by Amanda Repp, Rob Weigand and Cheng Xi.
August 2009 has been a good media month for Proctor & Gamble (PG). Morningstar declared the stock was undervalued, Barron’s included PG on a list of “12 Quality Stocks Ready to Rally,” and last week Dividends Value and iStockAnalyst recommended PG based on the company’s record of increasing dividends for 55 straight years. In light of all this recent interest in the stock, we decided to evaluate PG’s financial health and relative valuation. We’ll start with a recap of PG’s 5-year and 6-month returns vs. the S&P 500. The chart below shows that PG’s returns lagged the S&P 500 from 2004-2007, and the stock has matched the market’s 5-year return only because it exhibited less of a decline during the 2008-09 bear market. Overall, it’s been a lackluster stock for the past 5 years.
Like many other “high quality” stocks, PG has been left in the dust over the last 5-6 months as the market rallied off its lows from March 2009:
Several MBA students starting our Applied Portfolio Management program ran PG through our fundamental analysis process to determine if the stock was legitimately undervalued. Our modeling process includes forecasting a company’s financials using a set of stressful, below-average assumptions, and then determining if, under these assumptions, the company still appears financially healthy and their stock registers as undervalued based on a discounted cash flow (DCF) model. (We obtain our data via our subscription to Thomson/Reuters Baseline Direct.)
The table below shows the key assumptions we used in forecasting PG’s financials. The main stressor we threw into the forecast was growing future revenues more slowly than the “high single digits” expected by several of the articles cited above.
We also increased PG’s forecasted beta to 0.8, higher than the 5-year historical value of 0.6, which increases the cost of capital and dampens the DCF valuation estimates. We also took some energy out of the future dividend growth rate, which bloats the forecasted balance sheets with excess cash — this suppresses some of the forecasted value creation metrics such as Net Operating Profit After Tax (NOPAT), Free Cash Flow (FCF), and Economic Value Added (EVA).
PG’s relative valuation appears attractive compared to other brand-management and personal care stocks such as Clorox (CLX) and Avon (AVP). PG’s price-to-cash flow of 10 is lower than both of these stocks, whose P/CF ratios are over 14.
PG also trades at a lower P/E multiple than either CLX or AVP.
PG’s EPS and DPS display good historical growth, although earnings were flat in 2009, and the dip in 2010E reflects our conservative modeling assumptions. After 2010E, however, our model indicates that PG will be able to resume growing profits and dividends.
PG has large and stable profit margins historically. Consistent with a conservative modeling approach, our model results in a slight contraction of PG’s gross, operating and net margins in the forecast period. At an average operating margin of 18% and average net margin of 12%, however, PG should exhibit the same consistent profitability as it has in the past.
PG’s Return on Invested Capital (ROIC) is consistently above 40%, and exceeded 50% in 2008 and 2009. Our model tapers ROIC back down to the low 40s throughout the forecast period. The spread of ROIC over the cost of capital is a key component of value creation; PG’s spread of over 30% is large and significant. Return on Assets (ROA) and Return on Equity (ROE) are stable and healthy between 8-10% and 15-18%, respectively.
PG’s NOPAT and FCF declined slightly in 2009; these metrics are forecasted to decline again due to sluggish sales growth in 2010. Beyond 2010, however, we forecast that, even with sales growth averaging well below 5% per year, PG can continue growing NOPAT and FCF, which will drive long-term shareholder value creation.
The chart below shows that PG is on pace to create over $10 billion in Economic Value Added (EVA) in 2009, despite a difficult macroeconomic environment. We forecast that PG’s EVA will rise steadily from 2011-2019, fueling gains in Market Value Added (MVA). PG’s MVA is expected to rise from $130B to $160B over the next decade.
Below we overlay PG’s historical year-end stock price 2005-2009 (2009 price as of 08.28.09) with our year-by-year forecasted price from a discounted cash flow model 2010-2019. PG closed at $53 on August 28 — we forecast a 2010 fair DCF price in the range of $65-$67, with their DCF price ranging as high as $87 by 2019. These capital gains are in addition to the 3.3% dividend, of course. Further notice that this modest price path is forecasted along with contraction of PG’s Price/Sales and Enterprise Value/EBITDA ratios over the next 10 years. These DCF valuations can therefore be interpreted as more of a worst-case scenario for PG.
