Southern Company a Fairly Valued Stock

In this article, let´s consider Southern Company (SO, Financial), a $42.29 billion market cap, which has a trailing P/E ratio that indicates that the stock is relatively undervalued (PE 18.9x vs Industry Median 20.1x). The obvious question I’m sure you want to know is –Â what is the future stock price movement? Although I cannot predict exactly the moment, we can see some drivers of this Atlanta-based energy holding company, which is one of the largest producers of electricity in the U.S., and then try to analyze its intrinsic value and compare it with the actual trading price.

Principal drivers

This giant Southeast utility holding company has more than 45,500 megawatts of generating capacity and serves around 4.4 million customers in the Southeast through the principal ones that are: Alabama Power (1,444,809 customers as of December 31, 2013) and Georgia Power (2,396,537).

Regulations in the U.S., particularly Alabama and Georgia, are favorable for the company. We must say that the firm is making a huge investment program converting its massive coal fleet, focusing on a low-carbon coal unit in Mississippi and constructing the first new nuclear plant in the U.S., located in Georgia. Further, Southern has an upside potential to economic improvement than any other of the peer group. Regulation, which is favorable, is a key driver behind the construction program.

It´s dividend yield at 4.4% is very attractive and is above its peers. Dividends have been paid since 1948, and it has raised them 14 consecutive years. Additionally, it is expected to grow at 3.5% annually.

So now, let's take a look at a model which is applicable to stable, mature, dividend-paying firms and try to find the intrinsic value of the stock. Although the model has a number of characteristics that make it useful and appropriate for many applications, 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). 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 =0.22

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]

rSO = RF + βSO [GGM ERP]

= 4.9% + 0.22 [11.43%]

= 7.41%

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)

= ($47.19 ×7.41% – $2.1) ÷ ($47.19 + $2.1) = 2.84%.

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

I would recommend buying a stock only when it's selling at a decent margin of safety to your estimate of its fair value. But in this case, we found very similar values, so it makes me feel the company is fairly valued.

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.

Although this, hedge fund gurus like Ray Dalio (Trades, Portfolio), John Rogers (Trades, Portfolio), Paul Tudor Jones (Trades, Portfolio) and Ken Fisher (Trades, Portfolio) have added this stock in the second quarter of 2014.

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

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