We believe that Procter & Gamble (PG) is a high quality company with a Business Quality Score of 7 based on a scale of 1 to 10 (10 is best). Also, shares of Procter & Gamble appear to be undervalued based on a discounted cash flow analysis. Procter & Gamble stock would need to rise about 22% to reach fair value based on the closing price of $75.75/share on 02-08-2013.
Procter & Gamble is in the consumer staples business manufacturing many well-known products such as Tide laundry detergent. Due to the extensive nature of its operations, we thought it best to refer to the company's 10-K annual report in order to best describe its business.
Health Care: We compete in oral care, feminine care and personal health. In oral care, there are several global competitors in the market, and we have the number two market share position with over 20% of the global market. We are the global market leader in the feminine care category with over 30% of the global market share. In personal health, we are the global market leader in nonprescription heartburn medications behind our Prilosec OTC brand and in respiratory treatments behind our Vicks brand. Certain of our sales outside the U.S in personal health are generated through the PGT Healthcare partnership.
Fabric Care and Home Care: This segment is comprised of a variety of fabric care products, including laundry detergents, additives and fabric enhancers; home care products, including dishwashing liquids and detergents, surface cleaners and air fresheners; batteries; and pet care. In fabric care, we generally have the number one or number two share position in the markets in which we compete and are the global market leader, with over 25% of the global market share, primarily behind our Tide, Ariel and Downy brands. Our global home care market share is over 15% across the categories in which we compete. In batteries, we have over 25% of the global battery market share, behind our Duracell brand. In pet care, we compete in several markets in the premium pet care segment, with the Iams and Eukanuba brands. The vast majority of our pet care business is in North America, where we have approximately a 10% share of the market.
Baby Care and Family Care: In baby care, we compete mainly in diapers and baby wipes, with approximately 35% of the global market share. We are the number one or number two baby care competitor in most of the key markets in which we compete, primarily behind Pampers, the Company's largest brand, with annual net sales of approximately $10 billion. Our family care business is predominantly a North American business comprised largely of the Bounty paper towel and Charmin toilet paper brands. U.S. market shares are over 40% for Bounty and over 25% for Charmin.
Global Operations is comprised of our Market Development Organization (MDO), which is responsible for developing go-to-market plans at the local level. The MDO includes dedicated retail customer, trade channel and country-specific teams. It is organized along five geographic units: North America, Western Europe, Central & Eastern Europe/Middle East/Africa (CEEMEA), Latin America and Asia, which is comprised of Japan, Greater China and ASEAN/Australia/India/Korea (AAIK). Throughout MD&A, we reference business results in developing markets, which we define as the aggregate of CEEMEA, Latin America, AAIK and Greater China, and developed markets, which are comprised of North America, Western Europe and Japan.
Business Quality Analysis:
Procter & Gamble has a Business Quality Score of 7 out of 10 based on an analysis of historical data. We assign a Business Quality Score to each company undergoing analysis. The score is based on a scale of 1 to 10 with a value of 10 indicating the best possible Business Quality Score. Our Business Quality Score is a proprietary metric which takes into account the 10 year historical performance of the company. Performance is measured considering the absolute performance (and trends) in revenues, earnings, profit margins, and returns on assets/equity.
Low Business Quality Scores (3 or lower) indicate companies that are in a cyclical or commodity business. These businesses have erratic revenues and earnings with associated low profit margins and poor returns on capital. Low quality companies operate in highly competitive/cyclical businesses where consistent profits are nearly impossible to achieve.
High Business Quality Scores (7 or higher) indicate companies that are in high quality businesses with some type of durable competitive advantages that keep competitors at bay. These businesses typically have steadily rising revenues and earnings with associated high profit margins and good returns on capital.
Procter & Gamble's revenues have preformed reasonably well over the last 10 years growing at an annualized rate of about 7%. Revenues have risen steadily each year with the exception of 2009 and 2010. However, revenue growth in 2009 was not bad considering the horrible economic conditions at the time. Revenue growth has not been great the last 4 years, but we believe the future annualized revenue growth will return to an easily achievable 7% rate over the next 10 years.
Earnings Per Share:
Procter & Gamble has steadily grown earnings over the nine year period from 2003 to 2011 at an annualized growth rate of 8.7%. This is a reasonable growth rate which we believe will continue in the future. 2012 was a bad earnings year for Procter & Gamble that we feel will not be repeated in the near future.
A company's earnings per share is a measure of profitability for a company. The earnings per share is calculated by dividing the net income attributable to the common stock by the average number of common shares outstanding. One drawback in using earnings as a profitably measure is that it does not consider the amount of assets needed to generate the earnings. Earning the same profit using fewer assets is more profitable but this is not captured in the earnings per share calculation.
High quality companies will have steadily rising earnings that do not vary greatly through a full business cycle (expansion-recession-expansion). Investing in high quality companies is fairly easy assuming an investor has realistic profit expectations and has the patience to wait for a reasonable stock price relative to the company's value.
