2

Div 2

1.78

1.19

3

Div 3

2.03

1.12

4

Div 4

2.37

1.07

5

Div 5

2.81

1.04

5

Terminal Value

93.73

34.62

Intrinsic value

   

40.33

Current share price

   

48.10

Final Comment

In this case, we found that intrinsic value is lower than the share price, the stock is said to be overvalued and a potential sale.

Once the oracle of Omaha said, "It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price" (Warren Buffett (Trades, Portfolio)). So in this opportunity I recommend to stay away from Lexmark although Peter Lynch´s graph suggests just the opposite.

We have covered just one valuation method and investors should not be relied on alone in order to determine a fair (over/under) value for a potential investment.

Hedge fund gurus have also been active in the company. Jeremy Grantham (Trades, Portfolio), Ray Dalio (Trades, Portfolio), Steven Cohen (Trades, Portfolio) and Paul Tudor Jones (Trades, Portfolio) have reduced their positions in the first quarter of 2014.

Disclosure: Omar Venerio holds no position in any stocks mentioned.


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

About the author:

ovenerio
We provide independent fundamental research and hedge fund and insider trading focused investigation.

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