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Boeing Should Double To Be Fairly Value

August 08, 2014 | About:
ovenerio

ovenerio

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On June 30, Ken Fisher (Trades, Portfolio), the chief executive officer and chief investment officer of Fisher Investments, takes a long position on The Boeing Company (BA), an $86.36 billion market cap, which is the largest aircraft manufacturer in the world and one of the largest aerospace and defense giants.

The company has a trailing P/E ratio that indicates that the stock is relatively undervalued (18x vs 20.4x of industry mean).

So in this article, 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, it 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%. I think it is more appropriate to use this rate.

Beta: β =1.02

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]

rBA = RF + βBA [GGM ERP]

= 4.9% + 1.02 [11.43%]

= 16.56%

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

1,467,000

1,322,000

1,244,000

Net income applicable to common shares

4,585,000

3,900,000

4,018,000

Net sales

86,623,000

81,968,000

68,735,000

Total assets

92,663,000

88,896,000

79,986,000

Total Shareholders' equity

14,875,000

5,867,000

3,515,000

Ratios

     

Retention rate

0.68

0.66

0.69

Profit margin

0.05

0.05

0.06

Asset turnover

0.93

0.92

0.86

Financial leverage

8.93

18.95

25.47

       

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

0.68

       

Profit margin = Net Income ÷ Net sales =

0.05

   
       

Asset turnover = Net sales ÷ Total assets =

0.93

   
       

Financial leverage = Total assets ÷ Total Shareholders' equity =

6.23

 
       

Averages

     

Retention rate

0.68

   

Profit margin

0.05

   

Asset turnover

0.91

   

Financial leverage

17.78

   
       

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

 
       

Dividend growth rate

57.78%

   
       

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)

= ($118.34 ×16.56% – $2.92) ÷ ($118.34 + $2.92) = 13.75%.

The growth rates are:

Year

Value

g(t)

1

g(1)

57.78%

2

g(2)

46.77%

3

g(3)

35.77%

4

g(4)

24.76%

5

g(5)

13.75%

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

2.92

 

1

Div 1

4.61

3.95

2

Div 2

6.76

4.98

3

Div 3

9.18

5.80

4

Div 4

11.45

6.21

5

Div 5

13.03

6.06

5

Terminal Value

528.00

245.42

Intrinsic value

   

272.41

Current share price

   

118.34

Final Comment

Using a margin of safety, one should buy a stock when it is worth more than its price on the market (plus a margin: I recommend 20%). We found that intrinsic value more than double the share price, so we can conclude that the stock is undervalued and it makes sense to buy the stock if you trust in the model and assumptions.

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. Ray Dalio (Trades, Portfolio), Paul Tudor Jones (Trades, Portfolio), Bill Frels (Trades, Portfolio), Sarah Ketterer (Trades, Portfolio) and Murray Stahl (Trades, Portfolio) have taken long 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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