A Bermuda-Based Company Is Combining Cash and Stock Dividend Hike

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Feb 23, 2015

In this article, let's take a look at Argo Group International Holdings, Ltd. (AGII, Financial), a $1.35 billion market cap company, which is an international underwriter of specialty insurance and reinsurance products.

Dividend Hike

The firm has an attractive 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 1.32%, and we have favorable expectations regarding dividend growth and share repurchases for the next years.

It has announced a 11.1% increase in its quarterly dividend from 18 cents to 20 cents per share, which will generate an annualized dividend of $0.80. Last year, the firm hiked its quarterly dividend by 20%.

In addition, the company will pay a stock dividend of 10%, giving more value to shareholders. Combining the two effects, the firm has a 22.1% dividend hike.

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.

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 =0.98

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]

rAGII = RF + βAGII [GGM ERP]

= 4.9% + 0.98 [11.43%]

= 16.10%

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-Dec-13 31-Dec-12 31-Dec-11
Cash dividends declared 174.100 125.900 84.900
Net income applicable to common shares 474.600 401.300 125.200
Net sales 5.692.500 5.579.900 5.511.700
Total assets 6.069.700 6.222.000 6.160.900
Total Shareholders' equity 2.071.500 1.996.700 1.849.100
Ratios   Â
Retention rate 1 0,69 0,32
Profit margin 0,08 0,07 0,02
Asset turnover 0,94 0,90 0,89
Financial leverage 2,98 3,24 3,28
   Â
Retention rate = (Net Income – Cash dividends declared) ÷ Net Income = 0,63
   Â
Profit margin = Net Income ÷ Net sales = 0,08 Â Â
   Â
Asset turnover = Net sales ÷ Total assets = 0,94 Â Â
   Â
Financial leverage = Total assets ÷ Total Shareholders' equity = 2,93 Â
   Â
Averages   Â
Retention rate 0,55 Â Â
Profit margin 0,06 Â Â
Asset turnover 0,91 Â Â
Financial leverage 3,17 Â Â
   Â
g = Retention rate × Profit margin × Asset turnover × Financial leverage Â
   Â
Dividend growth rate 9,36% 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)

= ($52.67 ×16.10% – $0.80) ÷ ($52.67 + $0.80) = 14.36%.

The growth rates are:

Year Value g(t)
1 g(1) 9,36%
2 g(2) 10,61%
3 g(3) 11,86%
4 g(4) 13,11%
5 g(5) 14,36%

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 0,80 Â
1 Div 1 0,87 0,75
2 Div 2 0,97 0,72
3 Div 3 1,08 0,69
4 Div 4 1,22 0,67
5 Div 5 1,40 0,66
5 Terminal Value 92,19 43,70
Intrinsic value   47,20
Current share price   52,67

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.

According to the valuation, the stock is fairly valued and based on the dividends hike over the past, I would recommend watching this stock, specially considering that the PE ratio is close to a 3-year low. The bad news is that revenues and earnings fell short of Wall Street expectations.

Hedge fund guru Jim Simons (Trades, Portfolio) bought the stock while Paul Tudor Jones (Trades, Portfolio) has added the stock in the last quarter of 2014.

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


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