In this article, let's take a look at American Express Company (AXP, Financial), the $80.33 billion market cap company, which has recently announced a dividend hike.
12% 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. According to company reports, dividends have been paid since 1870.
On May 13, it has announced a 12% increase in its quarterly dividend to $0.29 from $0.26 per share, which will generate an annualized dividend of $1.16 per share. With a closing price of $79.08 it now offers an annualized dividend yield of 1.47%.
So now, let´s use all the information to try to find the intrinsic value of the stock.
Calculation of Intrinsic Value
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 = 2.75%[1]. 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 =1.29[2]
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%[3]
rAXP = RF + βAXP [GGM ERP] = 4.9% + 1.29 [11.43%]= 19.64%
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[4] we need to get the dividend growth rate:
| Financial Data (USD $ in millions) | Dec 31, 2014 | Dec 31, 2013 | Dec 31, 2012 |
| Cash dividendsdeclared | 1,041,000 | 939,000 | 902,000 |
| Net income applicable to common shares | 5,885,000 | 5,359,000 | 4,482,000 |
| Net sales | 35,999,000 | 34,932,000 | 33,781,000 |
| Total assets | 159,103,000 | 153,375,000 | 153,140,000 |
| Total Shareholders' equity | 20,673,000 | 19,496,000 | 18,886,000 |
| Ratios | Â | Â | Â |
| Retentionrate | 1 | 0.82 | 0.80 |
| Profitmargin | 0.16 | 0.15 | 0.13 |
| Assetturnover | 0.23 | 0.23 | 0.22 |
| Financialleverage | 7.92 | 7.99 | 8.13 |
| Â | Â | Â | Â |
| Retention rate = (Net Income – Cash dividends declared) ÷ Net Income = | 0.82 | ||
| Â | Â | Â | Â |
| Profit margin = Net Income ÷ Net sales = | 0.16 | Â | Â |
| Â | Â | Â | Â |
| Asset turnover = Net sales ÷ Total assets = | 0.23 | Â | Â |
| Â | Â | Â | Â |
| Financial leverage = Total assets ÷ Total Shareholders' equity = | 7.70 | Â | |
| Â | Â | Â | Â |
| Averages | Â | Â | Â |
| Retentionrate | 0.82 | Â | Â |
| Profitmargin | 0.15 | Â | Â |
| Assetturnover | 0.22 | Â | Â |
| Financialleverage | 8.01 | Â | Â |
| Â | Â | Â | Â |
| g = Retention rate × Profit margin × Asset turnover × Financial leverage | Â | ||
| Â | Â | Â | Â |
| Dividendgrowthrate | 22.02% | 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)
= ($75.08 × 19.64% – $1.29) ÷ ($75.08 + $1.29) = 17.92%.
The growth rates are:
| Year | Value | g(t) |
| 1 | g(1) | 22.02% |
| 2 | g(2) | 21.00% |
| 3 | g(3) | 19.97% |
| 4 | g(4) | 18.94% |
| 5 | g(5) | 17.92% |
G(2), g(3) and g(4) are calculated using linear interpolation between g(1) and g(5).
Intrinsic Value
| Year | Value | Cash Flow | Presentvalue |
| 0 | Div 0 | 1.16 | Â |
| 1 | Div 1 | 1.42 | 1.183 |
| 2 | Div 2 | 1.71 | 1.196 |
| 3 | Div 3 | 2.05 | 1.200 |
| 4 | Div 4 | 2.44 | 1.193 |
| 5 | Div 5 | 2.88 | 1.175 |
| 5 | Terminal Value | 196.46 | 80.131 |
| Intrinsicvalue | Â | Â | 86.08 |
| Current share price | Â | Â | 79.08 |
Final Comment
We found that intrinsic value is above the trading price, so we can conclude that the stock is undervalued. So, if you trust in the model and assumptions, I would recommend a buy on this stock. However, analysts usually use a margin of safety, which means that an investor should buy a stock when it is worth more than its price on the market plus a margin (more or less 20% is used). In this case, the margin of safety is around 9%.
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.
Moreover, American Express announced a new 150 million stock-buyback which replaces a former plan. This is important, because when firms purchase their own stock, they are signaling to the market that the company views its own stock as a good investment.Further, considering that the stock is down by 10.92% in the past 12 months and 14.2% year-to-date, I think it is a good entry point.
Disclosure: Omar Venerio holds no position in any stocks mentioned.
[1] This value was obtained from the U.S. Department of the Treasury
[2] This value was obtained from Yahoo Finance.
[3] These values were obtained from Blommberg´s CRP function.
[4] These values were obtained from Yahoo Finance.
