Procter & Gamble (NYSE:PG) trades at a multiple of 19.35 times year end June-2013 earnings. At first glance that looks expensive. Yet, it also trades with a dividend yield of 3.1%, which is a substantial premium to market yields: and that suggests it is cheap.
Procter & Gamble has a beta based on a five year regression, adjusted for beta's tendency to converge to 1, of 0.65. Based on a long-term risk free rate of 4.5%, and a long-term equity risk premium of 5.75%, we arrive in an expected market return of 10.25%. The capital asset pricing model, which adjusts market returns for risk as measured by beta, suggests that investors should expect a long-term return of 8.25% [Risk Free Rate + Beta * (Market Return - Risk Free Rate)] from the stock. The good news is that 3.1% of the total return of 8.25% comes from dividends, which leaves a target gain from price appreciation of 5.15%.
The question to answer is whether Procter & Gamble trading at $78.38 recently, is it priced to deliver a long-term return of 8.25%? In my view, Procter & Gamble is priced to deliver total annualized returns of 10.75%, if forward earnings growth expectations revert to a ten year annualized rate of about 7.75%. If this growth expectation is achieved, Procter & Gamble presents an opportunity to capture 2.50% of alpha: that is a total return of 10.75% minus the risk adjusted long-term return expectation of 8.25%.
A reversion in forward growth to 7.75% is quite a leap of faith to make given that over the last five years, earnings at Procter & Gamble has grown at an annualized growth rate of 2.16%, and 1.99% of that growth has been driven by buybacks rather than by growth in earnings. In recent years, Procter & Gamble has slipped up. They have not slipped up as far as the quality of their product portfolio is concerned. Rather, they have slipped up in competitive positioning, mainly driven by what is seen as poor pricing and marketing policy. They continue to have an attractive product portfolio. With Mr. McDonald's retirement last year, and the return of Mr. Lafley as CEO, there is much hope. After all Mr. Lafley led Procter & Gamble as CEO during 2000 to 2009, a period when Procter & Gamble grew earnings at an average rate of near 10% annually. My forward growth expectation of 7.75% may sound crazy to some given recent performance, but do bear in mind that five analysts on Reuters estimate average long-term growth rates of 8.7% with a high estimate of 10% and a low estimate of 6.7%. I may be crazy, but I'm not alone!
Procter & Gamble operates in the Consumer Staples sector. This sector is seen as a defensive sector by most investors. Typically, in this sector, we will find low beta companies, with lower sustainable long-term growth rates, and less volatility in earnings growth in the sector. We also expect to find healthy dividend yields. This sector profile is attractive with the markets priced as they are. But more importantly, we must also consider the forward prospects for this sector.
The Consumer Staples sector has high reach to emerging markets, which is where long-term growth expectations are high. But emerging market growth is more volatile. Thus while we can expect companies in the Consumer Staples to grow faster, we can also expect more volatility in that growth. And earnings volatility will mean beta's that creep up towards one, perhaps faster than most expect. It will also mean faster growth than most people expect. Today, expectations from emerging markets are set low because of typical cyclical volatility. When the emerging market growth cycle does reverse, expectations will be reset, and in all likelihood, expectations will climb higher than they should. Buying when expectations are low is often a good idea.
What is Procter & Gamble worth to an investor looking for a long-term return expectation of 8.25% and the following expectations?
- Sustainable earnings of $3.75. Sustainable earnings what a company can be expected to earn over the course of a typical economic cycle of six years. I estimate cyclically adjusted earnings as median earnings over a six-year period. It is the level of earnings which can be expected to grow at the projected long-term growth rates, notwithstanding departures from the long-term growth rates in the short-term. This is a very conservative estimate, considering $4.05 in earnings during the year ended 30 June 2013.
- Long-term growth rate of 5.25%, which is in-line with earnings growth seen during the year ended 30 June 2013. This is a very conservative growth estimate, especially considering that earnings growth in the year to 30th June 2014 is expected to come in at over 8%.
- Adjusted payout potential of 60%. The adjusted payout potential is that part of sustainable earnings that we can expect the company to return to shareholders via dividends and buybacks. The average adjusted payout ratio over the past six years has run at 60.25%, with about 50% of earnings being utilized to pay dividends, with the remainder being used to buy-back shares.
Mathematically it is calculated as Sustainable Earnings * [1 + Long-term Growth Rate] * Adjusted Payout Ratio / [Long-term Return Expectation - Long-term Growth Rate], that is $3.75 * 105.25%*60%/(8.25% - 5.25%) or $78.93. The stock presently trades at $78.38. Thus the stock is rightly priced - neither cheap, nor expensive. And it reflects what the market is pricing.
In my view, priced as present, Procter & Gamble will deliver a long-term total return of near 10.75%: that is the 8.25% required rate of return computed using the capital asset pricing model, plus alpha of 2.50%, being the difference between the 5.25% growth expectations priced by markets, and the near 7.75% growth which I expect.
For those of you who like viewing historic data, I have included several data tables covering sales, earnings, book value, share count and dividends over the past several years. This data is a combination my analysis and information from a Value Line report, which you can download here.
Source: Shares O/S from Value Line data which can be downloaded here. Rest is my analysis.
Source: Book Value per Share [BPS] from Value Line data which can be downloaded here. Rest is my analysis.
Source: Dividend per Share [DPS] from Value Line data which can be downloaded here. Rest is my analysis.
Source: Earnings per Share [EPS], Average PE, and Relative PE from Value Line data which can be downloaded here. Rest is my analysis.
Source: Sales per Share [SPS] from Value Line data which can be downloaded here. Rest is my analysis.
Disclosure: I am long PG. 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.