Maryland-based T. Rowe Price Group (TROW) is a global investment management company that provides funds, advisory services, account management, and retirement plans and services.
TROW offers its services to individuals, institutional investors, retirement plans, financial intermediaries, and more.
We are bullish on the stock because it has a quantifiable competitive advantage, a juicy dividend, and an attractive valuation.
T. Rowe’s Competitive Advantage
To measure TROW’s so-called “edge” against its competitors, we will be using a method called earnings power value (EPV). This method was invented by Bruce Greenwald.
EPV is measured as adjusted earnings divided by a company’s weighted average cost of capital. Another step, reproduction value, can be measured using a company’s total asset value.
While this may seem complicated, the idea itself is not. Essentially, assuming that hypothetical company XYZ won’t grow, if XYZ can generate more value from earnings compared to its total asset value, then that company is considered to have a competitive edge.
Though the formula itself is straightforward, there are quite a few steps required to calculate adjusted EBIT after tax. First, we need to compute the average EBIT margin of the past five years, which in the case of TROW is 44.3%.
Next, we normalized EBIT and calculated the net operating profit after tax or NOPAT. Please note that all calculations are in millions of dollars:
- NOPAT = LTM Revenue x Average EBIT Margin x (1 – Tax Rate)
- $2,685.0 = $7,672 x 0.443 x (1 – 0.21)
Now that we have NOPAT, we need to adjust depreciation and CapEx to account for the assumption of no growth because less investment would be required:
- Adjusted Depreciation = (0.5 x Tax Rate) x Five-Year Average Depreciation
- $18.7 = (0.5 * 0.21) x $177.7
Next, we will need to calculate the maintenance CapEx of for each of the past five years and then find the average:
- Maintenance CapEx = Total CapEx x (1 – Revenue Growth Rate)
Using the formula above for each of the past five years, we arrive at an average maintenance CapEx of $176.3.
Now that we have both adjusted depreciation and average maintenance capex, we can calculate the adjusted earnings and EPV as follows:
- Adjusted Earnings = NOPAT + Adjusted Depreciation – Average Maintenance Capex
- $2,527.3 = $2,685.0 + $18.7 – $176.3
- EPV = Adjusted Earnings / Weighted Average Cost of Capital
- $35,101.1 = $2,527.3 / 0.072
Since TROW has a total asset value of $12,500 (in millions), we can say that it does have a competitive advantage. In other words, assuming no growth for TROW, it would require $12,500 of assets to generate $35,101.1 in value over time. This is quite impressive.
Dividends & Buybacks
For investors that like dividends, TROW currently has a forward dividend yield of around 3.3%, which is considerably higher than the S&P 500’s (SPY) 1.3% yield.
When taking a look at its LTM free cash flow figure of $3.2 billion and net income of $3 billion, its $1-billion dividend payment looks safe.
If you took a look at TROW’s dividend history, you’d see that its dividend yield has been trending upwards. Its dividend yield hit a low of 1.9% in October 2013, and has been uptrending ever since.
Surprisingly, the yield is not too far off the levels seen in the 2020 COVID-19 market crash. This implies that the stock is relatively undervalued compared to itself.
Furthermore, when you take a look at TROW’s buyback yield, it was 3.5% in 2020 and 3.4% in 2021. Thus, when combining both dividends and buybacks, TROW returns around 6.7% – 6.8% to shareholders.
Even better, this does not consider the special dividend of $3 per share that TROW paid out last year. That dividend boosts its LTM dividend yield to about 5.2%, meaning that TROW actually returned 8.6% in capital back to shareholders in the past year. Not bad at all.
Another important thing to note is that the buyback yield may be even higher this year since TROW’s stock price has come down significantly, allowing the company to buy back a greater amount of shares.
Add in the fact that the dividend is likely to increase, as it has been steadily increasing over the years, and you could see predictable and steady capital returns near 8% – 10% in the next few years.
Valuation
To value TROW, we will use the excess returns model. This approach is more appropriate for financial companies because they tend to have volatile free cash flows.
As a result, trying to create forecasts for them is futile. The excess returns model allows us to use historical numbers instead, which are actual results. The formulas required are as follows:
- Excess Return = (Average ROE – Cost of Equity) x Book Value Per Share
- Terminal Value = Excess Return / (Cost of Equity – Growth Rate)
- Fair Value = Book Value Per Share + Terminal Value
We will use the following assumptions for our calculations:
- Average ROE: 31.1% (five-year average)
- Cost of Equity: 7.3%
- Book Value: $39.37
- Growth Rate: 2.8% (used 30-year U.S. Treasury yield as a proxy for long-term growth expectations)
Now that we have our assumptions, let’s plug them into the formulas:
- $9.37 = (0.311 – 0.073) x $39.37
- $208.22 = $9.37 / (0.073 – 0.028)
- $247.59 = $39.37 + $208.22
As a result, TROW is currently worth $247.59 per share under current market conditions. At its current price of ~$147, this implies 68% upside potential.
However, discount rates are always changing and companies are likely to see changes in ROE. As a result, we have created the table below to show the valuation of TROW under different conditions:
Note: Orange is the current average ROE, yellow is the valuation with different ROE values, and green is the cost of equity.
At the current price of around $147 at the time of this writing, TROW provides investors with a large margin of safety even if discount rates continue to trend higher and ROE trends lower.
Risks
The main risk for TROW would be discount rates potentially continuing to rise, as indicated by the table in the valuation section.
With the Federal Reserve ratcheting up its hawkish talk, bond yields have continued to rise, thus, putting pressure on valuations. If inflation cannot be tamed, this risk will continue to elevate.
Wall Street’s Take
Turning to Wall Street, T. Rowe has a Hold consensus rating, based on one Buy, four Holds, and three Sells assigned in the past three months. The average T. Rowe price target of $153.88 implies 4.7% upside potential.
Final Thoughts
TROW is a great business with a competitive advantage and attractive shareholder return yield that is trading below its intrinsic value.
In addition, Wall Street also believes that the price should be higher, although it remains more conservative.
As a result, we are bullish on the stock.
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