In this article, let's take a look at Vulcan Materials Company (VMC, Financial), a $11.18 billion market cap company, which produces and sells construction aggregates, asphalt mix, and ready-mixed concrete primarily in the U.S.
Stock Price Appreciation
After reporting strong fourth quarter results, the firm has announced a 66.7%% increase in its quarterly dividend to 10 cents from 6 cents per share, which will generate an annualized dividend of $0.4 per share. With a closing price of $85.1 this make an annualized dividend yield of 0.5%. Since then, the company has risen almost 19% and reached a new 52-week high of $85.80 on Mar 6.
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 =1.44
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]
rVMC = RF + βVMC [GGM ERP]
= 4.9% + 1.44 [11.43%]
= 21.36%
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:
| Financial Data (USD $ in millions) | Dec 31, 2013 | Dec 31, 2012 | Dec 31, 2011 |
| Cash dividends declared | 28,884 | 5,191 | 5,183 |
| Net income applicable to common shares | 204,923 | 24,382 | (52,593) |
| Net sales | 2,994,169 | 2,770,709 | 2,567,310 |
| Total assets | 8,061,902 | 8,259,143 | 8,126,599 |
| Total Shareholders' equity | 4,176,699 | 3,938,106 | 3,761,062 |
| Ratios | Â | Â | Â |
| Retention rate | 1 | 0.79 | 1.10 |
| Profit margin | 0.07 | 0.01 | -0.02 |
| Asset turnover | 0.37 | 0.34 | 0.32 |
| Financial leverage | 1.99 | 2.15 | 2.15 |
| Â | Â | Â | Â |
| Retention rate = (Net Income – Cash dividends declared) ÷ Net Income = | 0.86 | ||
| Â | Â | Â | Â |
| Profit margin = Net Income ÷ Net sales = | 0.07 | Â | Â |
| Â | Â | Â | Â |
| Asset turnover = Net sales ÷ Total assets = | 0.37 | Â | Â |
| Â | Â | Â | Â |
| Financial leverage = Total assets ÷ Total Shareholders' equity = | 1.93 | Â | |
| Â | Â | Â | Â |
| Averages | Â | Â | Â |
| Retention rate | 0.91 | Â | Â |
| Profit margin | 0.02 | Â | Â |
| Asset turnover | 0.34 | Â | Â |
| Financial leverage | 2.09 | Â | Â |
| Â | Â | Â | Â |
| g = Retention rate × Profit margin × Asset turnover × Financial leverage | Â | ||
| Â | Â | Â | Â |
| Dividend growth rate | 1.24% | Â | Â |
| Â | Â | Â | Â |
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)
= ($85.1 ×21.36% – $0.4) ÷ ($85.1 + $0.4) = 20.79%.
The growth rates are:
| Year | Value | g(t) |
| 1 | g(1) | 1.24% |
| 2 | g(2) | 6.12% |
| 3 | g(3) | 11.01% |
| 4 | g(4) | 15.90% |
| 5 | g(5) | 20.79% |
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 | 0.40 | Â |
| 1 | Div 1 | 0.40 | 0.33 |
| 2 | Div 2 | 0.43 | 0.29 |
| 3 | Div 3 | 0.48 | 0.27 |
| 4 | Div 4 | 0.55 | 0.25 |
| 5 | Div 5 | 0.67 | 0.25 |
| 5 | Terminal Value | 142.10 | 53.98 |
| Intrinsic value | Â | Â | 55.38 |
| Current share price | Â | Â | 85.10 |
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.
The market price of a stock tends to follow the intrinsic value, and in this case we found that is trading more than a half of the latter. This should indicate a sell recommendation, but the dividend hike initiative should boost investor confidence and in theory should lead to a stock price appreciation and this seems to be the case. The stock has risen about 29% year-to-date.
Hedge fund guru like Jim Simons (Trades, Portfolio) bought the stock, he added 321,865 shares to his portfolio in the fourth quarter of 2014. Others like Lee Ainslie (Trades, Portfolio), Steven Cohen (Trades, Portfolio), John Keeley (Trades, Portfolio) and Mario Gabelli (Trades, Portfolio) have taken long positions in that quarter, while Brian Rogers (Trades, Portfolio), Jean-Marie Eveillard (Trades, Portfolio) and Dodge & Cox has sold out the stock.
Disclosure: Omar Venerio holds no position in any stocks mentioned.
[1] This values where obtained from Blommberg´s CRP function.
