Dow Chemical (DOW) has shown steady earnings growth over the last several years, a factor that immediately attracts some investors. In addition, multiple analysts have been raving about the value opportunity based on qualitative factors. For example, Seeking Alpha contributor Winning Strategies recently argued that the company is poised for further growth due in part to its “innovative culture.” Similarly, contributor Brent Templeton expects some of the company’s upcoming projects will greatly enhance the value. These qualitative issues are excellent to consider in the final stages of an investment decision, but first one must use quantitative metrics to determine the company’s intrinsic value.
Benjamin Graham, the father of value investing, taught that the most important aspect to consider is whether the company is trading at a discount relative to its intrinsic value. It is through a thorough fundamental analysis that the investor is able to make a determination about a potential investment’s merits.
The model is inspired by the teachings of Benjamin Graham and considers numerous metrics intended to help the investor reduce risk levels. The first part of the analysis is to determine whether the company is suitable for the very conservative Defensive Investor or the less conservative Enterprising Investor, who is willing to spend a greater amount of time conducting further research.
In addition, Graham strongly suggested that investors avoid speculation in order to remove the subjective elements of emotion. This is best achieved by utilizing a systematic approach to analysis that will provide investors with a sense of how a specific company compares to another. By using theModernGraham method, one can review a company’s historical accomplishments and determine an intrinsic value that can be compared across industries.
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Defensive Investor – Must pass at least 6 of the following 7 tests: Score = 4/7
- Adequate Size of Enterprise – Market capitalization of at least $2 billion – PASS
- Sufficiently Strong Financial Condition – Current ratio greater than 2 – FAIL
- Earnings Stability – Positive earnings per share for at least 10 straight years – PASS
- Dividend Record – Has paid a dividend for at least 10 straight years – PASS
- Earnings Growth – Earnings per share has increased by at least 1/3rd over the last 10 years, using 3-year averages at the beginning and end of the period – FAIL
- Moderate PEmg (price over normalized earnings) ratio – PEmg is less than 20 – PASS
- Moderate Price to Assets – PB ratio is less than 2.5 or PB x PEmg is less than 50 – FAIL
Enterprising Investor – Must pass at least 4 of the following 5 tests or be suitable for a Defensive Investor: Score = 4/5
- Sufficiently Strong Financial Condition, Part 1 – Current ratio greater than 1.5 – PASS
- Sufficiently Strong Financial Condition, Part 2 – Debt-to-Net Current Assets ratio less than 1.1 – FAIL
- Earnings Stability – Positive earnings per share for at least 5 years – PASS
- Dividend Record – Currently pays a dividend – PASS
- Earnings growth – EPSmg greater than 5 years ago – PASS
|Value Based on 3% Growth||$38.40|
|Value Based on 0% Growth||$22.51|
|Market Implied Growth Rate||5.61%|
|Net Current Asset Value (NCAV)||-$16.97|
Balance Sheet – March 2015
Earnings Per Share
Earnings Per Share – ModernGraham
Dow Chemical is rather attractive when compared to some other companies in the industry. For example, a ModernGraham valuation of Du Pont (DD) indicates that company is suitable for Enterprising Investors but only fairly valued. In addition, Olin Corporation (OLN) was rated as unsuitable for Enterprising Investors and overvalued in its most recent ModernGraham valuation.
Dow Chemical is not suitable for Defensive Investors but it does pass the initial requirements of the Enterprising Investor. The Defensive Investor is concerned with the low current ratio, the insufficient earnings growth over the last ten years, and the high PB ratio, while the Enterprising Investor’s only concern is the level of debt relative to the net current assets. As a result, all Enterprising Investors should feel very comfortable proceeding to the next part of the analysis, which is a determination of the company’s intrinsic value.
When it comes to that valuation, it is critical to consider the company’s earnings history. In this case, it has grown its EPSmg (normalized earnings) from $1.49 in 2011 to an estimated $2.65 for 2015. This is a fairly strong level of demonstrated growth, and outpaces the market’s implied estimate for annual earnings growth of 5.61% over the next 7-10 years.
In recent years, the company’s actual growth in EPSmg has averaged considerably 15.59% annually, and while the ModernGraham valuation model reduces the actual growth to a more conservative figure when making an estimate, the model still returns an estimate of intrinsic value well above the current price, indicating that Dow Chemical is significantly undervalued at the present time.
Disclaimer: The author did not hold a position in any company mentioned in this article at the time of publication and had no intention of changing that position within the next 72 hours. Logo taken from Wikipedia for the sole purpose of identifying the company; this article is not affiliated with the company in any manner.