Its net profit margins are high (>20%), its ROE is high (> 25%) and it pays about 30%+ of its earnings as dividends.
Its trailing-twelve months earnings was $113.1 million and its market capitalisation recently was $1642 million.
How would you value the earnings and dividends of this company?
Using the thinking similar to that of Buffett:
1. The risk free interest rate offered by the banks is 4% per year.
2. How much deposit would you need to put in the bank to earn $113.1 million per year?
3. Answer: $113.1 million / 4% = $2827.5 million.
4. This company pays out 30%+ of its earnings as dividends, i.e. about $40 million.
5. How much deposit would you need to put in the bank to earn $40 million at present prevailing interest rate of 4% per year?
6. Answer: $40 million / 4% = $1000 million.
7. A fixed deposit gives you a fixed interest rate of the same amount every year, assuming that the interest rate paid remains unchanged.
8. On the other hand, this company's earnings are expected to grow quite fast in the coming years.
9. Assuming that this company can grow its earnings at a very low 2% per year for the next few years, with a high degree of predictability, how would you value this company?
10. Let's continue with the analogy above.
11. With its earnings of $ 113.1 million, growing at 2% per year, you will need to have a fixed deposit of the equivalent of $ 113.1 million / (4% - 2%) = $ 5655 million.
12. With its dividend of $ 40 million, growing at 2% per year, you will similarly have to have a fixed deposit of the equivalent of $ 40 million / (4% - 2%) = $ 2000 million.
Assuming no growth in its earnings or dividends, and using 4% risk free interest rate as the discount factor, the present values of
- the earnings stream is the equivalent to an asset of $ 2827.5 million.
- the dividends stream is the equivalent to an asset of $1000 million.
When growth is factored into the earnings and dividends stream, even at a low rate of growth of 2% and still using the 4% risk free interest rate as the discount factor, the present values of:
- the earnings stream is $ 5655 million.
- the dividends stream is $ 2000 million.
This company's market capitalization was $ 1642 million recently. Assuming no growth in the earnings of this company, the value of this company is anywhere between $1000 million (this price is supported by its dividend yield) and $2827.5 million (supported by its earning yield).
At $ 1642 million, its reward:risk ratio = 64.9%: 35.1%.
Since, this company is projected to grow its earnings with a high degree of predictability, at its present price of $ 1642 million, those who are buying into this company at the present price, enjoy a large margin of safety.