Apart from the Nice-Looking Dividend Yield, This Stock Is Not Cheap

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Dec 18, 2014

In this article, let's take a closer look at Frontier Communications Corporation (FTR, Financial), where we recently determined that, according to the relative valuation, the stock is trading higher and as a result, it is difficult to identify if there exists an adequate margin of safety to buy the stock.

Headroom

Since 2004, the firm 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 6.2%, which is considered very attractive for dividend investors.

According to a recent article published on MarketWatch, the company has the greatest headroom to raise dividends, based on trailing 12-month free cash flow yields. A company’s headroom to raise its dividend can be calculated by subtracting its current dividend yield from the cash flow yield.

Free cash flow yield - Dividend yield = Headroom

11.47% - 6.39 = 5.08%

Now, turning our attention to the future direction of the stock, let's take a look at the intrinsic value of this company and try to explain to investors the reasons why it is a good buy or not. In this article, we present a model that is by no means the be-all and end-all for valuation. The purpose is to force investors to evaluate different assumptions about growth and future prospects.

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 =0.51

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]

rFTR = RF + βFTR [GGM ERP]

= 4.9% + 0.51 [11.43%]

= 10.73%

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 399,768 399,390 746,387
Net income applicable to common shares 112,835 136,636 149,614
Net sales 4,761,576 5,011,853 5,243,043
Total assets 16,635,484 17,733,631 17,448,319
Total Shareholders' equity 4,055,481 4,107,596 4,455,137
Ratios   Â
Retention rate (3) -1.92 -3.99
Profit margin 0.02 0.03 0.03
Asset turnover 0.29 0.28 0.30
Financial leverage 4.08 4.14 3.62
   Â
Retention rate = (Net Income – Cash dividends declared) ÷ Net Income = -2.54
   Â
Profit margin = Net Income ÷ Net sales = 0.02 Â Â
   Â
Asset turnover = Net sales ÷ Total assets = 0.29 Â Â
   Â
Financial leverage = Total assets ÷ Total Shareholders' equity = 4.10 Â
   Â
Averages   Â
Retention rate -2.82 Â Â
Profit margin 0.03 Â Â
Asset turnover 0.29 Â Â
Financial leverage 3.94 Â Â
   Â
g = Retention rate × Profit margin × Asset turnover × Financial leverage Â
   Â
Dividend growth rate -8.54% 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)

= ($6.36 ×10.73% – $0.4) ÷ ($6.36 + $0.4) = 4.18%.

The growth rates are:

Year Value g(t)
1 g(1) -8.54%
2 g(2) -5.36%
3 g(3) -2.18%
4 g(4) 1.00%
5 g(5) 4.18%

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 0.40 Â
1 Div 1 0.37 0.33
2 Div 2 0.35 0.28
3 Div 3 0.34 0.25
4 Div 4 0.34 0.23
5 Div 5 0.36 0.21
5 Terminal Value 5.67 3.40
Intrinsic value   4.71
Current share price   6.36

Final comment

I would recommend buying a stock only when it's selling at a decent margin of safety to your estimate of its fair value. But in this case, we found the opposite situation, intrinsic value is lower than the share price so the stock is said to be overvalued and subject to a potential sale.

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 Joel Greenblatt (Trades, Portfolio), John Burbank (Trades, Portfolio), Jim Simons (Trades, Portfolio) and Steven Cohen (Trades, Portfolio) have reduced the stock in the third quarter of 2014.

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


[1] These values were obtained from Bloomberg´s CRP function.