Donaldson (DCI): Assessing The Company’s Value Using The Dividend Discount Model

Intro

If we pull up an intermediate chart of the Industrial player ‘Donaldson Company’, Inc. (NYSE:DCI), we can see that shares topped on in March of this year (where that overhead resistance actually coincided with the company’s 2021 highs). This means that shares at present are actually struggling to remain above their 10-week moving average although the popular MACD indicator recently triggered an intermediate sell signal. Suffice it to say, it will be interesting to see here over the near term if any potential down move gains traction here or whether shares of Donaldson can indeed make another run at taking out their all-time highs.

We state this because bulls may have been surprised that shares were not able to gain traction in March post the announcement of Donaldson’s second-quarter earnings numbers for fiscal 2023, especially around the areas of profitability. For example, the company’s non-GAAP reported Q2 number of $0.75 beat the estimate ($0.68) handily, and full-year guidance (now $3.03 per share approx.) was tightened by management (on the upside) which means 13%+ bottom-line earnings growth is now expected for fiscal 2023. Bottom-line growth in Donaldson Company is being driven by strong performances in both Mobile Solutions as well as Industrial Solutions despite the fact that the smaller Life Sciences segment continues to suffer from a significant decline in disk drive sales. Guidance on Donaldson’s 2023 operating margin was also a sign of strength in the report but yet as mentioned, shares have failed to gain any real traction to the upside

Suffice it to say, when strong forward-looking profitability metrics do not result in sustained share-price growth, it usually means that the stock’s valuation may be awry. Taking into account that the price we pay as investors ALWAYS matters, valuing a fundamentally strong company can be very tricky even in the best of times. However, since Donaldson is a proven dividend aristocrat (27 years of consecutive growth & counting), we can use the popular dividend discount model to try to stamp an accurate valuation on this company.

Dividend Discount Model

The formula we use is the following

where EDPS stands for ‘expected dividend per share,’ CCE denotes Donaldson’s cost of equity and DGR means the company’s dividend growth rate.

First off, we will look at Donaldson’s EPDS or expected dividend per share. To do this, we need to calculate Donaldson’s payout ratio (and corresponding retention ratio) as well as its return on equity. Over the past four quarters, $111.7 million was paid in dividends from an income pool of $357.2 million. This means the company’s GAAP dividend pay-out ratio comes in at 31.27%. Subtracting this percentage from 100% gives us Donaldson’s retention ratio (68.73%) which illustrates the income that is not paid out to shareholders in the form of a dividend but rather ‘retained’

Then, taking into account that Donaldson’s dividend cannot exceed the company’s earnings, by multiplying Donaldson’s retention ratio (68.73%) by its return on equity (30.91%), we can get a very solid read on the company’s sustainable dividend growth rate going forward (which comes to 21.24%). This means (although Donaldson is raising at a much lower clip at present), its present ROE of almost 31% and retention ratio of almost 69% demonstrates that the company could sustain a 21%+ annual dividend growth rate which again speaks very highly of the company’s present profitability. This exercise is useful because it gives us a ceiling at which the dividend can be increased going forward based on the company’s present ROE.

However, there is a difference between what is sustainable and what actually will be paid. Therefore, we will default to Donaldson’s 10-year average annual dividend growth rate which comes in at 9.54% Therefore by multiplying Donaldson’s present annual dividend of $0.96 by 1.0954%, we get an EPDS or expected dividend of $1.05 per share.

Cost Of Equity

Secondly, Donaldson’s ‘cost of equity’ refers to the rate of return required by investors to essentially invest in the company. It is a very important metric as it takes into account Donaldson’s expected growth while also discounting the present value of the company’s earnings. The formula to deduce Donaldson’s cost of equity is

Cost of equity = Risk-Free Rate + (Beta) x (Equity Risk Premium)

where the risk-free rate equates to a zero-risk investment (something like the 10-year US treasury = 3.52%). Beta is simply a proxy for Donaldson’s volatility (1.21) and ‘Equity Risk Premium’ denotes the absolute minimum return we can expect on the investment. Here we use a third-party calculation ‘Damodaran equity risk premium’ which currently comes in at 5.93% in the US.

Plugging the above numbers into the formula, we get the following

Cost of equity = 3.52 x 1.21(5.93) = 10.7%.

Therefore, if we plug all of our numbers into our final formula, we get

Value of Donaldson = EDPS / CCE – DGR = $1.05 / (10.7% – 9.54%)

Value = $1.05 / 0.016 = $65.62 per share.

Conclusion

Stamping a precise valuation on a stock is very difficult but running through a popular dividend discount model can give us some insights on Donaldson’s present value. For example, Donaldson’s soaring return on equity and high retention ratio really demonstrate the potential for sustained dividend growth in the company going forward. On the other hand, Donaldson’s 10%+ cost of equity offers a significant ‘hurdle’ rate and most likely will keep on going up due to prolonged inflation in the US. Therefore, with shares of Donaldson currently trading at approximately $63.40, we deem the Industrial player at best a ‘Hold’ at this present moment in time. We look forward to continued coverage.