China's Coming Baby Boom: Procter & Gamble Will Benefit, But Should You Buy It?

| About: The Procter (PG)

On November 15, 2013 the Chinese government announced, after the Third Plenum policy meetings in Beijing, that it would allow married couples to have two children if at least one spouse is an only child. Therefore is can be assumed that millions of couples in China meet the criteria to have a second child because of the previous one child per family rule. Seeing this as a great opportunity to make some money, I decided to investigate further and after two weeks of intense research, I stumbled across this

"Procter & Gamble (Guangzhou) Ltd comfortably leads nappies/diapers/pants in China, with a value share of 46% in 2012, up by almost one percentage point over 2011. Procter & Gamble's high brand awareness and developed distribution network across China have established its outstanding position in nappies/diapers/pants during the review period. The company has nurtured a loyal consumer base in the country with its frequent new product launches, upgraded existing product lines as well as aggressive advertising via various media."

Clearly after reading that Procter & Gamble (NYSE:PG) has a 46% market share in nappies, diapers and pants, I knew I had found what I was looking for. But over the years, experience has taught me that just because you get the story right does not mean that you will necessarily make money, particularly if the company's share price is fully valued. Therefore before buying Procter & Gamble I decided to put it through a free cash flow analysis.

This analysis will use the following six free cash flow ratios:

  • CapFlow
  • FROIC
  • Price to Mycroft Free Cash Flow
  • Mycroft/Michaelis Growth Rate
  • Free Cash Flow Payout Ratio
  • Free Cash Flow Reinvestment Rate

Those new to this analysis can find an introduction by going here that will explain in detail how each of these ratios is calculated. When used together, these unique ratios will generate a quantitative picture of a company's underlying fundamentals, including strengths and weaknesses.

Click to enlarge

The "2014 Mycroft Free Cash Flow Per Share" estimate, shown in the table above, is generated by taking the trailing twelve months (NYSE:TTM) free cash flow result for Procter & Gamble and then adding my Mycroft Michaelis Growth Rate into the equation in order to generate forward looking estimates for 2014. That growth rate is generated by using my FROIC ratio (Free Cash Flow Return on Invested Capital). Basically FROIC tells us how efficient operations are as it zeros in on how much free cash flow is generated for every $1 of total capital employed. Procter & Gamble has a FROIC of 12%, which means that for every $100 of invested capital, the company generates $12 in free cash flow. Now my Mycroft/Michaelis Ratio takes that 12% and multiplies it by the firm's free cash flow reinvestment rate. The reinvestment rate that I use is a free cash flow reinvestment rate instead of the standard one used by analysts that simply uses net income:

Free Cash Flow Reinvestment Rate = 100% - (Free Cash Flow Payout Ratio).

Or;

Free Cash Flow Reinvestment Rate = 100% - (Total Dividend/Total Free Cash Flow).

By replacing net income in the payout and reinvestment ratios with free cash flow, I am thus able to make my analysis more precise by incorporating capital spending (Cap Ex) into the equation.

Therefore from this we can determine that Procter & Gamble has a reinvestment rate of 38% and went on to use 62% of its free cash flow to pay out its dividend. Thus by taking 12% (FROIC) x 38% = 4.56% (rounded off to 5%). From there we add the dividend yield of 2.8% (rounded off to 3%) and we have a Mycroft/Michaelis growth rate of 5% + 3% = 8%.

Procter & Gamble's Mycroft Free Cash Flow per share of $4.20 was generated by taking its TTM free cash flow per share and multiplying it by (100% + 8% or 1.08). Once we have our result, we then take its current market price of $83.84 and divide it by $4.20 and get a Price to Mycroft Free Cash Flow result of 19.96. I consider a Price to Mycroft Free Cash Flow per share result of less than 15 to be good for purchase, and anything under 7.5 to be excellent.

Click to enlarge

The higher you go above 15, the more overvalued a company becomes. I use a Price to Mycroft Free Cash Flow per share result of 22.5 as my sell price, and 45 as my short price.

An appropriately priced stock should trade around a Price to Mycroft Free Cash Flow per share result of 15. This benchmark result was determined by backtesting.

Buy (opinion) = A Price to Mycroft Free Cash Flow per share result of less than 7.5 is considered excellent (50% below the initial Hold level), and anything under 15 is attractive.

The result I give as my Buy opinion in the table above uses a Price to Mycroft Free Cash Flow per share result of 7.5.

Hold (opinion) = 15 to 22.5 (I use 15 in the table).

Sell (opinion) = 22.5 or higher (50% above the initial Hold level). (I use 22.5 in the table).

Short (opinion) = 45 or greater. The Price to Mycroft Free Cash Flow per share result of 45 was determined by going back to the peak of the market (in the year 2000) and averaging the Price to Free Cash Flow per share results for the key players at that time. (I use 45 in the table).

The CapFlow ratio result that you see in our first table above is an original ratio I created in order to tell me how much Capital Spending is used as a percentage of Cash Flow. A result of less than 33% is considered ideal and with Procter & Gamble coming in at 27%, means that 73% of the company's cash flow is actually free cash flow and can be used for such things as buying back stock.

In conclusion, though Procter & Gamble may have a 46% market share in nappies, diapers and pants in China, my research shows that the company's upside is rather limited as it is approaching my sell price opinion. In a best case scenario it will take at least another 9 months before the first babies start showing up, so we have plenty of time to watch the progress and continue to follow how Procter & Gamble will prepare for the coming Chinese baby boom. We in fact do not have any concrete estimates as to how large this baby boom will be, so the smart move to make is to wait and make adjustments as the data starts coming in.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.