As an important part of any “Buy” thesis for PG rests on their ability to maintain and grow dividends, we also run several earnings quality tests, including the Piotroski 11-point Financial Fitness Scorecard (historical and forecasted values shown below) . . .
. . . and the Altman Bankruptcy Z-score. PG averages 8 out of 11 on the Piotroski test, and consistently scores in the low Safe Zone and/or high Grey Area based on the Altman test. We interpret these results — along with the company’s 55-year record of growing dividends — as evidence that PG is sufficiently financially stable to maintain and grow dividends according to investors’ expectations.
Additionally, PG has not attracted significant interest from short sellers since 2005. Many firms experienced a similar surge in short interest in Fall 2008 after the failure of Lehman Brothers.
As shown by the chart below, the surge in short interest in 2008 was proportional to an increase in PG’s volume, which explains why PG’s Days to Cover ratio has been stable for the past 3 years.
The last chart shows PG’s cumulative insider trading since 2004. For a large company, cumulative selling of $50 million in stock is not significant; insiders of most large companies are net sellers over time as they attempt to diversity their holdings. Since September 2008, PG’s insiders have actually slowed their selling; insiders of many comparable companies have been increasing selling over the same period.
Overall, our analysis suggests that, from a fundamental perspective, PG is a solid play for dividend-focused investors. The stock’s dividend yield of 3.3% is approximately equal to the yield on a 10-year T-note (about 3.5%). Of course, the company faces potential headwinds if consumers shy away from the premium brands in their portfolio and resist the company’s “trade up” strategy. Even if sales growth over the long term is half of what it’s been in the past 5 years, however, our analysis indicates the company is likely to be a slow and steady, albeit unexciting, value creator over the long run. We rate the stock a tepid “Buy.”
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Financial Market Commentary
Procter & Gamble: A Good Opportunity for Buy and Hold Investors
by Amanda Repp, Rob Weigand and Cheng Xi.
August 2009 has been a good media month for Proctor & Gamble (PG). Morningstar declared the stock was undervalued, Barron’s included PG on a list of “12 Quality Stocks Ready to Rally,” and last week Dividends Value and iStockAnalyst recommended PG based on the company’s record of increasing dividends for 55 straight years. In light of all this recent interest in the stock, we decided to evaluate PG’s financial health and relative valuation. We’ll start with a recap of PG’s 5-year and 6-month returns vs. the S&P 500. The chart below shows that PG’s returns lagged the S&P 500 from 2004-2007, and the stock has matched the market’s 5-year return only because it exhibited less of a decline during the 2008-09 bear market. Overall, it’s been a lackluster stock for the past 5 years.
Like many other “high quality” stocks, PG has been left in the dust over the last 5-6 months as the market rallied off its lows from March 2009:
Several MBA students starting our Applied Portfolio Management program ran PG through our fundamental analysis process to determine if the stock was legitimately undervalued. Our modeling process includes forecasting a company’s financials using a set of stressful, below-average assumptions, and then determining if, under these assumptions, the company still appears financially healthy and their stock registers as undervalued based on a discounted cash flow (DCF) model. (We obtain our data via our subscription to Thomson/Reuters Baseline Direct.)
The table below shows the key assumptions we used in forecasting PG’s financials. The main stressor we threw into the forecast was growing future revenues more slowly than the “high single digits” expected by several of the articles cited above.
We also increased PG’s forecasted beta to 0.8, higher than the 5-year historical value of 0.6, which increases the cost of capital and dampens the DCF valuation estimates. We also took some energy out of the future dividend growth rate, which bloats the forecasted balance sheets with excess cash — this suppresses some of the forecasted value creation metrics such as Net Operating Profit After Tax (NOPAT), Free Cash Flow (FCF), and Economic Value Added (EVA).
