- It's easy to get lost these days about the concept of value and price. Let's clarify.
- The Valuentum Buying Index is a strong sorting mechanism. Procter & Gamble registers a 4 on the index.
- We compare Procter & Gamble to peers Clorox, Colgate-Palmolive, and Johnson & Johnson.
It's easy to get lost these days about the concept of value and price. For starters, it seems that everyone has a different way to determine value. We know that the only true way to determine value is by calculating the cash flows that a particular company generates--after all, cash is the only thing that matters (a strong economic moat must transfer to strong cash flow to mean anything). And many like to think that value is the price at which a stock trades, which is not true. The price at which a stock trades is its price, and price is often different than value. With that said, let's dig into Procter & Gamble's (NYSE:PG) value. You can look up its price just about anywhere.
For those that don't know Valuentum, we think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors
If a company is undervalued both on a DCF and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. Procter & Gamble posts a Valuentum Buying Index score of 4 on our scale, reflecting our "fairly valued" DCF assessment of the firm, its attractive relative valuation versus peers, and bearish technicals. We compare Procter & Gamble to peers Clorox (NYSE:CLX), Colgate-Palmolive (NYSE:CL), and Johnson & Johnson (NYSE:JNJ). In the spirit of transparency, we show how the performance of our VBI has stacked up per underlying score:
Our Report on Procter & Gamble
Procter & Gamble's Investment Considerations
Procter & Gamble's Investment Highlights
• Procter & Gamble's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively.
• Procter & Gamble boasts some of the most recognized branded consumer packaged goods. Though the markets in which its products are sold are highly competitive, the firm is well-positioned in the industry and holds a significant market share position.
• Procter & Gamble has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 15.9% in coming years. Total debt-to-EBITDA was 1.6 last year, while debt-to-book capitalization stood at 32.4%.
• Procter & Gamble's brands include Tide, Ariel, Gillette, Venus, Bounty, Charmin, Pantene, Olay, Pampers, Crest, Oral-B, Duracell, and Vicks. These brands aren't going away anytime soon, and the
company's innovation pipeline remains robust.
• Procter & Gamble boasts 120+ consecutive years of dividend payments and 55+ consecutive years of dividend increases. Its payout is rock-solid.
Procter & Gamble's Business Quality
Procter & Gamble's Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Procter & Gamble's 3-year historical return on invested capital (without goodwill) is 20%, which is above the estimate of its cost of capital of 9.2%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Procter & Gamble's free cash flow margin has averaged about 11.8% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures, and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Procter & Gamble, cash flow from operations decreased about 18% from levels registered two years ago, while capital expenditures expanded about 29% over the same time period.
Procter & Gamble's Valuation Analysis
The estimated fair value of $74 per share represents a price-to-earnings (P/E) ratio of about 23.7 times last year's earnings and an implied EV/EBITDA multiple of about 13.5 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 4% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 1.9%. Our model reflects a 5-year projected average operating margin of 22.8%, which is above Procter & Gamble's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.5% for the next 15 years and 3% in perpetuity. For Procter & Gamble, we use a 9.2% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $74 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets, as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Procter & Gamble. We think the firm is attractive below $59 per share (the green line), but quite expensive above $89 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Procter & Gamble's fair value at this point in time to be about $74 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Procter & Gamble's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $90 per share in Year 3 represents our existing fair value per share of $74 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
Additional disclosure: PG and JNJ are included in the Dividend Growth portfolio.