I Would Recommend This Potash Stock Due to Its Drivers and Valuation

In this article, let´s consider Potash Corp. of Saskatchewan, Inc. (POT, Financial), a $28.01 billion market cap that has a trailing P/E ratio that indicates the stock is relatively undervalued (PE 21.7x vs Industry Median 22.7x). The obvious question I’m sure you want to know is –Â what is the future stock price movement? Although I cannot predict exactly the moment, we can see some drivers of this potash company, which is the world's largest integrated fertilizer and related industrial and feed products company by capacity.

Principal drivers

The company is the largest producer of potash worldwide. It produces all three primary crop nutrients, but potash remains the top of the firm's operations, representing 15% of global potash production and 19% of capacity. Last year, potash operations accounted for 41% of sales and 56% of gross profits in 2013, showing the importance of this product in the company´s income statement.

Apart from potash, the firm produces nitrogen and phosphate fertilizers. These industries have lower barriers to entry than potash. From a competitive standpoint, we rate the firm's phosphate operations as more attractive than its nitrogen business.

The company plans to expand its potash production capacity; the operational capacity is expected to reach 17 million metric tons by 2018, and we believe this will be a source of sustainable earnings potential for the company.

Considering other segments, the firm is the third-largest maker of nitrogen in the world and accounts for almost a third of sales. The company produces ammonia at three plants in the U.S. and one in Trinidad.

Its dividend yield at 4.1% is very attractive and is above its peers. Dividends have been paid since 1990. So now, 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, it 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.

This 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 =0.89

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]

rPOT = RF + βPOT [GGM ERP]

= 4.9% + 0.89 [11.43%]

= 15.07%

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 = (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:

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)

= ($36.96 ×15.07% – $1.4) ÷ ($36.96 + $1.4) = 10.52%.

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

Final comment

Using a margin of safety, one should buy a stock when it is worth more than its price on the market (plus a margin: I recommend 20%). We found that intrinsic value more than double the share price, so we can conclude that the stock is undervalued and it makes sense to buy the stock if you trust in the model and assumptions.

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 like Ray Dalio (Trades, Portfolio) and Jean-Marie Eveillard (Trades, Portfolio) added this stock in the second quarter of 2014.

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

[1] These values were obtained from Bloomberg´s CRP function.