It's time to update my valuations on some of the dividend growth favorite consumer staples companies. Consumer staple companies are great for dividend growth investors, because people need to wash their clothes and clean their house whether the economy is booming or busting, which provides for more stable operations. Today, I'm going to look at the consumer staple giant Procter & Gamble (NYSE:PG). Shares of Procter & Gamble closed trading on Friday, April 25th at $81.41, giving a current yield of 3.16%.
Analysts followed by Yahoo Finance expect Procter & Gamble to grow earnings 8.38% per year over the next 5 years, and I've assumed they can grow at 5.59% (2/3 of 8.38%) for the next three years and 3.50% in perpetuity. Running these numbers through a discounted earnings analysis with a 9% discount rate and summing over 30 years yields a fair value price of $82.80. This means the shares are trading at a 1.68% discount to the discounted earnings analysis.
The Graham Number valuation method was conceived of by Benjamin Graham, the father of value investing, and calculates the maximum price one should pay for a company given the earnings and book value. The Procter & Gamble Company earned $3.72 per share over the last twelve months, and has a current book value per share of $25.17. The Graham Number is calculated to be $45.90, suggesting that it's overvalued by 77.4%. Since we invest for the future, let's replace the earnings per share with forward-looking earnings of $4.21 for FY 2014. Keeping the book value per share the same and re-running the calculation gives a fair value of $48.83. Shares are still overvalued by 66.7%.
Average High Dividend Yield:
Procter & Gamble's average high dividend yield for the past 5 years is 3.54%, and for the past 10 years is 2.87%. This gives target prices of $72.77 and $89.65, respectively, based on the current annual dividend of $2.57. I expect that The Procter & Gamble Company's average dividend yield range will more closely resemble the 5-year rate going forward. Growth will be slower for a company as large as Procter & Gamble, so I'll use the 5-year target price in my fair value calculation. Shares are currently trading at a 11.9% premium to the average high dividend yield.
Average Low P/E Ratio:
Procter & Gamble's average low P/E ratio for the past 5 years is 14.14, and for the past 10 years is 16.36. This corresponds to a price per share of $59.52 and $68.87, respectively, based off the analyst estimate of $4.21 per share for fiscal year 2014. I'll use the average of the two low P/E ratio models in my target entry price calculation. This gives a low P/E target of 15.25 and a price target of $64.20. The Procter & Gamble Company is trading at a 26.8% premium to the low P/E ratio valuation.
Average Low P/S Ratio:
The Procter & Gamble Company's average low P/S ratio for the past 5 years is 1.93, and for the past 10 years is 2.10. This corresponds to a price per share of $55.46 and $60.27, respectively, based off the analyst estimate for revenue growth from FY 2013 to FY 2014. 2014 revenue per share is estimated at $28.75, and is calculated from revenue growth but not accounting for potential share buybacks. Currently, Procter & Gamble Company's P/S ratio is 2.60 on a trailing twelve-month basis. Once again, I'll use the average of the two P/S ratio models, $57.86, in my target entry price calculation. The Procter & Gamble Company is trading at a 40.7% premium to this price.
Gordon Growth Model:
The Gordon Growth Model is a quick way to calculate the fair value of a company using the current dividend, the expected dividend growth rate, and your required rate of return or discount rate. Assuming a constant 6.00% dividend growth rate and a discount rate of 9.00%, the GGM valuation method yields a fair price of $85.81. The Procter & Gamble Company is currently trading 5.1% discount to this price.
Dividend Discount Model:
For the DDM, I assumed that Procter & Gamble will be able to grow dividends for the next five years at the lowest of the 1, 3, 5, 10-year growth rates or 15%. In this case, that would be 8.73%. After that, I assumed The Procter & Gamble Company can continue to raise dividends at 6.98% (80% of 8.73%) for the next three years, and in perpetuity at 5.00%. The dividend growth rates are based off fiscal year payouts, and don't necessarily correspond to quarter-over-quarter increases. To calculate the value, I used a discount rate of 9.00% and summed over 50 years. Based on the DDM, The Procter & Gamble Company is worth $72.68, meaning it's trading at a 12.0% premium to this valuation.
