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Why Linear Technology Has Upside Potential – A Look at Fundamental Value
Posted by: Damian Illia (IP Logged)
Date: February 19, 2014 02:48PM

Linear Technology Corp. (LLTC) designs, makes and markets a broad line of high performance standard linear integrated circuits (ICs) that address a wide range of real-world signal processing applications. The firm's largest competitors include Texas Instruments Inc. (TXN), Maxim Integrated Products Inc. (MXIM) and Analog Devices Inc. (ADI).

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 reasonss 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.

a. 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:

i. Risk-Free Rate: Rate of return on LT Government Debt: RF = 2.67%

ii. Beta: β =1.25

iii. 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]

rLLTC = RF + βLLTC [GGM ERP]

= 2.67% + 1.25 [11.43%]

= 16.96%

b. 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:

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

With the GGM formula and simple math:

The growth rates are:

 Year Value g(t) 1 g(1) 32,01% 2 g(2) 27,59% 3 g(3) 23,18% 4 g(4) 18,76% 5 g(5) 14,34%

G(2), g(3) and g(4) are calculated using linear interpolation between g(1) and g(5).

d. Calculation of Intrinsic Value

 Year Concept Amount Present value 0 Div 0 1,05 1 Div 1 1,39 1,19 2 Div 2 1,77 1,29 3 Div 3 2,18 1,36 4 Div 4 2,59 1,38 5 Div 5 2,96 1,35 5 Terminal Value 129,26 59,06 Intrinsic value 65,64 Current share price 45,88

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. Steven Cohen (Trades, Portfolio), Jim Simons (Trades, Portfolio), Jean-Marie Eveillard (Trades, Portfolio) and Diamond Hill Capital (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: Diamond Hill Capital: ,
Jean-Marie Eveillard: ,
Stocks Discussed: , , , ,
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