Betting on a Fairly Value Stock with a Bullish Sentiment

In a previous article we analyzed the relative valuation of the stock,and concluded that it is trading higher and as a result, it is difficult to identify if there exists an adequate margin of safety to buy the stock. So, in this article let's take a closer look at W.W. Grainger, Inc. (GWW, Financial), and analyze the intrinsic value with an absolute valuation model.

Strategies

We have seen that the company is the largest industrial MRO distributor, and it is expanding internationally to promising regions such as Asia and South and Central America; as well as it is increasing the number of products in order to diversify its revenue growth. Further, it plans to implement other strategies such as acquisitions and expanding its e-commerce business.

Margins

The firm increased its gross margins by an average of 60 bp per year, and operating margins expanded 40 bp per year. The management expects more expansion in the next five years, with operating margins reaching 30-60 bp.

Dividend policy

Since 1965, the firm 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 1.8% and last year, Grainger increased its quarterly dividend 16%. It was the 42nd consecutive year in which it has boosted it.

Future direction

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 why 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).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 =1.18

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]

rGWW= RF + βGWW [GGM ERP]

= 4.9% + 1.18 [11.43%]

= 18.39%

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)

= ($244.02 ×18.39% – $4.32) ÷ ($244.02 + $4.32) = 16.33%.

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 that intrinsic value is very similar to the trading price, so we say the stock is fairly valued because the trading
price accurately reflects its actual value.

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 gurus like Jeremy Grantham (Trades, Portfolio) and Murray Stahl (Trades, Portfolio) have added this stock to their portfolios in the third quarter of 2014, as well as Pioneer Investments (Trades, Portfolio).

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

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