Procter & Gamble's trailing P/E is 21.86, and its forward P/E is 17.93. The PE3 based on the average earnings for the last 3 years is 21.33. I like to see the PE3 be less than 15, which Procter & Gamble is currently well over. Compared to its industry peers, The Procter & Gamble is undervalued versus Colgate-Palmolive Co. (NYSE:CL) 27.83 and Church & Dwight Company, Inc. (NYSE:CHD) (Full analysis here) 24.63, and fairly valued versus The Clorox Company (NYSE:CLX) 21.13. Previous comparisons are on a TTM basis. On a forward P/E basis, The Procter & Gamble Company is undervalued versus CL (20.01) and CHD (20.45) and CLX (18.95). Procter & Gamble is trading at a 5-year forward PEG ratio of 2.31, which has shares undervalued against CL (2.48) and CLX (2.65), and overvalued versus CHD (2.09). A PEG ratio of 1 is generally considered fair value, and Procter & Gamble is well above that level, but is trading in the range of its peers.
Procter & Gamble's gross margins for FY 2012 and FY 2013 were 53.2% and 49.6%, respectively, and have averaged a 52.3% gross profit margin over the last 5 years. The net income margin for the same years were 12.9% and 13.4%, with a five-year average of 14.0%. Procter & Gamble's gross margin has been fairly high and consistent, which is great news, although it's started to trend down over the last three fiscal years. Over the TTM, the gross profit margin has continued to decrease. I'll be looking for stabilization of the gross margin and preferably a return to the low-to-mid 50% range. Net profit margin has also been sliding since hitting a peak of 17.0% in FY 2009. The net income margin is still on the high end of the 10-year historical range, so there could very well be further retraction. Since each industry is different and allows for different margins, I feel it's prudent to make a company-to-company comparison. Over the TTM, Colgate-Palmolive's gross margin was 58.6% with a net profit margin of 12.9%, Clorox's gross margin was 42.7% with a net profit margin of 10.0%, and Church & Dwight had a gross margin of 45.0% with a net profit margin of 12.4%. Procter & Gamble is trailing only Colgate-Palmolive on gross margin, and is leading the way for net profit margin.
Since the end of FY 2004, Procter & Gamble's share count has actually increased at a 0.55% annualized rate, which is quite disappointing. However, since FY 2006, the share count has been reduced from 3.286B to 2.931B, which is good for an average annualized decrease of 1.62%. That's a total of 10.8% of the outstanding shares.
A negative number for the % change value means shares were bought back by the company, and a positive value means the shares outstanding increased.
Procter & Gamble is a dividend champion with 57 consecutive years of increasing the dividend, with the most recent increase being announced earlier this month. The dividend has been increased at 10.6%, 8.7%, 9.1%, and 11.8% annualized rates over the last 1, 3, 5, and 10-year periods, respectively. Dividend increases are based off fiscal year payouts, and don't necessarily correspond to quarter-over-quarter increases. To no one's surprise, Procter & Gamble has done a great job increasing the dividend. There's a reason that Procter & Gamble is a core holding for many dividend growth investors.
The payout ratio based off earnings per share has increased over the last 10 years, from 40.1% in FY 2004 to 59.3% in FY 2013, with an average of 45.6%. The EPS payout ratio was still at very good levels until FY 2011 as net income, and therefore, EPS has stagnated, while the dividend has continued to increase every year. Analysts are expecting pretty solid EPS growth over the next five years of 8.38% per year, and I expect the dividend increases to come in lower than that to lower the EPS payout ratio.
The free cash flow payout ratio has been increasing much like the EPS payout ratio, due to stagnant operating cash flow but continued dividend increases. Operating cash flow has essentially been flat over the last 5 fiscal years, declining from $14.92B in FY 2009 to $14.87B in FY 2013. That's an average annual decline 0.08%. Capital expenditures have increased over the same time period from $3.24B to $4.01B, for an average annual increase of 5.48%. Stagnant operating cash flow and increasing capex has led to a decline in free cash flow as well. Free cash flow, operating cash flow less capital expenditures, has declined from $11.68B to $10.87B over the same years, for an average annual decline of 1.79%. As a dividend growth investor, the sustainability of the dividend is of utmost importance to me, so I also like to calculate the free cash flow after paying the dividend, or FCFaD. Much like the rest of the cash flow metrics, the FCFaD has been in a downward trend. FCFaD has declined from $6.64B in FY 2009 to just $4.35B in FY 2013, for an average annual decline of 10.0%. It should be no surprise that the FCF payout ratio has increased over the last 10 years, from just 34.6% in FY 2004 to 60.0% in FY 2013. If operating cash flow, and therefore FCF, doesn't start increasing, then the FCF payout ratio will continue to increase and get to an unsustainable level. Currently, I don't believe there's much cause for concern, but it's something to watch closely.
