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Why Should You Sell State Street?
Posted by: Vanina Egea (IP Logged)
Date: February 25, 2014 05:18PM

State Street Corporation (STT) provides a range of products and services for institutional investors worldwide through its subsidiaries. Considering revenues reported in June 2013, the main products segments were Investment Servicing (66%), Investment Management (11%), and net interest revenue from the company's investment portfolio (23%). At that date, the company had more than \$26 trillion of assets under custody and administration and \$2 trillion of AUM. The firm's competitors include The Bank of New York Mellon Corporation (BK), JPMorgan Chase & Co. (JPM) and Northern Trust Corporation (NTRS).

Now, 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.

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%
2. Beta: β =1.75
3. 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]

rSTT = RF + βSTT [GGM ERP]

= 2.67% + 1.75 [11.43%]

= 22.67%

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.

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) 8,61% 2 g(2) 11,67% 3 g(3) 14,73% 4 g(4) 17,79% 5 g(5) 20,85%

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

Calculation of Intrinsic Value

 Year Concept Amount Present value 0 Div 0 1,04 1 Div 1 1,13 0,92 2 Div 2 1,26 0,84 3 Div 3 1,45 0,78 4 Div 4 1,70 0,75 5 Div 5 2,06 0,74 5 Terminal Value 136,84 49,26 Intrinsic value 53,29 Current share price 69,07

Final Comment

When the stock price is higher than the intrinsic value, the stock is said to be overvalued and it makes sense to sell the stock.

Hedge fund gurus have also been active in the company. Donald Yacktman (Trades, Portfolio), Jeremy Grantham (Trades, Portfolio), Mario Gabelli (Trades, Portfolio), Richard Pzena (Trades, Portfolio), Charles Brandes (Trades, Portfolio), Jim Simons (Trades, Portfolio) and the fund RS Investment Management (Trades, Portfolio) have divested in it in Q4 2013.

Disclosure: Vanina Egea holds no position in any stocks mentioned.

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

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Re Why Should You Sell State Street
Posted by: AlbertaSunwapta (IP Logged)
Date: February 26, 2014 07:07AM

Your analysis may be supported by recent insider selling.

However, capital gains taxes have to be factored into the intrinsic value sell decision.

StateStreet has what I believe is a fair to wide moat. (Pensions, etc don't switch overnight.)

The source of their AUM and growth in future AUM needs to be fleshed out. You may be right but corporate funding of current projected and increasingly critical unfunded pension liabilities may be a significant future source, aging baby boomers may cause massive net leakage, or massive net gains, etc. Where is AUM headed?

What potential does the firm have to significantly change WACC?

What does its debt distribution look like? (DDIS on Bloomberg Professional I believe.)

I don't own any position in StateStreet.

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