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Fundamentally Speaking

SAP AG (NYSE:SAP) recently announced that it would increase its annual shareholder distributions for the upcoming quarter. SAP AG will raise its dividend €0.85 (U.S.$1.11) per share. I had already analyzed SAP based on the common stock valuation ratios in its financial statements over the last five years and determined that it was a great investment idea. The April 19 earnings report release kept the bullish sentiment among investors.

SAP's P/E (price-to-earnings) ratio has been considerably higher than the industry average over the last five years and this signifies that investors are expecting higher future growth. Like the P/E ratio, the P/S (price-to-sales) reflects how many times investors are paying for every dollar of a company's sales. SAP AG has a high P/S ratio compared to other firms in the industry, but this actually makes it a less attractive investment. However, the fundamentals look good overall.

For instance, SAP's P/B (price-to-book) ratio is higher than the industry average and this is indicative of the high expectations that investors have for the tech giant.

SAP has a strong balance sheet and great revenue numbers over the last five years. Nonetheless, the numbers lag behind its closest rivals Oracle Corporation (NYSE:ORCL), International Business Machines Corp. (NYSE:IBM) and Microsoft Corporation (NASDAQ:MSFT). After all, the German tech firm has a much smaller market cap in comparison to its American rivals.

The Dividend Discount Model

The dividend discount model (DDM) also makes the case to buy SAP stock. The DDM is an easy to use tool for investors to quickly assess a stock as it is great at finding intrinsic stock value estimates.

The DDM is a procedure for valuing the price of a stock by using predicted dividends and discounting them back to present value. The idea is that if the value obtained from the DDM is higher than what the shares are currently trading at, then the stock is undervalued.

It is based on a discounted cash flow (DCF) valuation technique. Dividends are the most clear-cut measure of cash flow since these are obviously cash flows that go straight to the investor.

Intrinsic Stock Value

This is using the Dividends Per Share forecast.

Year

Value

DPSt or Terminal Value (TVt)T

Calculation

Present Value at 15.11%

0

DPS01

1.48

1

DPS1

1.70

=1.48*(1+15.26%)

1.48

2

DPS2

1.95

=1.70*(1+14.69%)

1.47

3

DPS3

2.23

=1.95*(1+14.13%)

1.46

4

DPS4

2.53

=2.23*(1+13.57%)

1.44

5

DPS5

2.86

=2.53*(1+12.97%)

1.42

5

Terminal Value (TV5)

154.15

=2.86*(1+13.01%)/(15.11%-13.01%)

76.29

Intrinsic Value of common stock (per share)

$83.56

Current share price

$78.87

1 DPS0 = Sum of last year dividends per share.

It is easy to see that SAP is undervalued from the table above and so it makes for a great investment idea. But there must be a number of questions on your mind. Specifically, what is the 'calculation' column and how are the growth rates obtained. The good thing is that I am going to show you everything so that you will be able to do a dividend discount model on any stock you wish to analyze.

Dividend growth rate [g] obtained from the PRAT model

The biggest calculation is getting the dividend growth rate [g] and this is the product of the profit margin [P], the retention rate [R], the asset turnover [A], and the financial leverage [T].

Selected Financial Data

Dec 31,2012

Dec 31, 2011

Dec 31, 2010

Dec 31, 2009

Dec 31, 2008

Dividends

1,727

925

788

851

827

Profit attributable to owners of parent

3,722

4,460

2,403

2,505

2,600

Revenue

21,391

18,465

16,539

15,296

16,098

Total assets

35,384

30,131

27,655

19,169

19,762

Equity attributable to owners of parent

18,675

16,475

13,014

12,150

10,068

USD $ in millions, translated from EUR €

Ratios

Dec 31,2012

Dec 31, 2011

Dec 31, 2010

Dec 31, 2009

Dec 31, 2008

Retention Rate

0.54

0.79

0.67

0.66

0.68

Profit margin

17.40%

24.16%

14.53%

16.38%

16.15%

Asset Turnover

0.60

0.61

0.60

0.80

0.81

Financial leverage

1.89

1.83

2.13

1.58

1.96

Now we have all the components in the PRAT model listed in the table above with their respective values. These components are calculated as follows.

Retention rate: (Profit attributable to owners of parent - Dividends) ÷ Profit attributable to owners of parent

Profit margin = 100 × Profit attributable to owners of parent ÷ Revenue

Asset turnover = Revenue ÷ Total assets

Financial leverage = Total assets ÷ Equity attributable to owners of parent

We have now obtained the PRAT model component values for 5 years and we obtain the averages which are summarized in the table below.

Averages

Retention Rate

0.67

Profit margin

17.72%

Asset Turnover

0.69

Financial leverage

1.88

We use the figures in the table above to get the dividend growth rate as implied by the PRAT model. This is the percentage used in the Year 1 row of the first table in this article that gives the intrinsic stock value according to the dividend discount model. The calculation is shown below for your convenience.

Retention rate × Profit margin × Asset turnover × Financial leverage

= 0.67 × 17.72% × 0.69 × 1.88 = 15.26%

Dividend growth rate [g] implied by Gordon growth model

This is an integral part of finding the intrinsic stock value. We start by estimating the required rate of return (RF). To do this, we start by obtaining the average of bid yields on the total amount of outstanding fixed-coupon U.S. Treasury bonds. These Treasury bonds should not be due or callable for another 10 years and the average will be an unweighted one. This value of 2.6% will act as a proxy for the risk-free rate of return.

The estimated rate of return on a market portfolio (RM) is widely estimated to be 13.19%. The systematic risk (β) for SAP is 1.24. The required rate of return on SAP (rSAP) is calculated as follows:

rSAP = RF + βSAP [E(RM) - RF]

= 2.60% + 1.18 [13.19% - 2.60%]

= 15.11%

Once this is found, we insert the values into the Gordon growth model equation.

g = 100 × (P0 × rSAP - D0) ÷ (P0 + D0)

= 100 × ($78.87 × 15.11% - $1.48) ÷ ($78.87 + $1.48) = 13.01%

where:

P0 = SAP stock price

D0 = Sum of last year dividends per share

Dividend growth rate [g] Forecast

Year

Value

gt

1

g1 (implied by PRAT model)

15.26%

2

g2

14.69%

3

g3

14.13%

4

g4

13.57%

5 and thereafter

g5 (implied by Gordon growth model)

13.01%

Conclusion: Now is the time to buy SAP AG shares

I have always been a firm believer in innovation. SAP AG is the world's ninth most valuable technology firm and the only European one in the top 10. The DDM shows that SAP is a great investment idea as the current stock price of $78.87 is lower than the calculated intrinsic value of $83.56.

The recent pullback that we have seen in the stock price over the long term is a good opportunity for investors to buy more SAP stock. The stock price has started to rise lately and has moved above the 20-day moving average (MA) and also the 50 day MA. This is an encouraging sign and a good time to buy SAP shares.

Source: Dividend Discount Model Reveals SAP AG Is Undervalued

Additional disclosure: Valuation is based on standard assumptions. There may exist particular things pertinent to stock value that are not analyzed here. In this case, the actual stock value may differ greatly from what has been estimated here. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for a specific situation.