Despite Hedge Fund Managers 'Reductions, Ameren Can Be a Good Buy

In this article, let's take a look at Ameren Corporation (AEE, Financial), a $10.63 billion market cap company, which is an electric utility company in the state of Missouri and in Illinois.

Revenues, Margins and Profitability

Looking at profitability, revenue grew by 1.95% but earnings per share decreased in the most recent quarter compared to the same quarter a year ago ($1.2 vs $1.25).

Finally, let´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.

The company has a current ROE of 8.72% which is lower than its peers: Scana (SCG, Financial), DTE Energy (DTE, Financial), Alliant Energy (LNT, Financial) and NiSource (NI, 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, Wisconsin Energy (WEC, Financial) could be the option. It is very important to understand this metric before investing and it is important to look at the trend in ROE over time.

Relative Valuation

In terms of valuation, the stock sells at a trailing P/E of 18.5x, trading at a discount compared to an average of 20.6x for the industry. To use another metric, its price-to-book ratio of 1.6x indicates a discount versus the industry average of 1.67x while the price-to-sales ratio of 1.8x is above the industry average of 1.65x.

As we can see in the next chart, the stock price has an upward trend in the five-year period. If you had invested $10.000 five years ago, today you could have $21.679, which represents a 16.7% compound annual growth rate (CAGR).

Compared to where it was a year ago, the stock is now trading at a higher level.

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

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 stock = 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 =0.57

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]

rAEE = RF + βAEE [GGM ERP]

= 4.9% + 0.57 [11.43%]

= 7.41%

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)

= ($108.16 ×14.50% – $2.8) ÷ ($108.16 + $2.8) = 11.61%.

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

Trading nearly the 52-week high seems to be announcing a fall in price. However, we think that it is the right time to add the stock to your long-term portfolio.

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. Further, the PE relative valuation makes me feel bullish on this stock.

However, hedge fund gurus like Jim Simons (Trades, Portfolio) and Paul Tudor Jones (Trades, Portfolio) have reduced this stock in their portfolios in the third quarter of 2014 as well as Pioneer Investments (Trades, Portfolio).

Disclosure: Omar Venerio holds no position in any stocks mentioned

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