Dreman and Barrow Are Betting on SeaDrill, But I Wouldn´t

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Aug 19, 2014

According to GuruFocus Guru Trades, on June 30, David Dreman (Trades, Portfolio) and James Barrow (Trades, Portfolio) took a long position on SeaDrill Limited (SDRL, Financial).

The company, a $17.47 billion market cap, has a trailing P/E ratio that indicates that the stock is relatively undervalued. So one question arises, why are these hedge fund managers betting on it?

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 stockj = 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 =1.42

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%

rSDRL = RF + βSDRL [GGM ERP]

= 4.9% + 1.42 [11.43%]

= 21.13%

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 1,287,000 1,925,000 1,440,000
Net income applicable to common shares 2,653,000 1,108,000 1,401,000
Net sales 5,282,000 4,478,000 4,192,000
Total assets 26,300,000 19,632,000 18,304,000
Total Shareholders' equity 7,512,000 5,503,000 5,977,000
Ratios   Â
Retention rate 0.51 -0.74 -0.03
Profit margin 0.50 0.25 0.33
Asset turnover 0.20 0.23 0.23
Financial leverage 4.04 3.42 3.22
   Â
Retention rate = (Net Income – Cash dividends declared) ÷ Net Income = 0.51
   Â
Profit margin = Net Income ÷ Net sales = 0.50 Â Â
   Â
Asset turnover = Net sales ÷ Total assets = 0.20 Â Â
   Â
Financial leverage = Total assets ÷ Total Shareholders' equity = 3.50 Â
   Â
Averages   Â
Retention rate -0.08 Â Â
Profit margin 0.36 Â Â
Asset turnover 0.22 Â Â
Financial leverage 3.56 Â Â
   Â
g = Retention rate × Profit margin × Asset turnover × Financial leverage Â
   Â
Dividend growth rate -2.35% Â Â
   Â

The retention ratio is the proportion of earnings kept back in the business as retained earnings. An alternative way to define the ratio is that it is the opposite of the payout ratio, which measures the percentage of earnings paid out to shareholders as dividends. It is 100% for companies that do not pay dividends, and it is 0% for companies that pay out their entire net income as dividends. So in the case that it is negative, it means that the company is paying more than it actually earns, taking the cash of its retained earnings.

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 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)

= ($37.25 ×21.13% – $4) ÷ ($37.25 + $4) = 9.38%.

The growth rates are:

Year Value g(t)
1 g(1) -2.35%
2 g(2) 0.58%
3 g(3) 3.52%
4 g(4) 6.45%
5 g(5) 9.38%

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 4.00 Â
1 Div 1 3.91 3.22
2 Div 2 3.93 2.68
3 Div 3 4.07 2.29
4 Div 4 4.33 2.01
5 Div 5 4.74 1.82
5 Terminal Value 44.10 16.91
Intrinsic value   28.93
Current share price   37.25

Final comment

In this case, we found that intrinsic value is lower than the share price, the stock is said to be overvalued and so 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)). With that in mind I recommend staying away from SeaDrill.

We have covered just one valuation method, and investors should not rely on one method alone in determining a fair (over/under) value for a potential investment.

Hedge fund gurus have also been active in the company. Eric Mindich (Trades, Portfolio) has sold out the stock in the second quarter of 2014.

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