In a previous article, we analyze quantitative aspects of Carter's, Inc. (CRI, Financial), a $4.3 billion market cap company, which is the largest branded marketer in the United States of apparel and related products exclusively for babies and young children. Now, in this article let's take a look at the intrinsic value and try to compare it with the current stock price.
Acquisition
Some years ago, the firm acquired Bonnie Togs, a specialty retailer. The purpose was to focus more on children's apparel. Before the deal, this company had been Carter's principal licensee in Canada since 2007.
Competitors
Competition is always a threat in this industry, where the primary competitors include Old Navy, The Gap (GPS, Financial), The Children's Place (PLCE, Financial), Gymboree, and Disney (DIS, Financial).
Earnings growth
The company has improved earnings per share by 26.8% in the most recent quarter compared to the same quarter a year ago, from $0.97 to $1.23. As we can appreciate in the next chart, it has demonstrated a pattern of positive earnings per share growth over the past two years.
During the past fiscal year, the firm increased its bottom line. It earned $2.77 versus $2.69 in the previous year. This year, Wall Street expects an improvement in earnings ($3.88 versus $2.77).
Not only does it have double-digit earnings growth, but also it demonstrates strong liquidity.
Dividend policy
On Nov. 13, the Board of Directors of the company declared a quarterly dividend of $0.19 per share, payable on December 5, 2014, to shareholders of record at the close of business on November 25, 2014. The current dividend yield is 1.0% and is ranked lower than 79% of the 556 Companies in the Apparel Manufacturing industry.
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 =0.46
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]
rCRI = RF + ĆĀ²CRI [GGM ERP]
= 4.9% + 0.46 [11.43%]
= 10.16%
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) | 12/31/2013 | 12/31/2012 | 12/31/2011 |
| Cash dividends declared | 27,715 | - | - |
| Net income applicable to common shares | 160,407 | 161,150 | 114,016 |
| Net sales | 2,638,711 | 2,381,734 | 2,109,734 |
| Total assets | 1,812,484 | 1,630,109 | 1,402,709 |
| Total Shareholders' equity | 700,731 | 985,479 | 805,709 |
| Ratios | Ć | Ć | Ć |
| Retention rate | 1 | 1.00 | 1.00 |
| Profit margin | 0.06 | 0.07 | 0.05 |
| Asset turnover | 1.46 | 1.46 | 1.50 |
| Financial leverage | 2.15 | 1.82 | 0.23 |
| Ć | Ć | Ć | Ć |
| Retention rate = (Net Income ā Cash dividends declared) Ć· Net Income = | 0.83 | ||
| Ć | Ć | Ć | Ć |
| Profit margin = Net Income Ć· Net sales = | 0.06 | Ć | Ć |
| Ć | Ć | Ć | Ć |
| Asset turnover = Net sales Ć· Total assets = | 1.46 | Ć | Ć |
| Ć | Ć | Ć | Ć |
| Financial leverage = Total assets Ć· Total Shareholders' equity = | 2.59 | Ć | |
| Ć | Ć | Ć | Ć |
| Averages | Ć | Ć | Ć |
| Retention rate | 0.94 | Ć | Ć |
| Profit margin | 0.06 | Ć | Ć |
| Asset turnover | 1.47 | Ć | Ć |
| Financial leverage | 1.40 | 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 | 11.83% | 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)
= ($81.34 Ć10.16% ā $0.76) Ć· ($81.34 + $0.76) = 9.14%.
The growth rates are:
| Year | Value | g(t) |
| 1 | g(1) | 11.83% |
| 2 | g(2) | 11.16% |
| 3 | g(3) | 10.49% |
| 4 | g(4) | 9.81% |
| 5 | g(5) | 9.14% |
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 | 0.76 | Ć |
| 1 | Div 1 | 0.85 | 0.77 |
| 2 | Div 2 | 0.94 | 0.78 |
| 3 | Div 3 | 1.04 | 0.78 |
| 4 | Div 4 | 1.15 | 0.78 |
| 5 | Div 5 | 1.25 | 0.77 |
| 5 | Terminal Value | 133.89 | 82.54 |
| Intrinsic value | Ć | Ć | 86.42 |
| Current share price | Ć | Ć | 81.34 |
Final Comment
When the stock price is lower than the intrinsic value, the stock is said to be undervalued and it makes sense to buy the stock. Although, it is recommended a margin of safety, usually a 20%, and in this case is only 6%.
In terms of relative valuation, the stock sells at a trailing P/E of 25.9x, trading at a slight premium compared to an average of 25.5x for the industry. To use another metric, its price-to-book ratio of 5.7x indicates a premium versus the industry average of 1.98x while the price-to-sales ratio of 1.6x is above the industry average of 1.03x.
This Zacks Rank #2 suggests that analysts believe in the stock and we think that it is the right time to add the stock to your long-term portfolio. For the upcoming years, we continue expecting a promising outlook for this industry. So, I feel confident on my bullish sentiment.
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 George Soros (Trades, Portfolio), Chuck Royce (Trades, Portfolio), Jim Simons (Trades, Portfolio) and Larry Robbins (Trades, Portfolio) added this stock to their portfolios in the third quarter of 2014, as well as Caxton Associates (Trades, Portfolio) and RS Investment Management (Trades, Portfolio).
Disclosure: Omar Venerio holds no position in any stocks mentioned.
[1] These values were obtained from BloombergĀ“s CRP function.
