A Freeport-McMoRan Buy Recommendation Is a Matter of Time

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Nov 26, 2014

In this article, let's take a look at Freeport-McMoRan Inc. (FCX, Financial), a $30.43 billion market cap company that deals in the mining of copper, gold and molybdenum.

CAGR

In ten years from 2003 to 2013, revenues increased at a CAGR of 25.2%, EPS increased at a CAGR of 17.2%, and the dividend rose at a CAGR of 32.0%. Since 2010, the firm has a dividend policy showing its commitment to return cash to investors in the form of dividends. The current dividend yield is 4.27%, which is considered very good to protect purchasing power as well as having a periodic income.

Some months ago we found that intrinsic value was lower than the share price, so the stock is said to be overvalued and subject to a potential sale. Let´s see now, if we can change our opinion.

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 =1.53

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]

rFCX = RF + βFCX [GGM ERP]

= 4.9% + 1.53 [11.43%]

= 22.39%

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) 31/12/2013 31/12/2012 31/12/2011
Cash dividends declared 2,537,000 1,242,000 1,814,000
Net income applicable to common shares 3,441,000 3,980,000 5,747,000
Net sales 20,921,000 18,010,000 20,880,000
Total assets 63,473,000 35,440,000 32,070,000
Total Shareholders' equity 20,934,000 17,543,000 15,642,000
Ratios   Â
Retention rate 0 0.69 0.68
Profit margin 0.16 0.22 0.28
Asset turnover 0.33 0.51 0.65
Financial leverage 3.30 2.14 2.28
   Â
Retention rate = (Net Income – Cash dividends declared) ÷ Net Income = 0.26
   Â
Profit margin = Net Income ÷ Net sales = 0.16 Â Â
   Â
Asset turnover = Net sales ÷ Total assets = 0.33 Â Â
   Â
Financial leverage = Total assets ÷ Total Shareholders' equity = 3.03 Â
   Â
Averages   Â
Retention rate 0.55 Â Â
Profit margin 0.22 Â Â
Asset turnover 0.50 Â Â
Financial leverage 2.57 Â Â
   Â
g = Retention rate × Profit margin × Asset turnover × Financial leverage Â
   Â
Dividend growth rate 15.32% 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)

= ($29.28 ×22.39% – $1.25) ÷ ($29.28 + $1.25) = 17.38%.

The growth rates are:

Year Value g(t)
1 g(1) 15,32%
2 g(2) 15,83%
3 g(3) 16,35%
4 g(4) 16,86%
5 g(5) 17,38%

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 1,25 Â
1 Div 1 1,44 1,18
2 Div 2 1,67 1,11
3 Div 3 1,94 1,06
4 Div 4 2,27 1,01
5 Div 5 2,66 0,97
5 Terminal Value 62,42 22,73
Intrinsic value   28.07
Current share price   29.28

Final comment

As we can see, the intrinsic value is almost equal to the trading price, meaning that the stock is now fairly valued. 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.

So, I think we can wait until we have another drop in price in order to buy this stock. Hedge fund managers Jim Simons (Trades, Portfolio), Jeremy Grantham (Trades, Portfolio), Paul Tudor Jones (Trades, Portfolio), Mario Gabelli (Trades, Portfolio), Chris Davis (Trades, Portfolio), Ron Baron (Trades, Portfolio) and John Buckingham (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 Bloomberg´s CRP function.