In this article we are going to show that Procter & Gamble stock is undervalued according to Buffett's owner earnings style analysis. Revenue is stable, the company has a long track record and large amounts of brand value, which creates a moat against shocks and instability.
P&G (PG) has been paying a dividend for 122 consecutive years since its incorporation in 1890 and has increased its dividend for 56 consecutive years at an annual compound average rate of approximately 9.5%.
We believe the stock presently is a good income opportunity with a good margin of safety.
The company sells consumer products in the segments of beauty, grooming, healthcare, fabric care/home care and baby/family care. It owns reputable and popular brands such as Duracell, Gillette, Oral-B and Pampers. It has significant international presence with the U.S. only being responsible for 35% of revenue.
The biggest strength the company has is its reputation for good products and good brands. That is a big asset on its balance sheet that does not show up in GAAP financials.
Thesis & Catalyst For Procter & Gamble Co.
We built an excel file with a FCF valuation model using Buffett's measure of "owner's earnings." Warren Buffett is known for being skeptical for conventional valuation models that rely on GAAP such as price-to-earnings ratio and the like. He defined one of his methods in the 1986 Letter to Shareholders:
These represent (A) reported earnings plus (B) depreciation, depletion, amortization, and certain other non-cash charges...less (C) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume....Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since must be a guess - and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes...All of this points up the absurdity of the 'cash flow' numbers that are often set forth in Wall Street reports. These numbers routinely include plus - but do not subtract .
The assumptions made in the model were:
- Free cash flow (owner's earnings) were defined as Operating cashflow minus Capex minus plus Proceeds from Asset sales. Why not use the company's own methodology of operating cash flows minus capex?I believe this methodology would give a distorted picture because asset sales represent some kind of recovery value from old capex and M&A so it reduces the cost of those operations, it makes the free cash flow numbers more realistic (those proceeds are available to buyback stock and pay out as dividends).
- The company will have a growth period where it's free cash flow will grow by 8% for 20 years (against the historical 10.8% since 1992, that was as far back as I could get EDGAR data for) then slow to 5% into infinity. This represents a period of global growth followed by growth slowing to more sustainable levels and PG's earnings growing in line with world nominal GDP (5% is my projection for long-term world nominal GDP, which is a decline from the historical 7% over the last few decades).
- The company's required return is 8.5%. CAPM would suggest 2.86% + 0.23 (10%-2.86%) = 4.5% but I believe that is too low given the history of M&A of this company (since 1992 M&A cashflows have been almost 30% of operating cashflows, they like to buy others out) plus its liabilities-to-equity ratio is also significant (more than 1). The fact that the company engages in so much M&A is a concern because M&A is a major way in which shareholder value gets destroyed and wasted (just look at HPQ). One can use a higher or lower required return in the excel file if one disagrees with these assumptions.
- I decreased the free cash flow by 20% as a starting value in the valuation to take into account for cashflows that are not available to shareholders due to costs such as non-recurring losses, litigation, restructuring costs, and other non-operating costs, etc. This is in line with Buffett's skepticism that measures are often too high due to a lack of subtractions and it provides a margin of safety against unexpected costs and cash charges.
Plugging these assumptions in the Excel file and calculating the fair value for the stock (through present value of future cash flows), we arrived at a stock price of $115 per share. But the issue with owner's earnings is that you don't really own the company and thus have no control over what the free cash flow is used for, the timing and size of dividends, buybacks etc. The control premium of a business is usually valued at 20%-30% in the U.S., if we decrease the fair value by 25% we reach the fair value of $86.48 per share, which would represent a 24.62% increase from current levels.
The stock currently has a owner earnings yield of 6.3%. If the stock were to close that valuation gap over the next 10 years, stock investors can expect returns (including dividends) of almost 10% a year, likely more if our assumptions prove too conservative.
PG stock is undervalued according to a conservative model based on Buffett's owner's earnings methodology. It has a 3.3% dividend yield plus a long track record of dividend increases along with stable business operations. The international diversification provides further protection against shocks. We believe the stock represents a safe income opportunity for anyone with a long horizon who won't panic due short-term factors hitting the headlines, especially when compared with alternative investments in long duration fixed income in the U.S.