In this article, let's take a look at Merck & Co. Inc. (MRK, Financial), a $169.28 billion market cap company, which is one of the world's largest drug makers, acquired Schering-Plough in November 2009.
Returning value to shareholders
The firm is a leader across the pharmaceuticals industry due to its diverse revenue base, a new strategic R&D initiative and good cash flow generation.
Since 1935, Merck has 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. The current dividend yield is 3.0%, which can improve in the future allowing higher shareholderĀ“s returns.
Additionally, the firm announced a $15 billion stock repurchase program in May 2013, inclusive of a $5 billion accelerated buyback which was completed in the Q2 2013.
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: ĆĀ² =0.52
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]
rMRK = RF + ĆĀ²MRK [GGM ERP]
= 4.9% + 0.52 [11.43%]
= 10.84%
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 āPRATā 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 31, 2013 | Dec 31, 2012 | Jan 1, 2012 |
| Cash dividends declared | 5,157,000 | 5,116.000 | 4,691,000 |
| Net income applicable to common shares | 4,404,000 | 6,168,000 | 6,272,000 |
| Net sales | 44,033,000 | 47,267,000 | 48,047,000 |
| Total assets | 105,645,000 | 106,132,000 | 105,128,000 |
| Total Shareholders' equity | 49,765,000 | 53,020,000 | 54,517,000 |
| Ratios | Ć | Ć | Ć |
| Retention rate | (0) | 0.17 | 0.25 |
| Profit margin | 0.10 | 0.13 | 0.13 |
| Asset turnover | 0.42 | 0.45 | 0.46 |
| Financial leverage | 2.06 | 1.97 | 1.93 |
| Ć | Ć | Ć | Ć |
| Retention rate = (Net Income ā Cash dividends declared) Ć· Net Income = | -0.17 | ||
| Ć | Ć | Ć | Ć |
| Profit margin = Net Income Ć· Net sales = | 0.10 | Ć | Ć |
| Ć | Ć | Ć | Ć |
| Asset turnover = Net sales Ć· Total assets = | 0.42 | Ć | Ć |
| Ć | Ć | Ć | Ć |
| Financial leverage = Total assets Ć· Total Shareholders' equity = | 2.12 | Ć | |
| Ć | Ć | Ć | Ć |
| Averages | Ć | Ć | Ć |
| Retention rate | 0.08 | Ć | Ć |
| Profit margin | 0.12 | Ć | Ć |
| Asset turnover | 0.44 | Ć | Ć |
| Financial leverage | 1.99 | Ć | Ć |
| Ć | Ć | Ć | Ć |
| g = Retention rate Ć Profit margin Ć Asset turnover Ć Financial leverage | Ć | ||
| Ć | Ć | Ć | Ć |
| Dividend growth rate | 0.88% | Ć | Ć |
| Ć | Ć | Ć | Ć |
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)
= ($59.64 Ć10.84% ā $1.76) Ć· ($59.64 + $1.76) = 7.67%.
The growth rates are:
| Year | Value | g(t) |
| 1 | g(1) | 088% |
| 2 | g(2) | 2.58% |
| 3 | g(3) | 4.27% |
| 4 | g(4) | 5.97% |
| 5 | g(5) | 7.67% |
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 | 1,76 | Ć |
| 1 | Div 1 | 1,78 | 1.60 |
| 2 | Div 2 | 1,82 | 1.48 |
| 3 | Div 3 | 1,90 | 1.39 |
| 4 | Div 4 | 2,01 | 1.33 |
| 5 | Div 5 | 2,17 | 1.29 |
| 5 | Terminal Value | 73,43 | 43.88 |
| Intrinsic value | Ć | Ć | 50.99 |
| Current share price | Ć | Ć | 59.64 |
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 15% lower than share price, so we can conclude that the stock is fairly valued and it makes sense to hold the stock if you already bought it.
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 managers Stanley Druckenmiller (Trades, Portfolio), Ray Dalio (Trades, Portfolio), Steven Cohen (Trades, Portfolio), Joel Greenblatt (Trades, Portfolio), Paul Tudor Jones (Trades, Portfolio), Ruane Cunniff (Trades, Portfolio), Mario Gabelli (Trades, Portfolio), Robert Bruce (Trades, Portfolio) and Ken Fisher (Trades, Portfolio) have added the stock in the third quarter of 2014, as well as Dodge & Cox.
Disclosure: Omar Venerio holds no position in any stocks mentioned.
[1] These values were obtained from BloombergĀ“s CRP function.
