A Leading Latin American Provider of Passenger and Cargo Service

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Jan 28, 2015

In this article, let's take a look at Copa Holdings SA (CPA, Financial), a $4.85 billion market cap company, which operates an airline in Panama providing international service throughout North, South and Central America, as well as an airline in Colombia providing domestic scheduled air service.

New destinations

The company focuses on international traffic and with a special plan to add new flights across Latin America, the Caribbean and North America. Of course, this plan is subject to negotiations between the government of Panama and the governments of the other countries. Through its Panama City hub, the firm is able to provide passenger traffic from multiple cities and serve each destination in an effective way because its base of operations is strategically located in Panama City.

We think that demand for air travel in Latin America is going to expand in the future, and it is crucial for Copa to expand its fleet capacity. Moreover, the deal with United Airlines has several positive effects. It has enhanced its brand in Latin America and also it has provided the company with cost benefits. We are talking about its low operating costs that have contributed to profitability.

Dividend policy

Since 2006, Copa 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 3.5%, with an annual payout of $3.84. The 5-year dividend growth rate of Copa Holdings is 51.1% and is ranked higher than 89% of the 19 Companies in the Airlines 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

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 =1.12

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]

rCPA = RF + βCPA [GGM ERP]

= 4.9% + 1.12 [11.43%]

= 17.70%

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) 12/31/2013 12/31/2012 12/31/2011
Cash dividends declared 64,696 192,612 72,410
Net income applicable to common shares 427,471 326,476 310,425
Net sales 2,608,332 2,249,388 1,830,921
Total assets 3,952,674 3,479,500 3,065,796
Total Shareholders' equity 1,901,906 1,536,544 1,389,531
Ratios   Â
Retention rate 1 0.41 0.77
Profit margin 0.16 0.15 0.17
Asset turnover 0.66 0.65 0.60
Financial leverage 2.30 2.38 2.45
   Â
Retention rate = (Net Income – Cash dividends declared) ÷ Net Income = 0.85
   Â
Profit margin = Net Income ÷ Net sales = 0.16 Â Â
   Â
Asset turnover = Net sales ÷ Total assets = 0.66 Â Â
   Â
Financial leverage = Total assets ÷ Total Shareholders' equity = 2.08 Â
   Â
Averages   Â
Retention rate 0.68 Â Â
Profit margin 0.16 Â Â
Asset turnover 0.63 Â Â
Financial leverage 2.38 Â Â
   Â
g = Retention rate × Profit margin × Asset turnover × Financial leverage Â
   Â
Dividend growth rate 16.24% 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)

= ($109.56 ×17.70% – $3.84) ÷ ($109.56 + $3.84) = 13.72%.

The growth rates are:

Year Value g(t)
1 g(1) 16.24%
2 g(2) 15.61%
3 g(3) 14.98%
4 g(4) 14.35%
5 g(5) 13.72%

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 3.84 Â
1 Div 1 4.46 3.79
2 Div 2 5.16 3.73
3 Div 3 5.93 3.64
4 Div 4 6.78 3.54
5 Div 5 7.72 3.42
5 Terminal Value 220.13 97.45
Intrinsic value   115.56
Current share price   109.56

Final comment

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.

Although the model indicates a fairly valued stock, we think that it is the right time to add the stock to your long-term portfolio due to the company´s focus to expand its operations by increasing flight frequencies on profitable routes and initiating service to new destinations.

Hedge fund managers Charles Brandes (Trades, Portfolio), Jim Simons (Trades, Portfolio) and Paul Tudor Jones (Trades, Portfolio) have added the stock in the third quarter of 2014, as well as Pioneer Investments (Trades, Portfolio).

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


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