Attractive Dividend Policy with Good Free Cash Flow

In this article, let's take a look at the intrinsic value of Linear Technology Corporation (LLTC, Financial), a $10.25 billion market cap company that designs, makes and markets a broad line of high performance standard linear integrated circuits (ICs) that address a wide range of real-world signal processing applications.

Key drivers

In a previous article we analyzed that Linear specializes in High-Performance Analog (HPA), which requires extreme precision and reliability. The purchasing decisions are based on performance rather than price, due to the low proportion of these products in the total cost. The company's chips are considered to be products that have long life and superior technology, so this is a clear advantage over new entrants. Further, the firm has a successful ability to retain its top talent people. The combination of these factors made Linear's returns to outpace its peers over the past years. To maintain profitability, the strategy followed by Linear is to compete for design wins. In cases where an electronics manufacturer is willing to accept a lower level of quality, the company often concedes these businesses to competitors.

Dividends

Linear 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. The current dividend yield is 2.5%, which is quite good to protect the purchasing power, especially considering the consistency of track-record dividends payments since 1992.

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 =1.37

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]

rLLTC = RF + βLLTC [GGM ERP]

= 4.9% + 1.37 [11.43%]

= 20.56%

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)

= ($22.16 ×22.73% – $0.9) ÷ ($22.16 + $0.9) = 17.94%.

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 found that intrinsic value is about 60% above the trading price, so we can conclude it is a good buy. When considering other aspects such as the growth drivers, I feel confident in my bullish sentiment.

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.

Pioneer Investments (Trades, Portfolio) has added the stock in the third quarter of 2014.

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

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