Following Steven Cohen and Steve Mandel

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Dec 16, 2014

In this article let's take a look at the intrinsic value and try to compare it with the current stock price in the case of Williams Companies, Inc. (WMB, Financial), a $31.5 billion market cap company whose primary focus is to connect North America's hydrocarbon resource plays to growing markets for natural gas, NGLs and olefins.

Not so bright

Although the company is well positioned in the Marcellus shale, which sounds promising over the next several years, it is also true that the primary assets are all held at Williams Partners, and it could lose some tax efficiency if there is any change in MLP tax treatment.

The company manages its business primarily in three segments: Williams Partners (comprised of its master limited partnership WPZ), Williams NGL & Petchem Services (formerly referred to as Midstream Canada & Olefins) and Access Midstream Partners (ACMP, Financial).

Moreover, a slower economic growth or a sustained decline in natural gas prices constitutes risks that the firm must face in those negative scenarios.

Dividend policy

This company is the world's largest diversified fertilizer company by capacity and is one of the world's largest potash producers. Since 1974, it has a dividend policy showing its commitment to return cash to investors in the form of dividends as it generates healthy cash flow on a regular basis. The current dividend yield is 4.65%.

Valuation

In stock valuation models, dividend discount models (DDM) define cash flow as the dividends to be received by the shareholders. Extending the period indefinitely, the fundamental value of the stock is the present value of an infinite stream of dividends according to John Burr Williams.

Although this is theoretically correct, it requires forecasting dividends for many periods, so we can use some growth models like: Gordon (constant) Growth Model, the Two- or Three-Stage Growth Model or the H-Model (which is a special case of a two-stage model). With the appropriate model, we can forecast dividends up to the end of the investment horizon where we no longer have confidence in the forecasts and then forecast a terminal value based on some other method, such as a multiple of book value or earnings.

To start with, the Gordon Growth Model (GGM) assumes that dividends increase at a constant rate indefinitely.

This formula condenses to: V0=(D0 (1+g))/(r-g)=D1/(r-g)

where:

V0 = fundamental value

D0 = last year dividends per share of Exxon's common stock

r = required rate of return on the common stock

g = dividend growth rate

LetĀ“s estimate the inputs for modeling:

Required Rate of Return (r)

The capital asset pricing model (CAPM) estimates the required return on equity using the following formula: required return on stockj = risk-free rate + beta of j x equity risk premium

Assumptions:

Risk-Free Rate: Rate of return on LT Government Debt: RF = 2.67%. This is a very low rate because of todayĀ“s context. Since 1900, yields have ranged from a little less than 2% to 15%; with an average rate of 4.9%. So I think it is more appropriate to use this rate.

Beta: ƎĀ² =0.73

GGM equity risk premium = (1-year forecasted dividend yield on market index) +(consensus long-term earnings growth rate) ā€“ (long-term government bond yield) = 2.13% + 11.97% - 2.67% = 11.43%[1]

rWMB = RF + ƎĀ²WMB [GGM ERP]

= 4.9% + 0.72 [11.43%]

= 13.24%

Dividend growth rate (g)

The sustainable growth rate is the rate at which earnings and dividends can grow indefinitely assuming that the firmĀ“s debt-to-equity ratio is unchanged and it doesnĀ“t issue new equity.

g = b x ROE

b = retention rate

ROE=(Net Income)/Equity= ((Net Income)/Sales).(Sales/(Total Assets)).((Total Assets)/Equity)

The ā€œPRATā€ Model:

g= ((Net Income-Dividends)/(Net Income)).((Net Income)/Sales).(Sales/(Total Assets)).((Total Assets)/Equity)

LetĀ“s collect the information we need to get the dividend growth rate:

