E.I du Pont de Nemours and Company (DD) is one of the oldest companies in the U.S. history. The diversified chemicals giant was founded in 1802 as a gunpowder mill. Over the years, the company became a global science and technology company worldwide. It operates in several segments, but is known best for its products in agriculture and nutrition. At some point in the early 20th century, DuPont was also a major shareholder in General Motor (GM) company. More recently, it sold its shares in Conoco, which merged with Phillips Petroleum to become ConocoPhillips (COP). DuPont is also famous for the "DuPont Analysis" which breaks the return on equity into three parts measured by profit margin, asset turnover, and equity multiplier.
As of the time of writing, DuPont stock was trading at $46 with a 52-week range of $37 - $57. It has a market cap of $43 billion. Trailing twelve month [ttm] P/E ratio is 12.5, and forward P/E ratio is 10.9. P/B, P/S, and P/CF ratios stand at 3.8, 1.2, and 8.9, respectively. Operating margin is 10.8%, and net profit margin is 9.2%. The company has some debt issues. Debt/equity ratio is 1.1. It pays a nifty yield of 3.55% with a payout ratio of 44%.
DuPont has a 3-star rating from Morningstar. Out of 14 analysts covering the company, 9 are 'buy', 1 is 'outperform', and 4 have hold ratings. Wall Street has diverse opinions on DuPont's future. Top line growth estimate is 8.9%, and the bottom line growth estimate is -0.3% for the next year. Average five-year annualized growth forecast estimate is 9.7%.
What is the fair value of DuPont given the forecast estimates? We can estimate DuPont's fair value using discounted earnings plus equity model as follows.
Discounted Earnings Plus Equity Model
This model is primarily used for estimating the returns from long-term projects. It is also frequently used to price fair-valued IPOs. The methodology is based on discounting the present value of the future earnings to the current period:
V = E_{0} + E_{1} /(1+r) + E_{2} /(1+r)^{2} + E_{3}/(1+r)^{3} + E_{4}/(1+r)^{4} + E_{5}/(1+r)^{5} + Disposal Value
V = E_{0} + E_{0} (1+g)/(1+r) + E_{0}(1+g)^{2}/(1+r)^{2} + … + E_{0}(1+g)^{5}/(1+r)^{5} + E_{0}(1+g)^{5}/[r(1+r)^{5}]
The earnings after the last period act as a perpetuity that creates regular earnings:
Disposal Value = D = E_{0}(1+g)^{5}/[r(1+r)^{5}] = E_{5} / r
While this formula might look scary for many of us, it easily calculates the fair value of a stock. All we need is the current-period earnings, earnings growth estimate, and the discount rate. To be as objective as possible, I use Morningstar data for my growth estimates. You can set these parameters as you wish, according to your own diligence.
Valuation
Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate. In order to smooth the results, I will also take the average of ttm EPS along with the mean EPS estimate for the next year.
E_{0} = EPS = ($3.68 + $4.28) / 2 = $3.98
Wall Street holds diversified opinions on the company's future. While analysts tend to impose subjective opinions on their estimates, the average analyst estimate is a good starting point. Average five-year growth forecast is 9.7%. Book value per share is $12.5.
The rest is as follows:
Fair Value Estimator | ||
V (t=0) | E_{0} | $3.98 |
V (t=1) | E_{0} (1+g)/(1+r) | $3.93 |
V (t=2) | E_{0}((1+g)/(1+r))^{2} | $3.89 |
V (t=3) | E_{0}((1+g)/(1+r))^{3} | $3.84 |
V (t=4) | E_{0}((1+g)/(1+r))^{4} | $3.80 |
V (t=5) | E_{0}((1+g)/(1+r))^{5} | $3.75 |
Disposal Value | E_{0}(1+g)^{5}/[r(1+r)^{5}] | $34.11 |
Book Value | BV | $12.50 |
Fair Value Range | Lower Boundary | $57.5 |
Upper Boundary | $70 | |
Minimum Potential | 24% | |
Maximum Potential | 52% |
(You can download FED+ Fair Value Estimator, here.)
I decided to add the book value per share so that we can distinguish between a low-debt and debt-loaded company. The lower boundary does not include the book value. According to my 5-year discounted-earnings-plus-book-value model, the fair-value range for DuPont is between $57.5 and $70 per share. At a price of $46, DuPont is at least 24% undervalued.
Summary
DuPont did not perform well this year, but the stock made a remarkable recovery since its dip of $18 at the peak of sub-prime crisis. Since then it returned almost 30% annually, and more than doubled its market cap. However, the stock's performance is well justified, and is based on strong fundamentals. DuPont was able to boost its earnings by almost 70% this year.
Based on my FED+ valuation, DuPont is trading at least 24% below its fair value range. Ticonderoga has a price target of $62. Therefore, I rate DuPont as a buy with a target price of $60. This explains why DuPont is a great stock to buy for strong income in 2012.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.