United Technologies Corp. (UTX, Financial) is a diversified business conglomerate serving various end-markets such as aerospace, defense and commercial construction. It has reported strong earnings per share improvement in fourth quarter 2013 compared to the same quarter a year ago. Additionally, the company has demonstrated a pattern of positive earnings per share growth over the past two years, as we can see in the next chart. We include the stock price because EPS often lead the stock price movement.
United Tech is in the aerospace and defense (A&D) industry, which is highly concentrated and largely dependent on federal government spending. The firm's competitors include The Boeing Company (BA, Financial) and General Electric Company (GE, Financial). Now, turning our attention to the future direction of the stock, let's take a look at the intrinsic value of this company and try to explain to investors the reasons it is a good buy or not.
In this article we present a model that is by no means the be-all and end-all for valuation. The purpose is to force investors to evaluate different assumptions about growth and future prospects.
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).
To start with, the Gordon Growth Model (GGM) assumes that dividends increase at a constant rate indefinitely.
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%
- Beta:β =1.16
- 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]
rUTX = RF + βUTX [GGM ERP]
= 2.67% + 1.16 [11.43%]
= 15.93%
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 can be estimated using Dupont formula:
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:
The growth rates are:
| Year | Value | g(t) |
| 1 | g(1) | 15.18% |
| 2 | g(2) | 14.79% |
| 3 | g(3) | 14.40% |
| 4 | g(4) | 14.01% |
| 5 | g(5) | 13.62% |
G(2). g(3) and g(4) are calculated using linear interpolation between g(1) and g(5).
Calculation of Intrinsic Value
| Year | Concept | Amount | Presentvalue |
| 0 | Div 0 | 2.36 | Â |
| 1 | Div 1 | 2.72 | 2.34 |
| 2 | Div 2 | 3.12 | 2.32 |
| 3 | Div 3 | 3.57 | 2.29 |
| 4 | Div 4 | 4.07 | 2.25 |
| 5 | Div 5 | 4.62 | 2.21 |
| 5 | Terminal Value | 227.07 | 108.44 |
| Intrinsicvalue | Â | Â | 119.86 |
| Current share price | Â | Â | 115.89 |
Final Comment
When the stock price is lower than the intrinsic value. the stock is said to be undervalued and it makes sense to buy the stock. A flaw of the model described is that it’s quite sensitive to the accuracy of the inputs. This is why we should always have a margin of safety in our estimates. In this case. we consider that the stock is fairly valued. We have covered just one valuation method and investors should rely on it alone in order to determine a fair (over/under) value for a potential investment.
Hedge fund gurus have also been active in the company. David Dreman (Trades, Portfolio), Joel Greenblatt (Trades, Portfolio) and PRIMECAP Management (Trades, Portfolio) have bought it in Q4 2013.
Disclosure: Victor Selva holds no position in any stocks mentioned.
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[1] This values where obtained from Blommberg´s CRP function.
