This Insurer Company Will Have 22 Consecutive Years of Dividend Increases

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Feb 26, 2015

In this article, let's take a look at ACE Limited (ACE, Financial), a $38.04 billion market cap company, which is a specialty insurer that provides commercial insurance and reinsurance for a diverse group of international clients.

New dividend proposal

The firm 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. Dividends have been paid since 1993.

The current dividend yield is 2.3%, and we have favorable expectations regarding dividend growth.

As we can appreciate, the dividend more than doubled in the past five years.

The board of directors announced today that it will recommend for shareholder approval an increase in the dividends for the twenty-second consecutive year.

The proposal is for a $0.08 increase, from $2.6 to $2.68 per share annually, to be paid in quarterly installments of $0.67 per share.

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 =1.01

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]

rACE = RF + βACE [GGM ERP]

= 4.9% + 1.01 [11.43%]

= 16.44%

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) 31-Dec-13 31-Dec-12 31-Dec-11
Cash dividends declared 517,000 815,000 459,000
Net income applicable to common shares 3,758,000 2,706,000 1,540,000
Net sales 19,261,000 17,936,000 16,834,000
Total assets 94,510,000 92,545,000 87,321,000
Total Shareholders' equity 28,825,000 27,531,000 24,332,000
Ratios   Â
Retention rate 1 0.70 0.70
Profit margin 0.20 0.15 0.09
Asset turnover 0.20 0.19 0.19
Financial leverage 3.35 3.57 3.69
   Â
Retention rate = (Net Income – Cash dividends declared) ÷ Net Income = 0.86
   Â
Profit margin = Net Income ÷ Net sales = 0.20 Â Â
   Â
Asset turnover = Net sales ÷ Total assets = 0.20 Â Â
   Â
Financial leverage = Total assets ÷ Total Shareholders' equity = 3.28 Â
   Â
Averages   Â
Retention rate 0.75 Â Â
Profit margin 0.15 Â Â
Asset turnover 0.20 Â Â
Financial leverage 3.54 Â Â
   Â
g = Retention rate × Profit margin × Asset turnover × Financial leverage Â
   Â
Dividend growth rate 7.66% Â Â
   Â

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)

= ($114.23 ×16.44% – $2.6) ÷ ($114.23 + $2.6) = 13.85%.

The growth rates are:

Year Value g(t)
1 g(1) 7.66%
2 g(2) 9.21%
3 g(3) 10.76%
4 g(4) 12.30%
5 g(5) 13.85%

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 2.60 Â
1 Div 1 2.80 2.40
2 Div 2 3.06 2.25
3 Div 3 3.39 2.14
4 Div 4 3.80 2.07
5 Div 5 4.33 2.02
5 Terminal Value 190.19 88.84
Intrinsic value   99.73
Current share price   114.23

Final comment

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.

According to the valuation, the stock is fairly valued, considering a margin of safety. The size of this will vary based on investor preference and the type of investing that she or he does, but I usually used a 20%. So based on the dividends hike over the past, I would recommend buying this stock, especially considering that the firm has a strong price growth.

Hedge fund gurus like Steven Cohen (Trades, Portfolio) and John Keeley (Trades, Portfolio) have added the stock in the last 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.