One of Icahn's Favorite Stocks Seems to be Overvalued

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Jul 01, 2015

One well-known activist investor, Carl Icahn (Trades, Portfolio), further increased his position in Chesapeake Energy Corporation (CHK, Financial) through Icahn Capital LP by 10% to $1.03 billion in the company's latest filing, with 73.05 million shares. Chesapeake is Icahn's eighth-largest holding in its $32.05 billion portfolio, and the stake represents 3.2% of Icahn´s portfolio, so we can conclude that the stock´s performance will affect its performance.

Icahn remains bullish on the company as evidenced by his increased position in the company's shares, so let´s try to find the intrinsic value of the stock based on an absolute valuation model and see if we can have an upside potential in this stock.

To estimate the fair value of Chesapeake, I will use the Dividend Discount Model (DDM). In stock valuation models, DDM define 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 (CAPM) 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%. So, I believe it is more appropriate to use this rate.

Gordon Growth Model Equity Risk Premium = (1-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! (NASDAQ: YHOO) Finance we obtain a β = 1.04

The result given by the CAPM is a cost of equity of: rCHK = RF + βCHK [GGM ERP] = 4.9% + 1.04 [11.43%]= 16.79%

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:

Av. Retention rate 0.75
Av. Profit margin 0.00
Av. Asset turnover 0.41
Av. Financial leverage 2.57

Now, is easy to find the g = Retention rate Ă— Profit margin Ă— Asset turnover Ă— Financial leverage = 0.3%

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)

= ($11.16 × 16.79% – $0.35) ÷ ($11.16 + $0.35) = 13.24%.

The growth rates are:

Year Value g(t)
1 g(1) 0.30%
2 g(2) 3.54%
3 g(3) 6.77%
4 g(4) 10.00%
5 g(5) 13.24%

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 0.35 Ă‚
1 Div 1 0.35 0.301
2 Div 2 0.36 0.266
3 Div 3 0.39 0.244
4 Div 4 0.43 0.229
5 Div 5 0.48 0.222
5 Terminal Value 15.41 7.095
Intrinsic value Ă‚ Ă‚ 8.36
Current share Price Ă‚ Ă‚ 11.16
Upside Potential Ă‚ Ă‚ -25%

Final comment

Intrinsic value is below the trading price by 25%, so according to the model and assumptions, the stock is overvalued and subject to a potential “sell” recommendation. However, we must keep in mind that the model is a valuation method and investors should not be relied on alone in order to determine a fair (over/under) value for a potential investment.

Despite the numerical analysis, the company has good fundamentals and drivers to grow in the future. For example, the alignment with its new objective to consolidate its portfolio and create better opportunities, as well as its good relative valuation measures in most of the cases relatively to its peers, are some reasons to remain bullish.

Paul Tudor Jones (Trades, Portfolio) and Joel Greenblatt (Trades, Portfolio) initiated a new position in the stock with 26,500 and 116,433 shares, respectively. Other hedge fund managers have taken long positions in the first quarter like Arnold Schneider (Trades, Portfolio), Ray Dalio (Trades, Portfolio), Murray Stahl (Trades, Portfolio), Charles Brandes (Trades, Portfolio), Richard Snow (Trades, Portfolio) and Bill Nygren (Trades, Portfolio).

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 Bloomberg´s CRP function.