Damian Illia

Should Alcoa Be in a Portfolio?

Alcoa Inc. (NYSE:AA) is one of the world's largest producers of primary aluminum as well as one of the world's largest suppliers of alumina, an intermediate raw material used to make aluminum products for a variety of end-markets. Alcoa is involved in every step of the aluminum-production process, from bauxite mining to the sale of specialized aluminum products. Aluminum demand and pricing are poised to recover from great lows, driving significant earnings growth potential for the company. The firm's competitor includes Aluminum Corporation Of China Limited (NYSE:ACH).

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.

Let´s estimate the inputs for modeling:

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 =1.9
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]

rAA = RF + βAA [GGM ERP]

= 2.67% + 1.9 [11.43%]

= 24.39%

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) -1.71% 2 g(2) 4.50% 3 g(3) 10.71% 4 g(4) 16.92% 5 g(5) 23.13%

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 0.12 1 Div 1 0.12 0.09 2 Div 2 0.12 0.08 3 Div 3 0.14 0.07 4 Div 4 0.16 0.07 5 Div 5 0.20 0.07 5 Terminal Value 19.27 6.47 Intrinsic value 6.85 Current share price 11.77

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. John Burbank (Trades, Portfolio). Ray Dalio (Trades, Portfolio). Jim Simons (Trades, Portfolio). Arnold Van Den Berg (Trades, Portfolio). Arnold Schneider (Trades, Portfolio). Joel Greenblatt (Trades, Portfolio) and Manning & Napier Advisors Inc. have also divested it in fourth quarter 2013.

Disclosure: Damian Illia 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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