Damian Illia

# A Strong Sell Despite a Buy Recommendation Due to Its Intrinsic Value

Philip Morris International Inc. (NYSE:PM) manufactures and markets cigarettes outside the U.S. in 180 countries. The company´s plan is to introduce new packaging, new blends and other line extensions. A key driver of the company is the strong market share and the economies of scale. Also, the company has combated unfavorable tax regulations with price increases, showing a good price-elasticity. The firm's competitors include British American Tobacco plc (NYSE:BTI) and Imperial Tobacco Group plc (ITYBY).

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:

• Risk-Free Rate: Rate of return on LT Government Debt: RF = 2.67%
• Beta: β =0.98
• 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]

rPM = RF + βPM [GGM ERP]

= 2.67% + 0.98 [11.43%]

= 13.87%

- 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 can be estimated using Dupont formula:

Let´s collect the information we need to get the dividend growth rate:

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) 10.48% 2 g(2) 10.10% 3 g(3) 9.73% 4 g(4) 9.35% 5 g(5) 8.98%

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 3.58 1 Div 1 3.96 3.47 2 Div 2 4.35 3.36 3 Div 3 4.78 3.24 4 Div 4 5.23 3.11 5 Div 5 5.69 2.97 5 Terminal Value 126.78 66.22 Intrinsic value 82.37 Current share Price 79.71

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. However. a few days ago. Zacks Investment Research downgraded the company to a Zacks Rank #5 (Strong Sell) according to an expected poor outlook for 2014. Other better-ranked stocks in the industry worth considering include Post Holdings. Inc. (POST). Diamond Foods Inc. (DMND) and The Hain Celestial Group Inc. (HAIN) that carry a Zacks Rank #2 (Buy).

Hedge fund gurus have also been active in the company. David Dreman (Trades, Portfolio). John Rogers (Trades, Portfolio). Joel Greenblatt (Trades, Portfolio). Jeff Auxier (Trades, Portfolio). Jeremy Grantham (Trades, Portfolio). Tom Russo (Trades, Portfolio). James Barrow (Trades, Portfolio). Tweedy Browne (Trades, Portfolio) and the fund Diamond Hill Capital (Trades, Portfolio) have also invested in it in Q4 2013.

Disclosure: Victor Selva holds no position in any stocks mentioned.

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

Damian Illia
A fundamental analyst at Lonetreeanalytics.com constantly looking for value and income investments.

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 Currently 4.17/512345 Rating: 4.2/5 (6 votes)

Tonyg34 - 3 years ago    Report SPAM

no offense to Zacks, but I'll take the other side of that currency bet. These exchange fluctuations have a way of working themselves out over time and I think the long term chart of the USD indicates that the current strength of the dollar won't be permanent

TFC - 3 years ago

A strong product lineup which aside from Vap will have a first market advantage and enourmous health advantages. That looks like a future value upside. I can think of few companies that look after shareholders and utilize capital better than PM.

Downside plain packaging, increased taxes and reduced volume for existing product. Economic growth drives volume above all else.

Again states and countries earn far more from a package of cigs than shareholders giving them a very strong economic incentive.

I hope all those nervous nellies sell please sell.

Batbeer2 - 3 years ago

FWIW I think the math you present here is elegant. I also think it is absolutely useless.

1) >> 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.

There are important differences between what John Burr Williams wrote and what you say.

2) You condense the Gordon growth formula to D1/(r-g).

The assumption being that the growth rate is constant. Does this matter? Will the condensed form spit out a result that is even close to the result produced by the long form if the growth rate is not constant?

Just to keep things simple, we could use g=1.1 and r=1 for the short form. For the long form we still use r=1 but we use g = (sine + 1.1). While we're at it, we could also do a long form with g = (cosine + 1.1). The economic cycle in this model is six years and almost four months.

Could anyone who didn't flunk math please work out if there's a significant difference between the long form and the short form if the growth rate fluctuates?

3) In any case, the math seems to indicate AAPL, AMZN, BBBY, BBRY and BRK all have a value of precisely \$0. It would be nice to know at what point in the alphabet this math does start to work.

Seriously! That is not a rhetorical question.