Buy Caterpillar Based On Price and Dividend Yield

In this article, let's take a look at Caterpillar Inc. (CAT, Financial), a $51.28 billion market cap company, which manufactures and sells construction and mining equipment, diesel and natural gas engines, industrial gas turbines, and diesel-electric locomotives worldwide.

Attractive Dividend Yield

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. Dividends have been paid since 1914 and it has paid higher dividends for 21 consecutive years.

At the beginning of the month, Caterpillar has announced an increase in its quarterly dividend to $0.70, which will generate an annualized dividend of $2.8 per share. With a closing price of $84.6 it now offers an annualized dividend yield of more than 3%, greater than its main competitor John Deere (DE, Financial), which offers a 2.72% dividend yield.

CEO´s Opinion

Caterpillar Chairman and CEO Doug Oberhelman said that he was pleased to announce that the firm was maintaining the dividends and continues saying that "In 2014, we kept a strong balance sheet and delivered the third highest operating cash flow in our history. In addition, we returned a record $5.8 billion in capital to stockholders through dividends and stock repurchase. This dividend supports our commitment to deliver superior returns to stockholders through the cycles."

Positive Signs

In terms of relative valuation, Caterpillar is trading at good levels. Also, we can appreciate these positive signs:

• P/E Ratio (=14.40) is close to 1-year low of 13.5
• P/B Ratio (=3.06) is close to 1-year low of 2.86
• P/S Ratio (=0.96) is close to 2-year low of 0.9

Further, following the recent Q1 results, Barclays raises its price target to $93 from $90.

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.

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 =1.18

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]

rCAT = RF + βCAT [GGM ERP]

= 4.9% + 1.18 [11.43%]

= 18.39%

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)

= ($84.6 × 18.39% – $2.8) ÷ ($84.6 + $2.8) = 14.59%.

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

The price is a bit below the intrinsic value, so we can say that the stock is fairly valued according to the model and its assumptions. Considering that the stock is down by 7.4% year-to-date and in the past 52-weeks the stock plummeted by 19.02%, I think it is the right moment to buy at the current level. Moreover, the firm´s stock dividend yield is close to 5-year high, which means a good yield in comparison with the actual scenario of low interest rates.

Michael Larson´s Bill & Melinda Gates Foundation Trust disclosed holding 11.26 million shares at the end of 2014, with the shares having an aggregate value of $1.03 billion. Among other investors, Joel Greenblatt (Trades, Portfolio)´s Gotham Asset Management, Ken Griffin´s Citadel Investment and Jim Simons (Trades, Portfolio)´ Renaissance Technologies, are in the top of the list, holding 860,565; 832,300 and 817,680 shares respectively.

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

[1] This values where obtained from Blommberg´s CRP function.