This San Diego-Based Chipmaker Looks Attractive

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Mar 10, 2015

In this article, let's take a look at Qualcomm Incorporated (QCOM, Financial), a $121.62 billion market cap company, which designs, develops, manufactures, and markets digital communications products and services in China, South Korea, Taiwan, and the U.S.

Dividend hike

The firm has an attractive dividend policy showing its commitment to return cash to investors in the form of dividends as it generates healthy cash flow on a regular basis. The current dividend yield is about 2.3%, which is quite good to protect the purchasing power, especially considering the consistency of track-record dividends payments and favorable expectations regarding dividend growth and share repurchases for the next years.

On Monday it announced a 14% increase in its quarterly dividend from 42 cents to 48 cents per share, which will generate an annualized dividend of $1.92.

With respect to the share buyback program, the company replaced the previous program and now plans to repurchase $10 billion in the next 12 months.

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

LetĀ“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 todayĀ“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: ƎĀ² =1.35

GGM equity risk premium = (1-year forecasted dividend yield on market index) +(consensus long-term earnings growth rate) ā€“ (long-term government bond yield) = 2.13% + 11.97% - 2.67% = 11.43%[1]

rQCOM = RF + ƎĀ²QCOM [GGM ERP]

= 4.9% + 0.57 [11.43%]

= 20.33%

Dividend growth rate (g)

The sustainable growth rate is the rate at which earnings and dividends can grow indefinitely assuming that the firmĀ“s debt-to-equity ratio is unchanged and it doesnĀ“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 ā€œPRATā€ Model:

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

LetĀ“s collect the information we need to get the dividend growth rate:

Financial Data (USD $ in millions) 28-Sep-14 29-Sep-13 30-Sep-12
Cash dividends declared 2,586,000 2,055,000 1,583,000
Net income applicable to common shares 7,967,000 6,853,000 6,109,000
Net sales 26,487,000 24,866,000 19,121,000
Total assets 48,574,000 45,516,000 43,012,000
Total Shareholders' equity 39,169,000 36,088,000 33,523,000
Ratios Ƃ Ƃ Ƃ
Retention rate 1 0.70 0.74
Profit margin 0.30 0.28 0.32
Asset turnover 0.55 0.55 0.44
Financial leverage 1.29 1.31 1.42
Ƃ Ƃ Ƃ Ƃ
Retention rate = (Net Income ā€“ Cash dividends declared) Ć· Net Income = 0.68
Ƃ Ƃ Ƃ Ƃ
Profit margin = Net Income Ć· Net sales = 0.30 Ƃ Ƃ
Ƃ Ƃ Ƃ Ƃ
Asset turnover = Net sales Ć· Total assets = 0.55 Ƃ Ƃ
Ƃ Ƃ Ƃ Ƃ
Financial leverage = Total assets Ć· Total Shareholders' equity = 1.24 Ƃ
Ƃ Ƃ Ƃ Ƃ
Averages Ƃ Ƃ Ƃ
Retention rate 0.71 Ƃ Ƃ
Profit margin 0.30 Ƃ Ƃ
Asset turnover 0.51 Ƃ Ƃ
Financial leverage 1.34 Ƃ Ƃ
Ƃ Ƃ Ƃ Ƃ
g = Retention rate Ɨ Profit margin Ɨ Asset turnover Ɨ Financial leverage Ƃ
Ƃ Ƃ Ƃ Ƃ
Dividend growth rate 14.46% Ƃ Ƃ
Ƃ Ƃ Ƃ Ƃ

Because for most companies, the GGM is unrealistic, letĀ“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)

= ($72.71 Ɨ20.33% ā€“ $1.92) Ć· ($71.71 + $1.92) = 17.23%.

The growth rates are:

Year Value g(t)
1 g(1) 14.46%
2 g(2) 15.15%
3 g(3) 15.85%
4 g(4) 16.54%
5 g(5) 17.23%

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

Calculation of Intrinsic Value

Year Value Cash Flow Present value
0 Div 0 1.92 Ƃ
1 Div 1 2.20 1.83
2 Div 2 2.53 1.75
3 Div 3 2.93 1.68
4 Div 4 3.42 1.63
5 Div 5 4.01 1.59
5 Terminal Value 151.68 60.13
Intrinsic value Ƃ Ƃ 68.60
Current share price Ƃ Ƃ 72.71

Final comment

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.

According to the valuation, the stock is overvalued by 6%, but considering a 20% margin of safety, we can say that the model tells us to hold the stock. But based on QualcommĀ“s dividend hike, I would recommend buying the stock.

When looking at the return of investing on Qualcomm, we can see that the stock is down about 3% year to date and 5% when considering the last 12 months. But after the Monday news, it was up by 1.7%, closing at $72.71. After the market closed, another 2.5% increase was obtained, reaching $75.25 in extended hours.

Gurus and funds like Sarah Ketterer (Trades, Portfolio), John Buckingham (Trades, Portfolio), Louis Moore Bacon (Trades, Portfolio), Paul Tudor Jones (Trades, Portfolio), Joel Greenblatt (Trades, Portfolio), David Rolfe (Trades, Portfolio), Jeremy Grantham (Trades, Portfolio), Brian Rogers (Trades, Portfolio), Bill Frels (Trades, Portfolio), Pioneer Investments (Trades, Portfolio), Murray Stahl (Trades, Portfolio), Steven Romick (Trades, Portfolio) and First Pacific Advisors (Trades, Portfolio) have added the stock in the fourth quarter of 2014.

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


[1] These values were obtained from BloombergĀ“s CRP function.