2023-11-21 21:30:35 ET
Summary
- Farmer Mac is a safe earnings growth machine, with a 79% increase in operating EPS over four years.
- Despite its low P/E ratio, Farmer Mac is valued higher than top-notch companies like Toll Brothers and Apple according to the dividend discount model. Why? Because.
- I estimate that Farmer Mac's "normal" dividend for DDM valuation purposes is around $10 per share.
- Dividend growth beyond '25 should be at least 8% a year.
- Farmer Mac has very high dividend stability because of its very low liquidity, interest rate and credit risks.
I’ve written a ton about Farmer Mac (AGM) over the past four years. Why? It’s a rounding error in the investment world. A little shrub among the big cap Sequoias.
I write so much because Farmer Mac is a safe earnings growth machine. Four years ago, in 2019, Farmer Mac’s operating EPS was $8.70. This year it should earn $15.59, according to Seeking Alpha’s survey of Wall Street analysts . That’s a 79% increase, compared to an S&P 500 increase of 38%. And over those four years, Farmer Mac didn’t experience a single loan loss.
Yet Farmer Mac’s P/E ratio on ’24 expected EPS is only 10, compared to the S&P 500 P/E of 18. Is Farmer Mac still really cheap? Do investors have legitimate concerns? What is a real fair value for this unique stock? Let’s turn to the professors for help.
Farmer Mac and the dividend discount model
The “dividend discount model [DDM] FR” is a classic theoretic valuation tool. Google’s AI defines the DDM as “ the idea that a stock's value is equal to the sum of all its future dividend payments, discounted back to their present value.” It is a common-sense notion that the goal of investors is to give up cash today to get more cash back in the future. Using the cash notion, I will broaden the term “dividend” here to include:
- Good old cash dividends.
- Stock buybacks, which is also cash earnings, but used to increase investors’ ownership of the company.
- The sale of the company, which returns to investors the full cash value of the company.
Some companies offer all three cash returns. For example, homebuilder Toll Brothers:
- Will pay an $0.84 per share dividend this year.
- Will spend $2.85 per share buying back stock, annualizing its first nine months’ repurchases.
- Didn’t get bought out, but could be one day.
Some companies offer two cash returns. For example, Apple:
- Will pay a $0.96 per share dividend this year.
- Will spend $4.75 per share buying back stock, annualizing its first nine months’ repurchases.
- But at a $3 trillion market cap, Apple is not a takeover candidate.
Now for Farmer Mac. Its GSE status rules out an acquisition, as well as share buybacks (politically incorrect). So Farmer Mac investors can only get cash returns from the dividend, which currently is $4.40.
Let’s now compare DDM valuations – stock prices as a multiple of cash returns:
- Toll Brothers: 23 times
- Apple: 34 times
- Farmer Mac: 38 times
What? Despite its low P/E, the DDM says that Farmer Mac is not only valued at more than topnotch homebuilder Toll Brothers, but at more than the god-like Apple!
Does that make sense? Based on my analysis below, my answer is “Yes it does”. That conclusion is based on the three factors that determine the DDM:
- The “normal” dividend
- The likely dividend growth rate
- The stability of dividend payments over time
Farmer Mac dividend analysis step #1: Its normal dividend. Up to $10, not $4.40.
Farmer Mac’s current dividend is $4.40. Is that “normal”? I say it is materially low. To understand why I say that, you need to understand two things:
- Farmer Mac’s GSE charter requires it to support farmers and their rural communities by lending money. Farmer Mac’s main operating priority is therefore to grow its lending assets.
- As a lender, Farmer Mac must support new loans with new equity. So if Farmer Mac grows its loan assets by 5%, it must grow its shareholders’ equity by the same 5%. Investors only get cash from Farmer Mac if its return on equity [ROE] exceeds its loan growth. In this example, if Farmer Mac’s ROE is 8%, it can pay dividends equal to 3% of that 8% ROE.
Let’s see how this dynamic has actually been working for Farmer Mac. I start with an earnings history and forecast:
Farmer Mac financial statements
Sources: Farmer Mac financial statements
The highlighted lines show that:
- EPS growth was dramatic this year because Farmer Mac’s interest margin jumped sharply.
- The margin widening was due to several factors: (1) an increased benefit from Farmer Mac’s GSE status and implied federal debt guarantee during the current turbulent bond market, (2) higher interest rates, which increased earnings on Farmer Mac’s large cash position, (3) growth in higher yielding farm and rural infrastructure loans.
- Credit costs remain negligible.
- Farmer Mac raised a substantial amount of preferred stock during 2019 to 2021, which turned out to be a well-timed tactic during that low interest rate period and provides cheap capital going forward.
Now for the “normal” dividend calculation:
Farmer Mac financial statements
Sources: Farmer Mac financial statements
This table shows that:
- Farmer Mac’s ROE has averaged nearly 20%.
- Asset growth has averaged less than half that rate. Since about two years ago, part of the reason has been that Farmer Mac has developed a securitization market for its assets, which takes them off of the company’s balance sheet, which is clearly a positive for dividends.
- Farmer Mac’s actual dividends paid have been far lower than its capacity to pay. The result has been a huge increase in excess capital, from $197 million at the end of 2019 to $581 million today.
In sum, Farmer Mac’s “normal” dividend for DDM valuation purposes is more like $10 per share than its current $4.40 actual dividend paid.
So why isn’t Farmer Mac actually paying that much higher dividend? In large part because it has a policy of limiting its dividend to 35% of earnings. I see no practical reason for its policy. After all, the S&P 500 dividend payout ratio is currently 38% (Google AI), and adding in share repurchases almost certainly takes that ratio over 50%. Farmer Mac can comfortably afford that 50% payout ratio. I do expect that over time Farmer Mac will move towards that ratio. The alternative is to pile up increasingly large amounts of excess capital.
Farmer Mac dividend analysis step #2: The expected dividend growth rate. At least 8%.
I am comfortable with an 8-10% range for several reasons:
- Farmer Mac has averaged 8% asset growth over the past two decades.
- National farm mortgage debt grew by 5% a year since 1990. Farmer Mac’s GSE advantage allows it to take market share while still generating high returns.
- Farmer Mac is making a material push into its relatively new opportunity to make rural infrastructure and alternative energy project loans. Solar and wind energy lending certainly seems like a material opportunity.
Farmer Mac dividend analysis step #3: The stability of future dividends. It’s high. I mean really high.
Farmer Mac, like other financial institutions, has three primary risks – liquidity, interest rate and credit. Farmer Mac scores very low on all three risks.
For further details see:
Farmer Mac: An Academic's Case For Higher Value