Betting on a Fairly Valued Stock

In this article, let's take a look at The Walt Disney Company (DIS, Financial), a $153.68 billion market cap company that is a media and entertainment conglomerate that has diversified global operations in theme parks, filmed entertainment, television broadcasting and consumer products.

Revenues, margins and profitability

Looking at profitability, revenue grew by 7.66% led earnings per share increased in the most recent quarter compared to the same quarter a year ago ($1.28 vs $1.01). During the past fiscal year, it increased its bottom line by earning $3.38 versus $3.12 in the prior year. This year, the market expects an improvement in earnings ($4.28 versus $3.38).

Finally, let's compare the best measure of performance for a firm's management: the return on equity. The ROE is useful for comparing the profitability of a company to that of other firms in the same industry.

The company has a current ROE of 16.53% which is higher than the one exhibit by Time Warner Inc. (TWX, Financial).In general, analysts consider ROE ratios in the 15-20% range as representing attractive levels for investment. So for investors looking those levels or more, Twenty-First Century Fox Inc. (FOXA, Financial) could be the option. It is very important to understand this metric before investing and it is important to look at the trend in ROE over time.

Relative Valuation

In terms of valuation, the stock sells at a trailing P/E of 21.5x, trading at a discount compared to an average of 30.8x for the industry. To use another metric, its price-to-book ratio of 3.34x indicates a premium versus the industry average of 2.62x while the price-to-sales ratio of 3.31x is above the industry average of 2.10x.

As we can see in the next chart, the stock price has an upward trend in the five-year period. If you had invested $10,000 five years ago, today you could have $30,469, which represents a 25% compound annual growth rate (CAGR).

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 =1.07

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]

rDIS = RF + βDIS [GGM ERP]

= 4.9% + 1.07 [11.43%]

= 17.13%

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)

= ($89.93 ×17.13% – $0.86) ÷ ($89.93 + $0.86) = 16.02%.

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 is 10% below the trading price so we can conclude that the stock is fairly valued if you trust in the model and assumptions. However, due to the PE relative valuation and the return on equity that significantly exceeds the industry average and make me feel bullish on this 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.

However, hedge fund guru Brian Rogers (Trades, Portfolio) has reduced this stock in the third quarter of 2014.

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

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