Ralph Lauren's Stock is Trading at Fair Valuation

In this article, let's take a look at the intrinsic value of Ralph Lauren Corporation (RL, Financial), a $13.87 billion market cap company, which designs, markets and distributes men's and women's apparel, accessories, fine watches and jewelry as well as other premium lifestyle products.

Key Drivers

This “one man show” company has implemented two key strategies. First, it has segmented target customers, and second, the policy of differentiation from its peers. For example, the distribution of its products without damaging the brand or introducing cannibalizing sales, also contribute to that differentiation.

An important growth opportunity is international expansion. The company plans to increase its presence in Europe and Asia. Strategies to elevate its brand positioning, improving its distribution network and merchandising operations are keys for growth. However, the firm has been restructuring, and as a consequence it closed about 95 points of distribution in Greater China.

Since 2003, Ralph Lauren has had a dividend policy showing its commitment to return cash to investors in the form of dividends as it generates healthy cash flow on a regular basis. Although the current dividend yield is not too high, it can improve in the future by allowing higher shareholder's returns.

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 =1.62

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]

rRL = RF + βRL [GGM ERP]

= 4.9% + 1.62 [11.43%]

= 23.42%

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:

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)

= ($174.66 ×23.42% – $1.8) ÷ ($174.66 + $1.8) = 22.16%.

The growth rates are:

G(2), g(3) and g(4) are calculated using linear interpolation between g(1) and g(5).

Calculation of Intrinsic Value

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 about 11% below the trading price, so we can conclude that the stock is fairly if you trust in the model and assumptions.

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

Due to internal growth and acquisitions, Ralph Lauren has a track record of profits and solid growth that will surely continue in the future. So, I feel bullish on this stock. Others with this same feeling are hedge fund gurus like Louis Moore Bacon (Trades, Portfolio), Andreas Halvorsen (Trades, Portfolio), Mario Gabelli (Trades, Portfolio), Paul Tudor Jones (Trades, Portfolio), Jeremy Grantham (Trades, Portfolio), Robert Olstein (Trades, Portfolio) and Murray Stahl (Trades, Portfolio) who added this stock to their portfolios.

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

[1] This values where obtained from Blommberg´s CRP function.