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One Undervalued Stock According to Its Intrinsic Value
Posted by: Damian Illia (IP Logged)
Date: February 17, 2014 11:43AM

In a previous article we saw the 13-F holdings of Absolute Return Investors. Here, let´s analyze if one of them, Exxon Mobil Corporation (XOM) is coherent to be in that long portfolio. Exxon does not need too much introduction. The company’s principal business consists of the exploration for, and production of, crude oil and natural gas, manufacture of petroleum products and transportation and sale of crude oil, natural gas and petroleum products. The firm's largest competitors include BP Plc (BP) and Chevron Corporation (CVX).

Turning our attention to the future direction of the stock, let's take a look at the intrinsic value of this company and try to explain to investors the reasons why it is a good buy or not.

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).

To start with, the Gordon Growth Model (GGM) assumes that dividends increase at a constant rate indefinitely.

Let´s estimate the inputs for modeling:

1. Required Rate of Return (r)

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

Assumptions:

1. Risk-Free Rate: Rate of return on LT Government Debt: RF = 2.67%
1. Beta: β =0.94
1. 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]

rXOM = RF + βXOM [GGM ERP]

= 2.67% + 0.94 [11.43%]

= 13.41%

1. 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 can be estimated using Dupont formula:

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.

1. Dividend growth rate (g) implied by Gordon growth model (long-run rate)

With the GGM formula and simple maths:

Final Comment

When the stock price is lower than the intrinsic value, the stock is said to be undervalued and it makes sense to buy the stock. I would advise fundamental investors to consider adding this stock according to our estimations.

Hedge fund gurus have also been active in the company. Jeremy Grantham (Trades, Portfolio), Ray Dalio (Trades, Portfolio), Richard Pzena (Trades, Portfolio), Tom Gayner (Trades, Portfolio), Ken Fisher (Trades, Portfolio) and Donald Yacktman (Trades, Portfolio) have also invested in it.

Disclosure: Damian Illia holds no position in any stocks mentioned.

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

Guru Discussed: Donald Yacktman: ,
Jeremy Grantham: ,
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