Is the Price Below Your Estimate of the Intrinsic Value?

In this article, let's take a look at Waste Management, Inc. (WM, Financial), a $24.33 billion market cap company, which is the largest U.S. trash hauling/disposal concern.

Threats

The actual macro scenario continues to place pressure on customers and led to higher prices, that is always a threat for the company, as well as the lower waste generation than the U.S. housing boom. These factors couldlead to pricing pressure and make it difficult for the firm to surpass it. Nevertheless, we still believe that waste volumes would recover in the future so we think the firmcould sustain price increases.

Growth of 10,000

If you had invested $10.000 five years ago, today you could have $19.715, which represents a 14.6% compound annual growth rate (CAGR).

Dividends Following Reported Results

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.We have favorable expectations regarding dividend growth and why not share repurchases for the next years. Dividends have been paid since 1998.

The company expected share repurchases to continue this year after it purchased $600 million in common stock during Q3 2014.

It has announced a 10% increase in its quarterly dividend from 35 to 38.5 cents per share, which will generate an annualized dividend of $1.54 per share. With a closing price of $54.69 this make an annualized dividend yield of 2.8%.

Due to strong fourth-quarter 2014 results, Waste Management reported good year-over-year improvement in earnings.

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 =0.78

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]

rWM = RF + βWM [GGM ERP]

= 4.9% + 0.78 [11.43%]

= 13.82%

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)

= ($54.69 ×13.82% – $1.54) ÷ ($54.69 + $1.54) = 10.7%.

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

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.

The market price of a stock tends to follow the intrinsic value and in this case is more than two times. In a previous article I recommend selling this stock, and I am not changing our opinion due to the operational challenges the company faces as well as the pricing environment.

Hedge fund gurus like John Buckingham (Trades, Portfolio), Mario Gabelli (Trades, Portfolio) and Ray Dalio (Trades, Portfolio) have reduced their positions in the last quarter of 2014, as well as Manning & Napier Advisors, Inc. and NWQ Managers (Trades, Portfolio).

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

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