A Dividend Hike That Justify the Trading Price

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Oct 29, 2014

In this article, let´s consider Lexmark International Inc. (LXK, Financial), a $2.57 billion market cap that has a trailing P/E ratio that indicates the stock is relatively undervalued (PE 12.7x vs Industry Median 30.5x).

Dividend hike

Its management has a history of creating value for shareholders. One way in which it is demonstrated is that the firm shows its commitment to return cash to investors in the form of dividends as it generates healthy cash flow on a regular basis. Days ago, on Oct. 23 the company announced that its board of directors declared a quarterly cash dividend of $0.36 per share of Lexmark Class A Common Stock. The dividend is payable on Dec. 12, 2014 to shareholders of record as of the close of business on Nov. 28, 2014. The current dividend yield is 3.5% which we consider good enough to protect purchasing power.

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 =1.78

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% + 1.78 [11.43%]

= 25.25%

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) 31-Dec-13 31-Dec-12 31-Dec-11
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   Â
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
   Â
Retention rate = (Net Income – Cash dividends declared) ÷ Net Income = 0.71
   Â
Profit margin = Net Income ÷ Net sales = 0.07 Â Â
   Â
Asset turnover = Net sales ÷ Total assets = 1.01 Â Â
   Â
Financial leverage = Total assets ÷ Total Shareholders' equity = 2.65 Â
   Â
Averages   Â
Retention rate 0.64 Â Â
Profit margin 0.06 Â Â
Asset turnover 1.08 Â Â
Financial leverage 2.66 Â Â
   Â
g = Retention rate × Profit margin × Asset turnover × Financial leverage Â
   Â
Dividend growth rate 10.13% Â Â
   Â

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)

= ($40.56 ×25.25% – $1.44) ÷ ($40.56 + $1.44) = 20.95%.

The growth rates are:

Year Value g(t)
1 g(1) 10.13%
2 g(2) 12.83%
3 g(3) 15.54%
4 g(4) 18.25%
5 g(5) 20.95%

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 Â
1 Div 1 1.59 1.27
2 Div 2 1.79 1.14
3 Div 3 2.07 1.05
4 Div 4 2.44 0.99
5 Div 5 2.96 0.96
5 Terminal Value 83.28 27.02
Intrinsic value   32.44
Current share price   40.56

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 is approximately 20% below the trading price, so we can conclude that the stock is fairly valued 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 like Jean-Marie Eveillard (Trades, Portfolio), David Dreman (Trades, Portfolio) and John Buckingham (Trades, Portfolio) added this stock in the second quarter of 2014.

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


[1] These values were obtained from Bloomberg´s CRP function.