Wendy's Absolute and Relative Valuation

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Nov 11, 2014

In this article, let's take a look at Wendy's Co (WEN, Financial), a $3.12 billion market cap company, which is one of the largest fast food restaurants.

Revenues, margins and profitability

Revenues declined by 19.55% but earnings per share increased in the most recent quarter compared to the same quarter a year ago ($0.08 vs $0.03). During the past fiscal year, the company increased its bottom line. It earned $0.12 versus $0.02 in the previous year. This year, Wall Street expects an improvement in earnings ($0.35 versus $0.12).

Now, letĀ“s compare the best measure of performance for a firm's management: the return on equity. The ROE is useful for comparing the profitability of a company to that of other firms in the same industry.

Ticker Company ROE (%)
WEN WendyĀ“s 7.25
DPZ Domino's Pizza Inc 31.53
PNRA Panera Bread Co Inc 25.80
DRI Darden Restaurants Inc 34.13
Ƃ Industry Median 10.51

The company has a current ROE of 7.25% which is lower than the one exhibit by DominoĀ“s Pizza (DPZ, Financial), Panera Bread (PNRA, Financial) and Darden Restaurants (DRI, Financial). In general, analysts consider ROE ratios in the 15-20% range as representing attractive levels for investment. So for investors looking those levels or more, all of those companies could be the options. It is very important to understand this metric before investing and it is important to look at the trend in ROE over time.

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Relative Valuation

In terms of valuation, the stock sells at a trailing P/E of 24.9x, trading at a discount compared to an average of 31.6x for the industry. To use another metric, its price-to-book ratio of 1.81x indicates a discount versus the industry average of 3.64x while the price-to-sales ratio of 1.52x is above the industry average of 1.35x. The first two metrics indicate that it is a buy recommendation.

03May20171303441493834624.png

As we can appreciate, the firm has demonstrated a pattern of positive earnings per share growth over the past two years.

Absolute 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

LetĀ“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 todayĀ“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: ƎĀ² =0.75

GGM equity risk premium = (1-year forecasted dividend yield on market index) +(consensus long-term earnings growth rate) ā€“ (long-term government bond yield) = 2.13% + 11.97% - 2.67% = 11.43%[1]

rWEN = RF + ƎĀ²WEN [GGM ERP]

= 4.9% + 0.75 [11.43%]

= 13.47%

Dividend growth rate (g)

The sustainable growth rate is the rate at which earnings and dividends can grow indefinitely assuming that the firmĀ“s debt-to-equity ratio is unchanged and it doesnĀ“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 ā€œPRATā€ Model:

g= ((Net Income-Dividends)/(Net Income)).((Net Income)/Sales).(Sales/(Total Assets)).((Total Assets)/Equity)

LetĀ“s collect the information we need to get the dividend growth rate:

Financial Data (USD $ in millions) Dec 29, 2013 Dec 30, 2012 Jan 1, 2012
Cash dividends declared - 3.667 -
Net income applicable to common shares 45.487 7.083 9.875
Net sales 2.487.410 2.505.242 2.431.358
Total assets 4.363.040 4.303.199 4.289.129
Total Shareholders' equity 1.929.486 1.985.855 1.996.069
Ratios Ƃ Ƃ Ƃ
Retention rate 1,00 0,48 1,00
Profit margin 0,02 0,00 0,00
Asset turnover 0,57 0,58 0,57
Financial leverage 2,23 2,16 2,81
Ƃ Ƃ Ƃ Ƃ
Retention rate = (Net Income ā€“ Cash dividends declared) Ć· Net Income = 1,00
Ƃ Ƃ Ƃ Ƃ
Profit margin = Net Income Ć· Net sales = 0,02 Ƃ Ƃ
Ƃ Ƃ Ƃ Ƃ
Asset turnover = Net sales Ć· Total assets = 0,57 Ƃ Ƃ
Ƃ Ƃ Ƃ Ƃ
Financial leverage = Total assets Ć· Total Shareholders' equity = 2,26 Ƃ
Ƃ Ƃ Ƃ Ƃ
Averages Ƃ Ƃ Ƃ
Retention rate 0,83 Ƃ Ƃ
Profit margin 0,01 Ƃ Ƃ
Asset turnover 0,57 Ƃ Ƃ
Financial leverage 2,40 Ƃ Ƃ
Ƃ Ƃ Ƃ Ƃ
g = Retention rate Ɨ Profit margin Ɨ Asset turnover Ɨ Financial leverage Ƃ
Ƃ Ƃ Ƃ Ƃ
Dividend growth rate 0,96% Ƃ Ƃ
Ƃ Ƃ Ƃ Ƃ

Because for most companies, the GGM is unrealistic, letĀ“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)

= ($8.3 Ɨ13.47% ā€“ $0.22) Ć· ($8.3 + $0.22) = 10.54%.

The growth rates are:

Year Value g(t)
1 g(1) 0,96%
2 g(2) 3,35%
3 g(3) 5,75%
4 g(4) 8,15%
5 g(5) 10,54%

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 0,22 Ƃ
1 Div 1 0,22 0,20
2 Div 2 0,23 0,18
3 Div 3 0,24 0,17
4 Div 4 0,26 0,16
5 Div 5 0,29 0,15
5 Terminal Value 10,95 5,82
Intrinsic value Ƃ Ƃ 6,67
Current share price Ƃ Ƃ 8,30

Final Comment

We found that intrinsic value is about 20% below the trading price, which means that it is a good point to sell the stock. This conclusion is the opposite that we have before with the relative valuation method. Gurus like John Keeley (Trades, Portfolio), Joel Greenblatt (Trades, Portfolio) and Murray Stahl (Trades, Portfolio) added the stock, while Jim Simons (Trades, Portfolio) and Paul Tudor Jones (Trades, Portfolio) reduced it in the second quarter of 2014.

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


[1] These values were obtained from BloombergĀ“s CRP function.