Financial Data (USD $ in millions) 31/12/2013 31/12/2012 31/12/2011
Cash dividends declared 1,471,000 1,129,000 671,000
Net income applicable to common shares 430,000 859,000 376,000
Net sales 6,860,000 7,486,000 7,930,000
Total assets 27,142,000 24,327,000 16,502,000
Total Shareholders' equity 4,864,000 4,752,000 1,296,000
Ratios Ƃ Ƃ Ƃ
Retention rate (2) -0,31 -0,78
Profit margin 0,06 0,11 0,05
Asset turnover 0,25 0,31 0,48
Financial leverage 5,65 8,04 3,84
Ƃ Ƃ Ƃ Ƃ
Retention rate = (Net Income ā€“ Cash dividends declared) Ć· Net Income = -2,42
Ƃ Ƃ Ƃ Ƃ
Profit margin = Net Income Ć· Net sales = 0,06 Ƃ Ƃ
Ƃ Ƃ Ƃ Ƃ
Asset turnover = Net sales Ć· Total assets = 0,25 Ƃ Ƃ
Ƃ Ƃ Ƃ Ƃ
Financial leverage = Total assets Ć· Total Shareholders' equity = 5,58 Ƃ
Ƃ Ƃ Ƃ Ƃ
Averages Ƃ Ƃ Ƃ
Retention rate -1,17 Ƃ Ƃ
Profit margin 0,07 Ƃ Ƃ
Asset turnover 0,35 Ƃ Ƃ
Financial leverage 5,84 Ƃ Ƃ
Ƃ Ƃ Ƃ Ƃ
g = Retention rate Ɨ Profit margin Ɨ Asset turnover Ɨ Financial leverage Ƃ
Ƃ Ƃ Ƃ Ƃ
Dividend growth rate -17,83% Ƃ Ƃ
Ƃ Ƃ Ƃ Ƃ

Because for most companies, the GGM is unrealistic, letĀ“s consider the H-Model which assumes a growth rate that starts high and then declines linearly over the high-growth stage, until it reverts to the long-run rate. A smoother transition to the mature phase growth rate that is more realistic.

Dividend growth rate (g) implied by Gordon growth model (long-run rate)

With the GGM formula and simple math:

g = (P0.r - D0)/(P0+D0)

= ($42.14 Ɨ13.24% ā€“ $2.28) Ć· ($42.14 + $2.28) = 7.43%.

The growth rates are:

Year Value g(t)
1 g(1) -17,83%
2 g(2) -11,52%
3 g(3) -5,20%
4 g(4) 1,11%
5 g(5) 7,43%

G(2), g(3) and g(4) are calculated using linear interpolation between g(1) and g(5).

Calculation of Intrinsic Value

Year Value Cash Flow Present value
0 Div 0 2,28 Ƃ
1 Div 1 1,87 1,65
2 Div 2 1,66 1,29
3 Div 3 1,57 1,08
4 Div 4 1,59 0,97
5 Div 5 1,71 0,92
5 Terminal Value 31,55 16,94
Intrinsic value Ƃ Ƃ 22,85
Current share price Ƃ Ƃ 42,14

Final comment

In this case, we found that intrinsic value is lower than the share price, the stock is said to be overvalued and so subject to a potential sale.

Once the oracle of Omaha said, "It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price" (Warren Buffett (Trades, Portfolio)). So in this opportunity based on this analysis I recommend to stay away from Williams Companies.

On the other hand, investment projects will provide with fresh cash flow, in order to maintain a 20% dividend growth over the next two years and this could change the model valuation.

We have covered just one valuation method and investors should not be relied on alone in order to determine a fair (over/under) value for a potential investment.

While Steven Cohen (Trades, Portfolio) and Steve Mandel (Trades, Portfolio) sold out the stock, other hedge fund gurus like Murray Stahl (Trades, Portfolio), Louis Moore Bacon (Trades, Portfolio), John Keeley (Trades, Portfolio) and Daniel Loeb (Trades, Portfolio) have reduced their positions in the stock in the third quarter of 2014.

Disclosure: Omar Venerio holds no position in any stocks mentioned.


[1] These values were obtained from BloombergĀ“s CRP function.