What to Expect From Apple's Dividend Hike?

A recent article published by CNBCÂ discussed the excess cash Apple Inc. (AAPL, Financial) has in the balance sheet and predicted the next dividend hike.

Several opinions

Citibank analyst Jim Suva thinks that the company will hike the dividend by at least 10%, while Scott Kessler from S&P Capital IQ thinks Apple will raise it in the range of 8% to 15%. More optimistic was Amit Daryanani, an RBC Capital Markets analyst, who thinks that the firm could hike dividends by as much as 50% in order to reach the level of other competitors such as Microsoft (MSFT, Financial) or Intel (INTC, Financial).

So now, let´s take a look at the company´s valuation and try to elucidate if it is a good buy at current levels and say something about the probable dividend hike.

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 =0.93

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]

rAAPL = RF + βAAPL [GGM ERP]

= 4.9% + 0.93 [11.43%]

= 15.53%

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)

= ($127.35 ×15.53% – $1.88) ÷ ($127.35 + $1.88) = 13.85%.

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

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

The price is far below the intrinsic value, so we can say that the stock is undervalued, and so, subject to a potential buy. In other words, according to this model, it doesn’t matter the future dividend hike, what really matters is that Apple should be in the investor´s long-term portfolio.

Hedge funds gurus like Steve Mandel (Trades, Portfolio) and Jim Simons (Trades, Portfolio) bought the stock in the fourth quarter of 2014. The successful activist investor Carl Icahn (Trades, Portfolio) was the largest shareholder of Apple, with 52.76 million shares valued at $5.82 billion at the end of 2014; the position accounted for over 18.2% of the fund’s equity portfolio and was the largest in terms of value.

Another fund that owns shares of Apple is Ken Fisher (Trades, Portfolio)‘s Fisher Asset Management, holding 10.76 million shares, up by 1% on the quarter; the value of the stake amounts to $1.19 billion as of the end of 2014.

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

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