Union Pacific (UNP) - Valuation Analysis

Description

Union Pacific Corporation, incorporated in 1969, is engaged in the transportation business. The Company’s principal operating company, Union Pacific Railroad Company, links 23 states in the western two-thirds of the United States of America. Union Pacific Railroad Company serves many United States population centers and provides them with mode of freight transportation. Union Pacific Railroad Company’s business mix includes Agricultural Products, Automotive, Chemicals, Energy, Industrial Products and Intermodal. The Company has 31,953 route miles, linking Pacific Coast and Gulf Coast ports with the Midwest and the eastern United States gateways and providing several corridors to key Mexican gateways. It serves the western two-thirds of the United States and maintains coordinated schedules with other rail carriers to move freight to and from the Atlantic Coast, the Pacific Coast, the Southeast, the Southwest, Canada and Mexico.
Source: Reuters

Valuation

I estimated the intrinsic value of UNP to be $99.37.  Key assumptions included:

                Core growth rate: 17.0%

                Terminal growth rate: 5.0%

                Risk-adjusted discount rate: 11.1%

                Operating ratio: 70%

                CAPEX as % of sales: 15.0%

                Depreciation as % of sales: 9.0%

                Effective tax rate: 36.0%

                Working capital as % of sales: -7.5%

Given the current market price of $102.20, UNP is overvalued by 2.9% to its intrinsic value.  The risk-adjusted margin of safety was calculated to be 8.3%.  Since the stock is trading above the estimated intrinsic value, it would be prudent to wait until shares of UNP fell.  Based on the $99.37 intrinsic value and 8.3% risk-adjusted margin of safety, it might be prudent to consider shares at $91.14 or below.

Dividends

The dividend appears to be growing faster than earnings growth and has increased in recent years.  From 2000 to the 2010, the dividend has grown from $0.40 per share to $1.31 per share.  The compound annual growth rates for the past ten-, five-, and three-years are:

                Ten years: 14.1%

                Five years: 21.6%

                Three years: 20.7%

Although growing faster than earnings, the dividend appears to be sustainable.  Based on either net income, dividend payout ratio has not exceeded 50%.  A dividend payout ratio of less than 50% is a positive allowing for sustainable growth and a cushion for short-term earnings volatility.  Below is the dividend payout ratio for the past five years:

                2006: 20.0%

                2007: 19.6%

                2008: 20.6%

                2009: 28.8%

                2010: 21.7%

In the book, The Ultimate Dividend Playbook, Josh Peters discusses a model to calculate a stock’s prospective return.  The model is called the Dividend Drill Return Model (DDRM).  It is based on the premise that the dividend total return is equal to the yield plus dividend growth.  Dividend growth is then broken into core growth (the rate of growth for total profits) plus share change (reduction of shares due to share repurchase). 

Given a core growth rate of 17.0% and current dividend yield of 1.9%, UNP’s cost of growth is $6.06 per share.  After reducing this amount and dividends of $1.90 per share, the funding gap is $2.38.  UNP may need to borrow the $2.38 per share to reduce outstanding shares or increase expansion; this amount is forecasted to have a -2.3% impact on share price.  As a result, the DDRM forecasts the projected total return for UTX to be 16.5%.  Below is a breakdown of the total return:

                Core growth rate: 17.0%

                Dividend yield: 1.9%

                Funding surplus: -2.3%

                Total return: 16.5%

Summary

Based on a valuation $99.37, shares are trading at a 2.9% premium to the intrinsic value.  UNP has aggressively increased dividends and the dividend appears sustainable as the payout ratio is less than 50%.  Based on the DDRM, the projected total return for UNP is 16.5%.  Shares of UNP look attractive at lower prices than where UNP is currently trading at.