Lower quality (cyclical) companies will have earnings that vary greatly over a business cycle. Often these cyclical companies will experience a drastic reduction in earnings during economic recessions. Investment profits can be had with investments in cyclical companies, but the timing of the buying and selling of the investment must be in sync with the ebb and flow of the stock market. Typically, the stock market will start to recover about 6 months before the economy comes out of recession. However, this point in time is not obvious in the moment and is only known later with the benefit of hindsight. Furthermore, timing when to sell a cyclical stock is even more difficult. Timing the stock market is a matter of luck so it is best to stick with the higher quality stocks where market timing is not as critical to investing success.
Operating Profit Margin:
Procter & Gamble has had consistently high operating profit margins in the range of 22.0% to 24.3% over the last 10 years. This is excellent performance because few companies have operating profit margins that are so consistent. 22.0% to 24.3% is a very tight range that shows how consistent Procter & Gamble's business has been over time.
The operating profit margin is earnings before interest and taxes are paid divided by net revenues. As a rule of thumb, consistent operating profit margins in the range of 15% to 20% or higher is an indicator of a good company with some type of durable competitive advantage. One exception to this rule of thumb is the retailing sector where operating margins in the 5% to 10% range are the norm even for great companies. One thing to look for is the trend in the operating profit margin. Ideally, the operating profit margin should be steady or rising over the past 10 years.
Net Profit Margin:
Procter & Gamble has had consistently high net profit margins in the range of 11.0% to 14.5% over the last 10 years. This is excellent performance as the net profit margin has consistently been above 11.0% over the last 10 years.
The net profit margin is net income divided by net revenues. For non-retailing companies, a consistent net profit margin of 7% or higher is an indicator of a good company with some type of durable competitive advantage. In the retailing sector a net profit margin in the range of 3% to 6% is the norm even for the best companies. Ideally, the net profit margin should be steady or rising over the past 10 years.
Return On Assets:
Procter & Gamble has had a consistently high return on assets in the range of 7.5% to 12.9% over the last 10 years. This is good performance but it would be better if the return on assets showed an upward trend instead of showing a downward trend from 2004 through 2007. The big change in the return on assets was caused by the acquisition of Gillette in 2005 in a $57 billion deal. Procter & Gamble's total assets more than doubled due to the acquisition. More recent data shows that the trend from 2007 through 2012 is range bound (flat trend) in the range of 7.5% to 8.9% which is good for such a large company.
Return on assets is a measure of how much profit is generated from a company's assets independent of how much debt is used to finance the acquisition of those assets. The return on assets is sometimes a better measure of profitability than return on equity because the return on equity can be significantly increased by adding more debt to a company's balance sheet. Adding more debt to a company can inflate profits but comes at the price of a greater risk of bankruptcy. Measuring profitability using the return on assets does not have this problem because to calculate the return on assets the net income plus the interest expense net of income tax savings is divided by the average total assets of the company. Thus, by dividing the net income (adjusted for the affects of debt financing) by the total assets (debt + equity) of the company, it cancels out the positive effects of debt. The return on assets is great for comparing the profitability of companies with different levels of debt in their capital structures. Generally speaking, a consistent return on assets of about 7% or more is a good indication of a good business with some type of durable competitive advantage. One exception to this rule of thumb is the banking sector where a return on assets of just 2% is considered exceptional.
Return On Equity:
Procter & Gamble has had a consistently high return on equity in the range of 16.3% to 45.7% over the last 10 years. This performance is good but the fact that the trend was downward in years 2005 through 2007 is an item of concern. However, the reason for the change in return on equity is that Procter & Gamble bought Gillette ($57 billion deal) in 2005 thus greatly increasing its shareholders' equity.
Return on equity measures a company's performance in financing and using assets to generate earnings. In contrast to the return on assets, the return on equity considers the effect of financing in generating profits. To calculate the return on equity, the net income (minus dividends paid on preferred stock) is divided by the average common shareholders' equity. As a rule of thumb, a consistent return on equity of 15% or more (assuming a reasonable level of debt financing) is an indicator of a good company with some type of durable competitive advantage.
Dividends Per Share:
Procter & Gamble is a dividend champion showing steadily increasing dividends over the last 10 years. The dividend has grown at an annualized growth rate of 10.1% over the last decade.
Payment of dividends can be a great indicator of a well managed company. It shows the company's management has the discipline to return profits to shareholders instead of using these profits to make investments that earn poor returns on capital. Sometimes the payment of dividends is a good indicator that a company has accurate accounting practices. A company that has a history of low debt levels and a high percentage of earnings paid out as dividends is very unlikely to be cooking the books. It would be nearly impossible for a company with consistently low debt levels to payout dividends over a long period of time if the company was generating fictitious earnings.
A discounted cash flow analysis reveals a fair value for Procter & Gamble of $92.16/share. We use the percent of revenue method in our discounted cash flow analysis. The model assumes an average weighted cost of capital (WACC) of 7.2%. Our WACC is calculated using a proprietary formula unique to our firm. An average annualized revenue growth rate of 7% is projected over the next 10 years. An average annualized revenue growth rate of 5% is assumed for every year thereafter.
Procter & Gamble appears to be a high quality company with an undervalued stock price. Based on a fair value of $92.16/share and the Procter & Gamble closing stock price of $75.75/share (on 02-08-2013) the stock must rise 21.7% to reach fair value.
Disclaimer: Ulfberht Capital is not an investment advisor. This article is not a recommendation to buy or sell securities. Always consult your investment advisor before making any investment decision.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in PG over the next 72 hours.