On their website, Procter & Gamble (PG) states that:
Three billion times a day, Procter & Gamble brands touch the lives of people around the world.
Long considered one of the “World’s Most Admired Companies” (#6 in Fortune Magazine’s list) and one of the most innovative companies (#12 Business Week’s 2009 ranking), Procter & Gamble’s (PG) quality products can be found in most households in more than 180 countries worldwide.
Therefore, we feel little needs to be said about the quality of this fine company and its prospects for continued operating excellence long into the future. We feel the real story here is one of opportunity based on unprecedented undervaluation.
Consistent Earnings Growth
Looking at Procter & Gamble Co. (PG), with the perspective provided by our Graham Dodd earnings driven Fundamentals-at-a-Glance tool, tells a compelling story.
Figure 1 below shows that Procter & Gamble (PG) has consistently grown earnings at a remarkable rate of 11.9% since 1990 (green shaded area). Dividends paid out of these earnings to shareholders have followed suit (light blue shaded area) with a compounded growth rate at over 11% per year correlating to earnings growth.
The story becomes very compelling when you overlay monthly closing stock prices and see how closely they correlate to earnings over this almost 20-year period (19 years, 7 months).
As can be seen from Figure 2, the price line (black) closely follows and therefore strongly correlates to earnings (dark green line with white triangles) with the exception of two periods. The first was marked by overvaluation and spanned over most of 1997, 1998 & 1999 (red circle).
Note how abruptly the price fell back to earnings justified value over the spring of calendar year 2000. From this point, stock price once again followed earnings with the expected normal volatility until the fall of calendar year 2008.
Since earnings held up nicely this precipitous drop is attributed to panic and represents historically extreme undervaluation (blue circle).
FIGURE 2: PG 20 year GDF Earnings to Price Correlation (see short video)
The current PE ratio of just over 13 is the lowest valuation that Procter & Gamble (PG) has traded at going all the way back to 1990. The normal PE ratio for this blue chip stalwart has hovered around 20. The green line with white triangles on Figures 1 & 2 equals a normal PE ratio of 20.8 (GDF-EDMP 20.8).
Since 1990, Procter & Gamble (PG) represents a poster child for the controversial buy and hold strategy, even at today’s depressed price. The combination of growing earnings coupled with a correlated increasing dividend richly rewarded shareholders since 1/31/1990. See Figure 3 below.
The Importance of Valuation
However, to accentuate the importance of valuation look how devastating overvaluation is to shareholder returns. On 12/31/1999, Procter & Gamble (PG) was trading at an overvalued price of $54.78 (red arrow). Its earnings justified and normal valuation on that date was only $35.24 (yellow arrow).
Therefore, even though earnings grew at almost 11% (10.8%) shareholder returns were an anemic one-tenth of one percent compounded excluding dividends and only 2% compounding including dividends. (See Figures 4 & 5 below.)
FIGURE 4: PG 10 year Earnings to Price Correlation (see short video)
Return to Normal Valuation
We believe that today’s undervalued price for Procter & Gamble (PG) represents a mirror image of the past ten years. Just as it was logical, and in our view inevitable, for Procter & Gamble’s (PG) price to fall to earnings justified levels when it was overvalued, the opposite equally applies.
Therefore, at today’s compelling low valuation shareholders can rationally expect a valuation kicker going forward. The current consensus of leading analysts, reporting to First Call, expect Procter & Gamble’s (PG) long-term growth rate to continue at 10% or better.
Consequently a return to a normal 20 PE ratio should drive returns above the customary 10% - 12% that shareholders have traditionally enjoyed. Add a 3% current dividend growing at 10% per year and the total return opportunity becomes extraordinary for such a low-risk holding.
We don’t expect any major surprises when Procter & Gamble (PG) reports fiscal 2009 earnings in a few weeks. Although they are currently expected to experience a rare down year in fiscal 2010, it should only be a modest decline. Most companies in the world can only look with envy upon the strength Procter & Gamble (PG) demonstrated through the recession.
We think that Procter & Gamble (PG) today represents a compelling investment choice for prudent investors with a long-term horizon. We believe that long term implies a holding period of at least three to five years representing a typical business cycle. Procter & Gamble’s stock may never be this cheap again based on valuation.
Full disclosure: Long PG at the time of writing.