In this article, let´s consider AbbVie Inc. (ABBV, Financial), a $97.38 billion market cap company that is a global research-based pharmaceuticals business that emerged as a separate entity following its spin-off from Abbott Laboratories.
Key drivers
The key product is Humira, an anti-inflammatory product, an injectable biologic TNF (tumor necrosis factor) blocker treatment for rheumatoid arthritis (RA) and similar conditions. More than a half of total sales and a higher portion of earnings came from Humira, so the product will drive the majority of the company´s performance over the next three years.
New opportunities in markets such as China and Japan will be good in the future while we still believe that Humira could continue to post double-digit growth.
Cash flows are strong and predictable. This helped to pay dividends since 2013. The current yield is 2.8% which is considered quite good to protect investor´s 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 =1.928
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]
rABBV = RF + βABBV [GGM ERP]
= 4.9% + 1.928 [11.43%]
= 26.94%
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 | 2,555,000 | - | - |
| Net income applicable to common shares | 4,128,000 | 5,275,000 | 3,433,000 |
| Net sales | 18,790,000 | 18,380,000 | 17,444,000 |
| Total assets | 29,198,000 | 27,008,000 | 19,521,000 |
| Total Shareholders' equity | 4,492,000 | 350,000 | 11,932,000 |
| Ratios | Â | Â | Â |
| Retention rate | 0.38 | 1.00 | 1.00 |
| Profit margin | 0.22 | 0.29 | 0.20 |
| Asset turnover | 0.64 | 0.68 | 0.89 |
| Financial leverage | 12.06 | 4.40 | 3.27 |
| Â | Â | Â | Â |
| Retention rate = (Net Income – Cash dividends declared) ÷ Net Income = | 0.38 | ||
| Â | Â | Â | Â |
| Profit margin = Net Income ÷ Net sales = | 0.22 | Â | Â |
| Â | Â | Â | Â |
| Asset turnover = Net sales ÷ Total assets = | 0.64 | Â | Â |
| Â | Â | Â | Â |
| Financial leverage = Total assets ÷ Total Shareholders' equity = | 6.50 | Â | |
| Â | Â | Â | Â |
| Averages | Â | Â | Â |
| Retention rate | 0.79 | Â | Â |
| Profit margin | 0.23 | Â | Â |
| Asset turnover | 0.74 | Â | Â |
| Financial leverage | 6.58 | Â | Â |
| Â | Â | Â | Â |
| g = Retention rate × Profit margin × Asset turnover × Financial leverage | Â | ||
| Â | Â | Â | Â |
| Dividend growth rate | 90.48% | Â | Â |
| Â | 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)
= ($59.98 ×26.94% – $1.96) ÷ ($59.98 + $1.96) = 22.92%.
The growth rates are:
| Year | Value | g(t) |
| 1 | g(1) | 90.48% |
| 2 | g(2) | 73.59% |
| 3 | g(3) | 56.70% |
| 4 | g(4) | 39.81% |
| 5 | g(5) | 22.92% |
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 | 1.96 | Â |
| 1 | Div 1 | 3.73 | 2.94 |
| 2 | Div 2 | 6.48 | 4.02 |
| 3 | Div 3 | 10.16 | 4.97 |
| 4 | Div 4 | 14.20 | 5.47 |
| 5 | Div 5 | 17.45 | 5.30 |
| 5 | Terminal Value | 534.12 | 162.07 |
| Intrinsic value | Â | Â | 184.76 |
| Current share price | Â | Â | 59.98 |
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 triple the trading price, so we can conclude that the stock is undervalued 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 Louis Moore Bacon (Trades, Portfolio), Lee Ainslie (Trades, Portfolio), Paul Tudor Jones (Trades, Portfolio) and Ken Fisher (Trades, Portfolio) added the stock in the second quarter of 2014, as well as NWQ Managers (Trades, Portfolio) and Manning & Napier Advisors, Inc.
Disclosure: Omar Venerio holds no position in any stocks mentioned.
[1] These values were obtained from Bloomberg´s CRP function.
