Amgen shares remain undervalued as the firm increases dividends
Omar Venerio
Dec 21, 2015
Amgen Inc. (AMGN, Financial) recently raised its quarterly dividend to $1.00 per share or $4.00 on an annual basis. This way, the stock yields 2.5% if the share price stays at current levels at $158.8. According to GuruFocus, its yield is ranked higher than 88% of the 233 companies in the Global Biotechnology industry. Moreover, it is close to a five-year high.
What makes possible the dividend hike is the solid financial position. Also, Piotroski F-Score of 8 is 8 is indicating very healthy situation. The company has a history deploying capital through share repurchases and dividends.
The day the company announced the dividend increase, the stock moved higher. The company is trading at a P/E ratio of 18.96x, which is cheap when compared to Johnson & Johnson (JNJ, Financial):
| Company | P/E Ratio | Dividend Yield (%) |
| AMGN | 18.96 | 2.5 |
| JNJ | 19.56 | 2.9 |
Intrinsic value
The Yahoo! Finance consensus price target is $188.75, representing an upside potential of 18.8%, so now let´s try to estimate the fair value of the firm. For that purpose I will use the Dividend Discount Model (DDM). In stock valuation models, DDM defines cash flow as the dividends to be received by the shareholders. The model 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).
Once we have selected 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.
Let´s estimate the inputs for modeling:
First, we need to calculate the different discount rates, i.e. the cost of equity (from CAPM). The capital asset pricing model estimates the required return on equity using the following formula: required return on stock j = risk-free rate + beta of j x equity risk premium
Risk-free rate: Rate of return on LT Government Debt: RF = 3.03%[1]. I think this is a very low rate. Since 1900, yields have ranged from a little less than 2% to 15%, with an average rate of 4.9%. I believe it is more appropriate to use this rate.
Gordon Growth Model Equity Risk Premium = (one-year forecasted dividend yield on market index) + (consensus long-term earnings growth rate) – (long-term government bond yield) = 2.13% + 11.97% - 2.67% = 11.43%[2]
Beta: From Yahoo! Finance we obtain a β = 1.2575.
The result given by the CAPM is a cost of equity of: rPRU = RF + βPRU [GGM ERP] = 4.9% + 1.2575 [11.43%] = 19.27%.
Dividend growth rate (g)
The sustainable growth rate is the rate at which earnings and dividends can grow indefinitely assuming that the firm´s debt-to-equity ratio is unchanged and it doesn´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 “PRAT” Model:
g= ((Net Income-Dividends)/(Net Income)).((Net Income)/Sales).(Sales/(Total Assets)).((Total Assets)/Equity)
Collecting the financial information for the last three years, each ratio was calculated, and then to have a better approximation I proceeded to find the three-year average:
| Retention rate | 1.30 |
| Profit margin | 0.26 |
| Asset turnover | 0.60 |
| Financial leverage | 1.47 |
Now, is easy to find the g = Retention rate × Profit margin × Asset turnover × Financial leverage = 16.95%
Because for most companies, the GGM is unrealistic, let´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. In other words, 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)
= ($158.8 × 19.27% – $4.0) ÷ ($158.8 + $4.0) = 16.95%.
The growth rates are:
| Year | Value | g(t) |
| 1 | g(1) | 30.09% |
| 2 | g(2) | 26.80% |
| 3 | g(3) | 23.52% |
| 4 | g(4) | 20.23% |
| 5 | g(5) | 16.95% |
G(2), g(3) and g(4) are calculated using linear interpolation between g(1) and g(5).
Now that we have all the inputs, let´s discount the cash flows to find the intrinsic value:
| Year | Value | Cash Flow | Present value |
| 0 | Div 0 | 3.16 | |
| 1 | Div 1 | 4.11 | 3.447 |
| 2 | Div 2 | 5.21 | 3.664 |
| 3 | Div 3 | 6.44 | 3.794 |
| 4 | Div 4 | 7.74 | 3.825 |
| 5 | Div 5 | 9.05 | 3.750 |
| 5 | Terminal Value | 454.93 | 188.463 |
| Intrinsic value | 206.94 | ||
| Current share price | 158.80 | ||
| Upside Potential | 30% |
Final comment
Intrinsic value is above the trading price by 30%, so according to the model and assumptions, the stock is undervalued. Considering a margin of safety (usually 20%), we could say that the stock is a "buy".
However, we must keep in mind that the model is a valuation method and investors should not rely on this alone in order to determine a fair (over/under) value for a potential investment.
Hedge fund gurus like John Hussman, John Burbank, Andreas Halvorsen and George Soros have initiated new positions in the stock. Moreover, First Pacific Advisors also bet on this stock with 53,260 shares. On the other hand, Alan Fournier sold out the stock in the third quarter of 2015.
Disclosure: As of this writing, Omar Venerio did not hold a position in any of the aforementioned stocks.
[1] This value was obtained from the U.S. Department of the Treasury
[2] These values were obtained from Blommberg´s CRP function.
