Oracle: Capture The Alpha

May. 4.14 | About: Oracle Corporation (ORCL)

Summary

Oracle approaches its all-time highs, backed by solid momentum.

Unlike the 2000's highs, this time around Oracle is backed by fundamentals including value, growth and quality too.

Fundamentals offer something for value, growth, and high quality investors. This should help better price discovery and drive prices towards $48.

I am looking at Oracle (NASDAQ:ORCL) today as it approaches its all-time highs set in 2000. But this time, with a big difference. In 2000 Oracle reached for the skies backed by momentum. Today it is backed by momentum too. But unlike the past, today Oracle offers great value for value investors, great growth for growth investors, and great quality for those who focus on high quality offerings.

Let's start with the value. Whether we look at P/E trailing twelve months, Forward (Year End May 2015) P/E, or PEG ratios, Oracle outperforms the market capitalization weighted indicators for the market, the technology sector and the application software industry. Analysts expect the year-end May 2014 to close with non-GAAP earnings of $2.91, which indicates the stock is trading at just over 14 times May 2014 earnings. That is cheap for a stock expected to grow earnings at 10.5% over the coming five years.

Oracle also has established a decent record on returning shareholder value. The company pays out about 22.3% of profits via a dividend which provides a yield of 1.18%.

Source: Alpha Omega Mathematica

The company also uses buybacks to great effect. Over the past five years, the company has reduced annualized average diluted shares outstanding by 5.58%. The company has returned value at an annualized rate of 1.14%, net of dilution resulting from employee and other issuances via buybacks. Taken together, the value returned to shareholders yields 2.32% and represents an adjusted payout ratio of near 44%.

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And what has Oracle done with the remaining 56% of retained earnings? They have used it to drive earnings growth at an annualized rate of 16.3% over the past five years. This implies that they have been able to earn a return on incremental equity invested of 29.1% (56% Retained Earnings Multiplied by 29.1% Return on Incremental Equity delivers growth of 16.3%). The S&P 500 delivered operating earnings of $107.30 for the year ended December 2013, which grew from $56.86 for the year ended December 2009: this represents an annualized growth rate of 13.54%. Thus, Oracle has also delivered an impressive growth dividend of 2.8% (Growth less Market Growth is the growth dividend or growth premium). This equates to a payout of 17% (2.8% Growth dividend divided by 16.3% growth), over and above the 44% adjusted payout ratio.

Source: Alpha Omega Mathematica

In terms of quality, we have impressive insider ownership at 25%, which outperforms the market capitalization weighted indicators for the market, the technology sector and the application software industry. And we have institutional ownership which is also well ahead of the market capitalization weighted indicators for the market, the technology sector and the application software industry. As far as quality of return and profitability, every one of the indicators monitored at Alpha Omega Mathematica outperform the market, the technology sector and the application software industry.

With this kind of performance, it is not surprising that Ellison gets away with paying himself as much as he does!

Source: Alpha Omega Mathematica

And finally we have momentum. It has been strong and remains strong. But unlike the 2000's, this time the strength is backed by strong fundamentals. Nonetheless, momentum will often drive prices well over the value. And nothing we have discussed so far gives us any information on what Oracle might be worth.

Source: Alpha Omega Mathematica

What is Oracle worth?

Mathematically, the worth of Oracle is estimated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate].

I will accept May 2014 consensus estimates of $2.91 as representing sustainable earnings.

I accept the analyst long-term growth estimate of 10.5% as a reliable estimate of forward five year growth. In my view the growth potential for the S&P 500 has increased to 6.25% (about 50% from 8% Global Nominal Potential GDP growth and 50% from 4.5% U.S. Nominal Potential GDP growth). Thus I compute a composite very long-term growth rate of 6.67%, based on an assumption that growth will revert to being in line with the growth potential for the S&P 500 of 6.25% in the sixth year. This is not to say that it will revert to 6.25%, it simply suggests that I am unwilling to accept higher growth rates beyond the estimable five-year horizon.

As far as the adjusted payout ratio is concerned, I will estimate it at 55.50%. This is somewhat below the 44% paid out via dividends and buybacks plus the growth dividend payout of 17%. In arriving at this estimate, I am assuming that return on incremental equity invested shall decline to 15% as competition intensifies. To achieve a 6.67% very long-term growth target, 44.50% of profits will need to be re-invested, leaving 55.50% available to shareholders.

Assuming a long-term risk free rate of 4.5% and an equity risk premium of 5.75%, an investor in a stock with a beta of 1.00 as reported by Value Line should demand a return of 10.25%. And so the long-term return expectation I am looking for from Oracle is 10.25%.

Based on these assumptions, Oracle is worth $48 as [106.67% * $2.91 * 55.50% / (10.25%-6.67%)]. If I am right, there is $8 (18%) of alpha available for capture, after which a long-term return of 10.25% can be reasonably expected.

If Oracle is not quite what you are looking for in the application software space, have a look at Synaptics (NASDAQ:SYNA), Open Text (NASDAQ:OTEX) and MICROS Systems (NASDAQ:MCRS), which are mid-cap application software stocks offering a nice mix of growth and value.

If you do use the above formula, please read this explanatory note.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.