General Motors Reinstated Dividend Payment

Author's Avatar
Oct 30, 2014

In this article, let´s consider General Motors Company (GM, Financial), a $49.36 billion market cap that is the world's second-largest producer of cars and trucks. It has a trailing P/E ratio that indicates that the stock is relatively overvalued (PE 50.9x vs Industry Median 15.8x).

The company maintains quality and has one of the best designs. Not only cars, it is also a leader in truck models, too. We think that, in the near future when vehicle demand recovers, the firm will be in an excellent position to grow its earnings. Further, the company focuses on four brands instead of eight, making marketing efforts more concentrated and efficient. Efficiency is reflected also in pricing policies, where it developed a pricing model searching for profitability. This means that is operating a demand-pull model where it produces only to meet demand.

In 2008, the firm suspended its dividend before eventually going through a bankruptcy reorganization. This year, General Motors reinstated the dividends payment for 30 cents per share quarterly, showing its commitment to returning cash to investors. The current dividend yield is 2.9% which is good to protect investors' purchasing power. So let´s use this information to try to find the intrinsic value of the stock.

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 =1.69

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]

rGM = RF + βGM [GGM ERP]

= 4.9% + 1.69 [11.43%]

= 24.22%

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 1,687,000 939,000 916,000
Net income applicable to common shares 3,770,000 4,859,000 7,585,000
Net sales 155,427,000 152,256,000 150,276,000
Total assets 166,344,000 149,422,999 144,603,000
Total Shareholders' equity 42,607,000 36,244,000 38,120,000
Ratios   Â
Retention rate 0.55 0.81 0.88
Profit margin 0.02 0.03 0.05
Asset turnover 0.93 1.02 1.04
Financial leverage 4.22 4.02 3.89
   Â
Retention rate = (Net Income – Cash dividends declared) ÷ Net Income = 0.55
   Â
Profit margin = Net Income ÷ Net sales = 0.02 Â Â
   Â
Asset turnover = Net sales ÷ Total assets = 0.93 Â Â
   Â
Financial leverage = Total assets ÷ Total Shareholders' equity = 3.90 Â
   Â
Averages   Â
Retention rate 0.75 Â Â
Profit margin 0.04 Â Â
Asset turnover 1.00 Â Â
Financial leverage 4.04 Â Â
   Â
g = Retention rate × Profit margin × Asset turnover × Financial leverage Â
   Â
Dividend growth rate 10.70% Â Â
   Â

Because the GGM is unrealistic for most companies, 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)

= ($31.17 ×24.22% – $1.2) ÷ ($31.17 + $1.2) = 19.61%.

The growth rates are:

Year Value g(t)
1 g(1) 10.70%
2 g(2) 12.93%
3 g(3) 15.16%
4 g(4) 17.38%
5 g(5) 19.61%

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 1.20 Â
1 Div 1 1.33 1.07
2 Div 2 1.50 0.97
3 Div 3 1.73 0.90
4 Div 4 2.03 0.85
5 Div 5 2.43 0.82
5 Terminal Value 63.00 21.30
Intrinsic value   25.92
Current share price   31.17

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 Murray Stahl (Trades, Portfolio), Michael Price (Trades, Portfolio) and Richard Snow (Trades, Portfolio) bought the stock in the second quarter of 2014, while James Barrow (Trades, Portfolio), John Paulson (Trades, Portfolio), John Burbank (Trades, Portfolio) and Caxton Associates (Trades, Portfolio) sold out the stock in the same time frame.

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


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