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“THE VALUE OF A SHARE DEPENDS ON ITS FUTURE DIVIDENDS”

“THE VALUE OF A SHARE DEPENDS ON ITS FUTURE DIVIDENDS”

Dr Neoh Soon Kean

In an article in i3investor written by me on dividend yield investing here,

http://klse.i3investor.com/blogs/kcchongnz/85015.jsp

I have articulated the importance of dividends for an investor. I would like to summarize here:

1. It is real, money into pocket for an investor to spend, or reinvest in the same or other shares.
2. It provides a floor to share price when bear stampedes, and you don’t get panic and sleepless.
3. It keeps us in touch with reality when there is irrational exuberance in the market.
4. It prevents you from being side-tracked by events which have little of or no real benefits to you as a shareholder of a company.

In addition, and more importantly, dividend payment and especially increasing dividend payments provides a positive signal from the management that the company is doing well and can afford to pay, and that they are willing to share the fruits of success of the company with shareholders.

I have also written an article on why I think Padini is a good company, and will likely continue to be a good company in this thread:

http://klse.i3investor.com/blogs/kcchongnz/85800.jsp

I have also written two articles in i3investor recently on the use of dividend discount model (DDM) to estimate the intrinsic values of two companies and compare their share prices to see if there were large margin of safety investing in them. These companies are Pintaras and Perstima as shown in the links below.

http://klse.i3investor.com/blogs/kcchongnz/83959.jsp

http://klse.i3investor.com/blogs/kcchongnz/85379.jsp

In this article, I am doing the same thing using DDM to estimate the intrinsic value of Padini and see if there is a wide margin investing in Padini, as you know, a good company may not be a good investment if the price is not right.  

Padini share price movement

Figure 1 below shows its share price performance of Padini for the last 5 years.

Figure 1: Past 5 years share price movement of Padini

It shows Padini’s share price was at its peak at RM2.33 in August 24 2012 more than 3 years ago. Since then it is in a down trend and reaches its trough at RM1.30 on 7^th October 2015 before climbing back to a close of RM1.62 on 5^th November 2015.

There are some analysts’ reports on Padini as shown in the link below.

http://klse.i3investor.com/servlets/ptg/7052.jsp

The average target price given by 5 investment bankers is only at about RM1.60, with the lowest at RM1.30 and the highest at RM1.80. At RM1.62 now, there seems to be little upside for this stock, according to those investment bankers and professional analysts.

Let us do a little different, instead of using the simplistic PE ratio for getting the fair value of Padini, we use the DDM to estimate the intrinsic value of Padini, and see what the margin of safety is investing in it at the present price.

“It is impossible to produce superior performance unless you do something different from the majority.”              Sir John Templeton

Padini distributed 10 sen dividend last year. At RM1.62, the dividend yield, DY, is 6.2%, about 50% higher than the fixed deposit rate. It is this high dividend yield which attracts me again on this stock.

It is also this steady dividend payments which provides the certainties on the estimation of future cash flows, and the lesser uncertainties in the estimation of its intrinsic value using the Dividend Discount Model (DDM). Having a good estimation of the intrinsic value, then compare with its share price, I can have a good feel of the margin of safety in investing in Padini.

“A stock dividend is something tangible-it is not earnings projection; it is something solid, in hand. A stock dividend is a true return on the investment. Everything else is hope and speculation.”

Richard Russell

In this article below in i3investor, I have set up some theoretical background for DDM, and used it to value a construction company, Pintaras Jaya, which we will use it for other stocks, including Padini.

http://klse.i3investor.com/blogs/kcchongnz/83959.jsp

Dividend Discount Model, DDM for Padini

As shown in Table 1 in the Appendix, Padini’s dividend payment has been growing from four sen per share five years ago in 2010 to 10 sen for the fiscal year ending 30 June 2015, for compounded annual growth rate (CAGR) of 20%. What is the intrinsic value of Padini using DDM?

Here, we will use the expected dividend payment for half the last 5 years rate, or 10%, for the next 10 years, and then a terminal dividend growth rate of 3% according to the rate of inflation after that as the company becomes a more matured company.

The future dividend payments are discounted to the present value at a discount rate of 10%. This discount rate is a conservative estimate as Padini has an excellent balance sheet and stable earnings and cash flows. I would have used a lower discount rate if not for the competitiveness of the industry.

