Texas Instruments Continues Trading at its 52-Week High

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Nov 17, 2014

In this article, let's take a look at the intrinsic value of Texas Instruments Inc. (TXN, Financial), a $54.54 billion market cap company that is one of the world's largest manufacturers of semiconductors. It also produces scientific calculator products and DLP products for TVs and video projectors.

Key drivers

The company acquired National Semiconductor and so it has expanded its manufacturing capacity. We still believe this might attract additional high-volume of analog chip orders. It focuses on the analog chip business because it contributes to the highest margins. But it has reduced its positions on the wireless chip business which is a lower-margin one.

While competing in several markets, it is a leader in the analog chip market. It continues with the strategy of differentiation and gaining exposure to many end markets and customers. We believe that increasing exposure to longer life cycle products like in the industrial and automotive markets is a right decision.

Strong cash

Since 1962, Texas has a 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 2.4%, which can improve in the future allowing higher shareholder´s returns.

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 =1.31

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]

rTXN = RF + βTXN [GGM ERP]

= 4.9% + 1.31 [11.43%]

= 19.87%

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:

Financial Data (USD $ in millions) Dec 31, 2013 Dec 31, 2012 Dec 31, 2011
Cash dividends declared 1,175,000 819,000 644,000
Net income applicable to common shares 2,162,000 1,759,000 2,236,000
Net sales 12,205,000 12,825,000 13,735,000
Total assets 18,938,000 20,021,000 20,497,000
Total Shareholders' equity 10,807,000 10,961,000 10,952,000
Ratios
Retention rate 0,46 0.53 0.71
Profit margin 0.18 0.14 0.16
Asset turnover 0.64 0.64 0.67
Financial leverage 1.74 1.83 1.92
Retention rate = (Net Income – Cash dividends declared) ÷ Net Income = 0.46
Profit margin = Net Income Ă· Net sales = 0.18
Asset turnover = Net sales Ă· Total assets = 0.64
Financial leverage = Total assets Ă· Total Shareholders' equity = 1.75
Averages
Retention rate 0.57
Profit margin 0.16
Asset turnover 0.65
Financial leverage 1.83
g = Retention rate Ă— Profit margin Ă— Asset turnover Ă— Financial leverage
Dividend growth rate 10.75%

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)

= ($51.63 ×19.87% – $1.36) ÷ ($51.63 + $1.36) = 16.77%.

The growth rates are:

Year Value g(t)
1 g(1) 10.75%
2 g(2) 12.26%
3 g(3) 13.76%
4 g(4) 15.27%
5 g(5) 16.77%

G(2), g(3) and g(4) are calculated using linear interpolation between g(1) and g(5).

Calculation of Intrinsic Value

Year Value Cash Flow Present value
0 Div 0 1.36
1 Div 1 1.51 1.26
2 Div 2 1.69 1.18
3 Div 3 1.92 1.12
4 Div 4 2.22 1.07
5 Div 5 2.59 1.05
5 Terminal Value 97.43 39.36
Intrinsic value 45.03
Current share price 51.18

Final comment

Trading nearly the 52-week high seems to be announcing a fall in price. However, we think that it is the right time to add the stock to your long-term portfolio for the key drivers and the valuation. So, 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.

Hedge fund managers Bill Frels (Trades, Portfolio), Paul Tudor Jones (Trades, Portfolio), Joel Greenblatt (Trades, Portfolio) and Wallace Weitz (Trades, Portfolio) have added the stock in the third quarter of 2014, as well as Manning & Napier Advisors, Inc. and RS Investment Management (Trades, Portfolio).

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


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