In this article, let's take a look at Fifth Street Finance Corporation (FSC, Financial), a $1.09 billion market cap company, which is a growing asset manager that provides credit solutions to small and mid-sized businesses.
Principal hedge fund's activity
Paul Tudor Jones disclosed holding 51,742 shares of the company´s shares at the end of 2014, up by 409% in the fourth quarter of 2014, with the shares having an aggregate value of $0.41 million. Israel Englander´s Millennium Management was another hedge fund manager that had a strong activity in that quarter, holding 1.89 million shares, up by 111% and the value of the stake amounting to $15.2 million.
Bad news?
The firm has an attractive dividend policy showing its commitment to return cash to investors in the form of dividends. But, it recently announced a dividend cut, which means that event that makes the investor think about a financial stress or a lack of confidence in the future cash generation. The dividend yield was about 14%, and considering the new dividend it will be around 10%.
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 =0.61
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]
rFSC = RF + βFSC [GGM ERP]
= 4.9% + 1.24 [11.43%]
= 11.87%
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) | Sep 30, 2014 | Sep 30, 2013 | Sep 30, 2012 |
| Cash dividends declared | (132,468) | (115,438) | (91,866) |
| Net income applicable to common shares | 112,532 | 101,821 | 79,401 |
| Net sales | 242,489 | 188,142 | 141,871 |
| Total assets | 2,668,218 | 2,072,333 | 1,389,002 |
| Total Shareholders' equity | 1,478,475 | 1,368,872 | 903,570 |
| Ratios | Â | Â | Â |
| Retention rate | 2 | 2.13 | 2.16 |
| Profit margin | 0.46 | 0.54 | 0.56 |
| Asset turnover | 0.09 | 0.09 | 0.10 |
| Financial leverage | 1.87 | 1.82 | 1.70 |
| Â | Â | Â | Â |
| Retention rate = (Net Income – Cash dividends declared) ÷ Net Income = | 2.18 | ||
| Â | Â | Â | Â |
| Profit margin = Net Income ÷ Net sales = | 0.46 | Â | Â |
| Â | Â | Â | Â |
| Asset turnover = Net sales ÷ Total assets = | 0.09 | Â | Â |
| Â | Â | Â | Â |
| Financial leverage = Total assets ÷ Total Shareholders' equity = | 1.80 | Â | |
| Â | Â | Â | Â |
| Averages | Â | Â | Â |
| Retention rate | 2.16 | Â | Â |
| Profit margin | 0.52 | Â | Â |
| Asset turnover | 0.09 | Â | Â |
| Financial leverage | 1.80 | Â | Â |
| Â | Â | Â | Â |
| g = Retention rate × Profit margin × Asset turnover × Financial leverage | Â | ||
| Â | Â | Â | Â |
| Dividend growth rate | 19.15% | Â | Â |
| Â | 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)
= ($7.11 × 11.87% – $1.1) ÷ ($7.11 + $1.1) =-3.12%.
The growth rates are:
| Year | Value | g(t) |
| 1 | g(1) | 19.15% |
| 2 | g(2) | 13.58% |
| 3 | g(3) | 8.02% |
| 4 | g(4) | 2.45% |
| 5 | g(5) | -3.12% |
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 | 1.10 | Â |
| 1 | Div 1 | 1.31 | 1.17 |
| 2 | Div 2 | 1.49 | 1.19 |
| 3 | Div 3 | 1.61 | 1.15 |
| 4 | Div 4 | 1.65 | 1.05 |
| 5 | Div 5 | 1.60 | 0.91 |
| 5 | Terminal Value | 10.32 | 5.89 |
| Intrinsic value | Â | Â | 11.36 |
| Current share price | Â | Â | 7.11 |
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 price is far below the intrinsic value so we can say that the stock is undervalued, and so, in my opinion subject to a potential buy. Further, considering that the stock is down by 11.61% year-to-date, I think it is time to take a long position on it. In the past 12 months, the stock was down 24.28%. As outlined in the article, the revised dividend yield of 10% may be sufficient for me and also to attract investors.
Hedge fund guru Zeke Ashton bought 270,000 shares while David Einhorn sold out the stock in the fourth quarter of 2014.
Disclosure: Omar Venerio holds no position in any stocks mentioned.
[1] These values were obtained from Bloomberg´s CRP function.