PG’s relative valuation appears attractive compared to other brand-management and personal care stocks such as Clorox (CLX) and Avon (AVP). PG’s price-to-cash flow of 10 is lower than both of these stocks, whose P/CF ratios are over 14.
PG also trades at a lower P/E multiple than either CLX or AVP.
PG’s EPS and DPS display good historical growth, although earnings were flat in 2009, and the dip in 2010E reflects our conservative modeling assumptions. After 2010E, however, our model indicates that PG will be able to resume growing profits and dividends.
PG has large and stable profit margins historically. Consistent with a conservative modeling approach, our model results in a slight contraction of PG’s gross, operating and net margins in the forecast period. At an average operating margin of 18% and average net margin of 12%, however, PG should exhibit the same consistent profitability as it has in the past.
PG’s Return on Invested Capital (ROIC) is consistently above 40%, and exceeded 50% in 2008 and 2009. Our model tapers ROIC back down to the low 40s throughout the forecast period. The spread of ROIC over the cost of capital is a key component of value creation; PG’s spread of over 30% is large and significant. Return on Assets (ROA) and Return on Equity (ROE) are stable and healthy between 8-10% and 15-18%, respectively.
PG’s NOPAT and FCF declined slightly in 2009; these metrics are forecasted to decline again due to sluggish sales growth in 2010. Beyond 2010, however, we forecast that, even with sales growth averaging well below 5% per year, PG can continue growing NOPAT and FCF, which will drive long-term shareholder value creation.
The chart below shows that PG is on pace to create over $10 billion in Economic Value Added (EVA) in 2009, despite a difficult macroeconomic environment. We forecast that PG’s EVA will rise steadily from 2011-2019, fueling gains in Market Value Added (MVA). PG’s MVA is expected to rise from $130B to $160B over the next decade.
Below we overlay PG’s historical year-end stock price 2005-2009 (2009 price as of 08.28.09) with our year-by-year forecasted price from a discounted cash flow model 2010-2019. PG closed at $53 on August 28 — we forecast a 2010 fair DCF price in the range of $65-$67, with their DCF price ranging as high as $87 by 2019. These capital gains are in addition to the 3.3% dividend, of course. Further notice that this modest price path is forecasted along with contraction of PG’s Price/Sales and Enterprise Value/EBITDA ratios over the next 10 years. These DCF valuations can therefore be interpreted as more of a worst-case scenario for PG.
As an important part of any “Buy” thesis for PG rests on their ability to maintain and grow dividends, we also run several earnings quality tests, including the Piotroski 11-point Financial Fitness Scorecard (historical and forecasted values shown below) . . .
. . . and the Altman Bankruptcy Z-score. PG averages 8 out of 11 on the Piotroski test, and consistently scores in the low Safe Zone and/or high Grey Area based on the Altman test. We interpret these results — along with the company’s 55-year record of growing dividends — as evidence that PG is sufficiently financially stable to maintain and grow dividends according to investors’ expectations.
Additionally, PG has not attracted significant interest from short sellers since 2005. Many firms experienced a similar surge in short interest in Fall 2008 after the failure of Lehman Brothers.
As shown by the chart below, the surge in short interest in 2008 was proportional to an increase in PG’s volume, which explains why PG’s Days to Cover ratio has been stable for the past 3 years.
The last chart shows PG’s cumulative insider trading since 2004. For a large company, cumulative selling of $50 million in stock is not significant; insiders of most large companies are net sellers over time as they attempt to diversity their holdings. Since September 2008, PG’s insiders have actually slowed their selling; insiders of many comparable companies have been increasing selling over the same period.
Overall, our analysis suggests that, from a fundamental perspective, PG is a solid play for dividend-focused investors. The stock’s dividend yield of 3.3% is approximately equal to the yield on a 10-year T-note (about 3.5%). Of course, the company faces potential headwinds if consumers shy away from the premium brands in their portfolio and resist the company’s “trade up” strategy. Even if sales growth over the long term is half of what it’s been in the past 5 years, however, our analysis indicates the company is likely to be a slow and steady, albeit unexciting, value creator over the long run. We rate the stock a tepid “Buy.”
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