Prudential Financial Inc. (PRU, Financial) has raised its quarterly dividend to 70 cents per share. This way, the stock yields 3.32% if the share price stays at current levels ($85.65). However, thanks to GuruFocus we can find that dividend yield is ranked lower than 69% of the 107 Companies in the Global Insurance - Life industry. A simple question arises: Is it worth it?
What makes possible the dividend hike is the solid financial position, and we expect it to use excess capital to continue repurchase shares and for dividend payments. We should note that Prudential has a history of deploying capital through share repurchases, dividend as well as acquisitions.
The day after the company declared the dividend increase, the stock moved higher by more than 1%. Let's try to find the intrinsic value of the stock and compare it with its trading price. But first, let's see the relative valuation.
The company is trading at a P/E ratio of 11.3x, which is expensive when compared to MetLife (MET, Financial) but cheaper than American International Group (AIG, Financial). By dividend yield, Prudential's dividend looks more attractive than its peers.
| Company | P/E Ratio | Dividend Yield (%) |
| Prudential | 11.30 | 3.32 |
| MetLife | 9.83 | 2.92 |
| AIG | 17.91 | 1.09 |
Intrinsic Value
The Yahoo! (YHOO, Financial) Finance consensus price target is $97.56 per share, representing an upside potential of 14%, so let´s try to estimate the fair value of the firm. For that purpose I will use the Dividend Discount Model (DDM). In stock valuation models, DDM defines cash flow as the dividends to be received by the shareholders. The model 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).
Once we have selected 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.
Let´s estimate the inputs for modeling:
First, we need to calculate the different discount rates, i.e. the cost of equity (from CAPM). The capital asset pricing model (CAPM) estimates the required return on equity using the following formula: required return on stock j = risk-free rate + beta of j x equity risk premium
Risk-Free Rate: Rate of return on LT Government Debt: RF = 3.03%[1]. I think this is a very low rate. Since 1900, yields have ranged from a little less than 2% to 15%; with an average rate of 4.9%. It is more appropriate to use this rate.
Gordon Growth Model 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%[2]
Beta: From Yahoo! Finance we obtain a β = 1.3709
The result given by the CAPM is a cost of equity of: rPRU = RF + βPRU [GGM ERP] = 4.9% + 1.3709 [11.43%] = 20.57%
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)
Collecting the financial information for the last three years, each ratio was calculated, and then, to have a better approximation, I proceeded to find the three-year average:
| Retention rate | -0.16 |
| Profit margin | 0.02 |
| Asset turnover | 0.08 |
| Financial leverage | 19.74 |
Now, it is easy to find the g = Retention rate Ă— Profit margin Ă— Asset turnover Ă— Financial leverage = -0.42%.
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. In other words, 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)
= ($84.29 × 20.57% – $2.80) ÷ ($84.29 + $2.80) = 16.69%.
The growth rates are:
| Year | Value | g(t) |
| 1 | g(1) | -0.42% |
| 2 | g(2) | 3.86% |
| 3 | g(3) | 8.14% |
| 4 | g(4) | 12.41% |
| 5 | g(5) | 16.69% |
G(2), g(3) and g(4) are calculated using linear interpolation between g(1) and g(5).
Now that we have all the inputs, let's discount the cash flows to find the intrinsic value:
| Year | Value | Cash Flow | Present value |
| 0 | Div 0 | 2.80 | Ă‚ |
| 1 | Div 1 | 2.79 | 2.312 |
| 2 | Div 2 | 2.90 | 1.992 |
| 3 | Div 3 | 3.13 | 1.787 |
| 4 | Div 4 | 3.52 | 1.666 |
| 5 | Div 5 | 4.11 | 1.612 |
| 5 | Terminal Value | 123.65 | 48.530 |
| Intrinsic value | Ă‚ | Ă‚ | 57.90 |
| Current share price | Ă‚ | Ă‚ | 84.29 |
| Upside potential | Ă‚ | Ă‚ | -31% |
Final comment
Intrinsic value is below the trading price by more than 31%, so according to the model and assumptions, the stock is overvalued. Not even considering a margin of safety (usually 20%) we could say that the stock is fairly valued.
However, we must keep in mind that the model is a 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 like Joel Greenblatt, Sarah Ketterer, Ray Dalio and Scott Black have upped their stakes by 125%, 31%, 19% and 15%. On the other hand, John Burbank, RS Investment Management and Caxton Associates sold out the stock, while Ken Heebner and Jeremy Grantham have reduced their positions by 65.61% and 68.45%, respectively.
Disclosure: As of this writing, Omar Venerio did not hold a position in any of the aforementioned stocks
[1] This value was obtained from the U.S. Department of the Treasury.
[2] These values were obtained from Bloomberg's CRP function.