This is essentially a two-stage dividend growth model; one at supernormal growth stage growing dividend at 10% a year, and the other, a terminal growth with a perpetual growth rate of 3%.

Padini has good earnings and cash flows although there is a little up and down over the years. The earnings and cash flows on average is substantially higher than its dividend payout as shown in Table 1 in the appendix.  Free cash flows (FCF) was very high at 23 sen a share for the most recent year. It averages 8 sen per share over the last 10 years, and with a clear increasing trend. It is from this internally generated FCF that dividend is paid out, without having to borrow money from the bank. Padini also has a very healthy balance sheet with RM246m cash, or 37 sen per share, which will provide the more confidence and visibility of the good future dividend pay-out.

With these good numbers, we will use a discount rate of 10.0%, a risk premium of 6% over the bank fixed deposit rate, for discounting future expected dividends to the present to obtain its intrinsic value.

DDM computations

Table 2 in the appendix show the data and assumptions and the two-stage DDM computed using a spreadsheet. The present value of all future dividends using this method is shown to be RM2.47 per share, representing a margin of safety of 34% investing in Padini at today’s price of RM1.62 on 5^th November 2015. For a company like Padini, a MOS of more than 30% is what I am looking for.

I would like to carry out a few more checks before concluding if Padini is a good company as a long-term investment.

Is the dividend payment sustainable?

Let us carry out the following checks and answer the questions to see if the strategy is a viable one and if dividend payment for Padini is sustainable according to what I have proposed here:

http://klse.i3investor.com/blogs/kcchongnz/85015.jsp

1. Dividend yields at least two thirds the bank fixed interest rate, currently about 4.0%.

At RM1.62and a dividend of 10 sen, DY is 0.10/1.62 = 6.2%, 50% above the FD rate. A big tick.

2. Dividend pay-out ratio should be less than a cut-off rate, say 65-80% so that there is money left for the business to grow with the reinvestment for potential increase in future dividend.

Average pay-out ratio is only 43% over the last 10 years, and last year was 82%.

It is hence okay as after pay-out out a big a good dividend, it still has substantial retained earnings for future growth. Another big tick.

3. A business model that doesn’t require massive amounts of capital outlays relative to its earnings power.

For the last 10 years, its capital expenses amount to only 42% and 35% of its net income and cash flows from operations (CFFO) respectively. It is not a capital intensive kind of business and most earnings can be distributed to shareholders. Another big tick for Padini.

4. Reasonable expected growth rate in earnings at least matches the overall economy, say >4%, also for the potential growth in dividends in the future.

Revenue of Padini has been growing at a high CAGR of 14.6% for the last 10 years. The 10-years long term CAGR of its net profit at 12.5% is also fantastic. However, earnings per share EPS has dropped a little from 14.5 sen in 2012 to 12.2 sen in 2015 due to the stiff competitions of the industry. With the proven and proactive management, it isn’t much of a concern yet.

5. Strong balance sheet for sustainability of dividend payment.

Padini has RM246m, or 37 sen cash per share in its balance sheet, and with little debt. There is hence no evidence that dividend payment is unsustainable, in my opinion. Another big tick.

6. High return of equity and capitals > 12% such that the dividend payment is not only sustainable, but grows from internally generated funds.

For the financial performance as at 30^th June 2015, the return on equity and invested capital for Padini are very high at 41% and 20% respectively, much higher than its costs of capital. Another big tick.

7. Shareholder-friendly management dedicated to treating shareholders as owners

Looking at the dividend payment over the years, there is the sign that the management must have been doing something right for the shareholders. Another big tick.

Conclusions

Padini has been a high growth stock with stable earnings and cash flows, plus steady and increasing dividend pay-out, plus a healthy balance sheet. Using the DDM, it is shown that at RM1.62, it has a high margin of safety of 34% investing in this stock. A few checks also show the dividend pay-out is likely to be sustainable.

The industry Padini is in has been getting increasing competitive, and analysts have not been giving a high target price for it recently using the simplistic price-to-earnings ratio. However, with the proven record of the management in shareholder value enhancement, I am confident that it can overcome whatever challenges it encounter in the future.

I have added Padini again as a stock in my portfolio.

KC Chong (8^th November 2015)

ckc14training2@gmail.com

Appendix

Table 1: Past performance of Padini

Table 2: Assumptions and computations for DDM