In this article, let's take a look at Patterson Companies, Inc. (PDCO, Financial), a $5.16 billion market cap company, which distributes dental, veterinary, and rehabilitation supplies.
Decreasing Rate
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. The previous dividend increase was made in March 2014, when it raised the quarterly payout by 25% to 20 cents. Now, it has announced a 10% increase in its quarterly dividend from 20 to 22 cents per share, which will generate an annualized dividend of $0.8 cents per share.
Although the firm has lowered the dividend rate growth, from 25% to 10%, probably due to its small cash flow generation, we are going to see that this level of dividend suits its current market price.
The dividend yield was 1.60%, and with a closing price of $50.04, we obtain an annualized dividend yield of 1.76%.
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.
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 =0.65
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]
rPDCO = RF + βPDCO [GGM ERP]
= 4.9% + 0.65 [11.43%]
= 12.33%
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) | Apr 26, 2014 | Apr 27, 2013 | Apr 28, 2012 |
| Cash dividends declared | 85,657 | 43,767 | 54,741 |
| Net income applicable to common shares | 200,612 | 210,272 | 212,815 |
| Net sales | 4,063,715 | 3,637,212 | 3,535,661 |
| Total assets | 2,864,677 | 2,681,778 | 2,739,368 |
| Total Shareholders' equity | 1,471,664 | 1,394,455 | 1,375,202 |
| Ratios | Â | Â | Â |
| Retention rate | 1 | 0.79 | 0.74 |
| Profit margin | 0.05 | 0.06 | 0.06 |
| Asset turnover | 1.42 | 1.36 | 1.29 |
| Financial leverage | 2,00 | 1.94 | 1.87 |
| Â | Â | Â | Â |
| Retention rate = (Net Income – Cash dividends declared) ÷ Net Income = | 0.57 | ||
| Â | Â | Â | Â |
| Profit margin = Net Income ÷ Net sales = | 0.05 | Â | Â |
| Â | Â | Â | Â |
| Asset turnover = Net sales ÷ Total assets = | 1.42 | Â | Â |
| Â | Â | Â | Â |
| Financial leverage = Total assets ÷ Total Shareholders' equity = | 1.95 | Â | |
| Â | Â | Â | Â |
| Averages | Â | Â | Â |
| Retention rate | 0.70 | Â | Â |
| Profit margin | 0.06 | Â | Â |
| Asset turnover | 1.36 | Â | Â |
| Financial leverage | 1.93 | Â | Â |
| Â | Â | Â | Â |
| g = Retention rate × Profit margin × Asset turnover × Financial leverage | Â | ||
| Â | Â | Â | Â |
| Dividend growth rate | 10.27% | Â | Â |
| Â | 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)
= ($50.04 ×12.33% – $0.88) ÷ ($50.04 + $0.88) = 10.39%.
The growth rates are:
| Year | Value | g(t) |
| 1 | g(1) | 10.27% |
| 2 | g(2) | 10.30% |
| 3 | g(3) | 10.33% |
| 4 | g(4) | 10.36% |
| 5 | g(5) | 10.39% |
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 | 0.88 | Â |
| 1 | Div 1 | 0.97 | 0.86 |
| 2 | Div 2 | 1.07 | 0.85 |
| 3 | Div 3 | 1.18 | 0.83 |
| 4 | Div 4 | 1.30 | 0.82 |
| 5 | Div 5 | 1.44 | 0,80 |
| 5 | Terminal Value | 81.81 | 45.74 |
| Intrinsic value | Â | Â | 49.91 |
| Current share price | Â | Â | 50.04 |
Final Comment
As outlined in the article, this company is one of the largest distributors of dental supplies in North America, which also sells veterinary supplies and rehabilitative equipment. Further, it has diversified its business, strategic acquisitions in veterinary and patient rehabilitation products are key drivers for long term growth.
We have covered just one valuation method and investors should not rely on this alone in order to determine a fair (over/under) value for a potential investment. In the model, we found that the price is practically the same as the intrinsic value, so we can say that the stock is fairly valued.
Hedge funds gurus like John Hussman (Trades, Portfolio), Steven Cohen (Trades, Portfolio), Paul Tudor Jones (Trades, Portfolio) and Robert Olstein (Trades, Portfolio) have taken long positions in the stock in the fourth quarter of 2014.
Disclosure: Omar Venerio holds no position in any stocks mentioned.
[1] This values where obtained from Blommberg´s CRP function.
