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How is a dividend calculated

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3M Is Undervalued On A Discounted Dividend Basis

Apr. 4, 2015 5:42 PM • mmm

  • 3M as an investment is largely tied to free cash flow and dividends.
  • Many investors/analysts see 3M as overvalued.
  • The stock is actually undervalued on a discounted dividend basis.

3M (NYSE:MMM ) grew EPS at an average of 6.5% annually for the past five years. However, the stock increased by an average of about 15% annually over that time period. Typically, you wouldn't think that a stock that is growing earnings at a slower than average pace would approximately double in five years. 3M actually outpaced the market over that five-year span.

The reason for 3M's strong performance has a lot to do with the company's strong positive free cash flow generation. The company rewards shareholders directly by paying out dividends from this cash flow. 3M has a 57-year track record of paying increasing dividends. This is a consistency that attracts and retains dividend growth investors. Going forward, I expect 3M to continue its track record of increasing its dividends as earnings and free cash flow continue to grow.

While earnings increased at an average of 6.5% for the past five years, the future growth is expected to be more robust. Consensus estimates are calling for about 9.5% average annual EPS growth over the next five years. 3M typically comes within a penny or two of meeting its EPS estimates, so I would expect the underlying stock to perform well as the company achieves this growth. The stock has outperformed both the S&P 500 and the Dow Jones Industrial Average over decades. So, I expect the stock to continue its outperformance, as investors continue to see the value in 3M as a long-term dividend growth story. There are many investors who participate in 3M's dividend reinvestment plan (NYSEARCA:DRIP ), where the dividend payments are piled back into the stock at regular intervals, growing their investment over the long-term. This participation in the DRIP plan creates automatic steady demand for the stock. The regularity of these investments due to the company's earnings consistency, contribute to the stock's strong performance over the long-term.

The company's free cash flow increased at an average annual pace of 6.4% for the past four years, which was approximately in-line with earnings growth. This was higher than 3M's average annual net income growth of 4.9% and lower than its EPS growth of 7.4% over the past four years. Going forward, 3M's free cash flow growth is likely to be higher as its expected earnings growth rate is expected to be higher than the past few years. The company is able to spend less on CapEx than it produces in operating cash flow to maintain and grow its free cash flow over time. This is valuable for shareholders as the company uses its free cash flow to pay out its dividends.

Numerous analysts have talked about how 3M looks overvalued. This is based on

comparing the trailing and forward PE ratios to the broader market. Although 3M's trailing and forward PE ratios of 21.7 and 18 are higher than the S&P 500's ratios of 18.9 and 17.4, respectively, I think that a dividend discount analysis provides a better measure for 3M's valuation. I believe this because 3M consistently increases its dividends over time.

The dividend discount model calculates the company's intrinsic value based on the dividend growth rate and the required rate of return. The formula is:

Dividends ÷ (Required Rate of Return - Dividend Growth Rate)

The required rate of return = risk free rate + (market risk premium x the stock's beta)

I used the 30-year treasury rate of 2.53% as the risk free rate. The market risk premium was calculated by taking the stock market's long-term return of 9.9% - the risk free rate of 2.53% = 7.37%. Plugging the stock's beta of 1.18 into the formula, the required rate of return is 11.2%. I estimated the dividend growth rate to be 9%, which is lower than the average annual expected EPS growth of 9.5%. Using the dividend payment of $4.10 per share the formula looks like this:

$4.10 ÷ (11.2% - 9%) = $186.36

So, 3M's intrinsic value is $186, which is 14% higher than the current price of $163. Therefore, the stock is undervalued on a dividend discount basis.

I expect the stock to continue to outperform the market as earnings continue to grow. 3M's earnings strength and consistency is a result of the company's steady revenue growth. 3M typically grows revenue in the low single digits year-over-year. The company also achieves a high return on equity of 32%. So, 3M gets a great return for every dollar that it invests. This also contributes to 3M's steady earnings growth.

The company's revenue growth grows steadily as consumers rely on the numerous 3M brands. 3M's products under the brands such as the company name, Filtrete, Scotch-Brite, Scotch, Command, Nexcare, Sharpie, Bic, Thinsulate, etc. are products that can be counted on for reliability and consistency in performance. The product reliability leads to revenue growth along with 3M's numerous acquisitions.

I think that the stock will continue to perform well going forward as earnings increase at a strong pace. The stock's valuation is still attractive on a discounted dividend basis, so there is plenty of room for future gains in the underlying stock and for dividend growth. Given the undervaluation and expected annual earnings growth of 9.5%, I think it is reasonable that the stock will continue to outperform the market going forward.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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