Lockheed: A Buy According to Absolute and Relative Valuation Models

Lockheed Martin Corporation (LMT, Financial), a $50.37 billion market cap company that is the world's largest military weapons manufacturer, has a P/E ratio that indicates that the stock is relatively undervalued (16.5x vs 22.1x of industry mean). So in this article, let's take a look at a model which is applicable to stable, mature, dividend-paying firms and try to find the intrinsic value of the stock. Although the model has a number of characteristics that make it useful and appropriate for many applications, is by no means the be-all and end-all for valuation. The purpose is to force investors to evaluate different assumptions about growth and future prospects.

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). With the appropriate model, we can forecast dividends up to the end of the investment horizon where we no longer have confidence in the forecasts and then forecast a terminal value based on some other method, such as a multiple of book value or earnings.

To start with, the Gordon Growth Model (GGM) assumes that dividends increase at a constant rate indefinitely. The formula condenses to: V0=(D0 (1+g))/(r-g)=D1/(r-g)

where:

V0 = fundamental value

D0 = last year dividends per share of Exxon's common stock

r = required rate of return on the common stock

g = dividend growth rate

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 stockj = risk-free rate + beta of j x equity risk premium

Assumptions:

Risk-Free Rate: Rate of return on LT Government Debt: RF = 2.67%. This is a very low rate because of today´s context. Since 1900, yields have ranged from a little less than 2% to 15%; with an average rate of 4.9%. So I think it is more appropriate to use this rate.

Beta: β =0.64

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%

rLMT = RF + βLMT [GGM ERP]

= 4.9% + 0.64 [11.43%]

= 12.22%

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:

ROE=(Net Income)/Equity= ((Net Income)/Sales).(Sales/(Total Assets)).((Total Assets)/Equity)

The “PRAT” Model:

g= ((Net Income-Dividends)/(Net Income)).((Net Income)/Sales).(Sales/(Total Assets)).((Total Assets)/Equity)

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

We think that the rate obtained is too high, so we are going to consider the average Dividends Per Share Growth Rate during the past 10 years which was 20.90% per year.

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:

g=(P0.r - D0)/(P0+D0)

= ($158.18 ×12.22% – $5.32) ÷ ($158.18 + $5.32) = 8.56%.

The growth rates are:

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

Calculation of Intrinsic Value

Using margin of safety, one should buy a stock when it is worth more than its price on the market. We found that intrinsic value is 30% higher than share price, so we can say that the stock is undervalued and it makes sense to buy the stock.

We have covered just one valuation method and investors should not be relied on alone in order to determine a fair (over/under) value for a potential investment.

Hedge fund gurus have also been active in the company. Louis Moore Bacon (Trades, Portfolio), Ray Dalio (Trades, Portfolio) and Joel Greenblatt (Trades, Portfolio) have taken long position in the stock in the first quarter of 2014.

Disclosure: Omar Venerio holds no position in any stocks mentioned.

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