By: Ahmed Ishtiaq
General Electric (GE) is one of the most popular stocks among investors. The stock suffered deeply from the sub-prime crises, but it is steadily moving upward since 2009. As of the time of writing, GE was trading for $22.5 per share. In the last 12 months, the company earned $1.39 per share and paid about 50% of its earnings as dividends. Based on an annual dividend of 76 cents, the dividend yield stands at 3.41%. While GE returned 22% in the last year, I think GE is still highly undervalued. In this article, I estimate GE's fair value using a dividend discount model to prove my point.
The dividend discount formula I use is based on the model suggested by Brealey, Myers and Marcus [BMM]. In chapter 7 of their book, the authors suggest a three-step valuation model to estimate the intrinsic value of a stock. Here is a brief summary of each step:
Step1: In step 1, we estimate the present value of future dividends for the near future. Similar to Future Earnings Discounted (FED+) Model, BMM suggests using a five-year period. Therefore, I use five years as the horizon period to estimate the present value of dividend payments to investors.
Step 2: Next, we estimate the present value of all future dividend streams of a company after five-year period. To calculate the growth in the future dividends, we use the sustainable growth rate. This rate is simply calculated as the percentage of earnings, which are not distributed times the return on equity.
Step 3: Finally, we calculate the fair value of the company's stock by summing up the present value of dividends up to the horizon year and the present value of the stock prices at the horizon.
Fair Value Estimation
Step1: Analysts expect General Electric to grow earnings at an annual rate of 11% for the next five years. While this seems like an optimistic forecast, I think it is attainable. As we are experiencing some sort of global recovery, GE is likely to benefit from that recovery. Of course, it would be implausible to forecast that growth rate can be sustained indefinitely. After the five-year period, we will use the sustainable growth rate, which will be substantially lower.
Our assumption is that GE will not only grow its earnings by 11%, but it will also increase its dividends by the same percentage. We also assume a more or less stable payout ratio of 50%. Thus, the model will assume that the dividends and earnings will follow this schedule:
Dividends (50% of Earnings)
The present value of the future dividend streams until year 2017 can be calculated according to the following formula:
PV = Div1/(1+r) + Div2/(1+r)2 + Div3/(1+r)3 + Div4/(1+r)4 + Div5/(1+r)5
Based on the above formula the present value of the future dividend payments until 2017 will be
= $0.76 + $0.76 + $0.76 + $0.76 + $0.76 = $3.80
Step 2: This would be a bit trickier as we need to estimate General Electric's dividend growth rate after five years. As no such estimate is currently available, we will derive our own estimate. For the purpose, we keep our assumption that 50% of earnings will be distributed as dividends.
One simple method to calculate the sustainable earnings rate is to multiply the return on equity with plowback ratio. The plowback ratio is defined as the percentage of earnings that is not distributed as dividends. Since we assumed GE pays 50% of earnings as dividends, the plowback ratio will also be 50%.
Historically, General Electric's return on equity varied between 8% and 25%. So, taking ROE as 15% seems like a reasonable estimate. Multiplying this number with the plowback ratio gives us a sustainable growth rate of 15% x 50% = 7.5%.
While it is likely that the earnings will have a relatively smooth transition to this sustainable level, we will simplify the model and claim that earnings growth will fall to this level after five-year period. Based on this assumption we can estimate the dividend in the year 2018 as $1.28 x 1.075, which will give us a value of $1.38.
Since we calculated a constant growth rate of 7.5% after five years, we can simply use Gordon's constant growth dividend discount model. Based on this model, the value of dividends after 2017 can be calculated as follows:
PV2017 = Div2018 / (discount rate - growth rate) = $1.38 / (0.11 - 0.075) = $39.33
Note that the value above is not discounted to the current period. It is the nominal value of future dividend streams in year 2017. Therefore, we need to discount that value to the current period.
Step 3: In the last step we sum up the present value of forecast dividends up to 2017, and the present value of the stock's price at 2017. The following calculation will give us the present value of General Electric's stock as
$3.80 + $39 / (1.11)5 = $3.80 + $23.34 = $27.64
As we stated before, GE is going through substantial reorganization. The company is applying cost-cutting strategies to focus on its industrial operations. In recent years, GE's profit margins contracted due to global recession. However, along with a better market performance in the stock market, cost cutting has helped General Electric to achieve higher margins and return on equity.
GE Return on Equity data by YCharts
Since January 2009, GE's stock is on the rise. It moved up all the way to above $20 from its dip of $8. Nevertheless, it is still trading way below its heyday valuations. Before the subprime crises GE was trading for as high as $33.
Based on the three-step dividend-discount valuation model, GE has an intrinsic value of $27.64. That estimate suggests an upside potential of about 20%. The FED+ valuation model suggests a fair value range of $25 - $35. Analysts also agree with me. While not as bullish as the above model suggests, their mean target of $25 suggests substantial upside potential. Both Oppenheimer and Deutsche Bank have targets of $25.