Return on Equity and Return on Capital Invested:
Procter & Gamble's ROE has averaged a very strong 18.6% over the last five fiscal years, with ROCI averaging 14.1%. However, both ROE and ROCI have been declining over the last five fiscal years. The decline can once again be attributed to stagnating earnings. The good thing is that the balance sheet has been improving over that time, as debt levels have been declining while equity levels have increased. In FY 2009, total debt was $36.97B, and in FY 2013, it was $31.54B. With equity levels increasing from $63.10B to $68.06B over the same years, the debt-to-equity level has improved from 0.33 to 0.28, with debt-to-capitalization improving from 24.7% to 21.9%. It's good to see that even though Procter & Gamble has struggled over the last five years, debt levels have actually declined.
Revenue and Net Income:
Since the basis of dividend growth is revenue and net income growth, we'll now look at how Procter & Gamble has done on that front. Revenue growth since the end of FY 2004 has been solid, with a 5.6% annual increase; growing from $51.41B to $84.17B. Net Income over the same years has grown at an annualized rate of 6.4%, from $6.48B to $41.74B. Since net income has been growing faster than revenue, the net income margin has improved from 12.6% in FY 2004 to 13.0% in FY 2013. However, Procter & Gamble's struggles have mainly surface over the last five fiscal years as revenue has stagnated. Revenue in FY 2008 was $83.50B, and has grown at just a 0.16% annualized rate. While revenue has flat-lined, net income has declined from $12.08B in FY 2008, for an average annual decrease of 1.3%.
This chart shows the historical high and low prices since FY 2004 and the forecast based on the low, average, and high P/E ratios and the expected EPS values from the discounted earnings calculation above. I have also included a forecast based off a P/E ratio that is 75% of the average low P/E ratio. I like to buy near the 75% low P/E ratio price, although this price doesn't usually come around very often. In the case of Procter & Gamble, the target low P/E ratio is 15.25 and the 75% low P/E ratio is 11.44. This corresponds to an entry price of $64.20 based off the expected earnings of $4.21 for FY 2014, with a 75% target price of $44.64. Currently, Procter & Gamble is trading at a $36.77 premium to the 75% low P/E target price and a $17.21 premium to the target low P/E price. If you look at the chart, the current price line intersects the average P/E line towards the middle of FY 2016, suggesting that it's currently above fair value and that you're paying up for about 1.5 years of growth at current prices. The current price line intersects the low P/E line towards the end of FY 2023, so you're paying quite a premium for a slower-growing company. If growth comes in above analyst estimates, then these numbers are subject to change for the better; however, the same is true in the reverse.
The average of all the valuation models gives a target entry price of $69.07, which means that The Procter & Gamble Company is currently trading at a 17.9% premium to the target entry price. I've also calculated it with the highest and lowest valuation methods thrown out. In this case, the Graham Number and Gordon Growth Model valuations are removed, and the new average becomes $70.06. Shares are currently trading at a 16.2% premium to this price as well.
Assuming that Procter & Gamble grows its earnings and dividends at the rates that I assumed, you're looking at market average returns over the next 10 years. In 2023, EPS would be $7.67, and slapping an average P/E of 17.11 gives a price of $131.21. Over the next 10 years, you'd also receive $40.43 per share in dividends, for a total return of 110.83%, which is a 7.74% annualized rate if you purchase at the current price. If you purchase at the target entry price of $70.06, the 10-year total return jumps to 144.99%, or a 9.37% annualized rate.
According to Yahoo Finance, the 1-year target estimate is $87.37, suggesting that the share price has about 7.32% upside over the next year. Morningstar has Procter & Gamble as a 4-star stock, meaning it's trading below their fair value estimate of $89.00. Morningstar's estimate suggests about 9.32% upside over the next year. The following table is from Morningstar, and shows the current valuation of Procter & Gamble compared to its industry, the S&P 500, and its 5-year averages.
The Procter & Gamble Company is a huge consumer staples powerhouse, with 25 brands of $1 billion or more in annual sales and 15 more brands between $0.5B and $1B in annual sales. It's hard to walk through any store without finding several of its products on an aisle. Procter & Gamble's struggles have been well-documented, and ex-CEO, A.G. Lafley has been brought back on board to right the ship. Since his taking over as CEO, Procter & Gamble has begun to move in the right direction again, as sales have started to increase once again and cost-cutting/productivity measures have been put in place.
Procter & Gamble announced 3Q2014 results last week, and overall, it was a solid quarter with 3% organic volume and sales increases. Currency issues continue to be an issue, and led to a 3% drag on earnings for the quarter. I'm not concerned about currency issues in the long term, as they usually tend to work themselves out, where they help in some years and hurt in others. The 3% organic volume and sales growth was a welcome sight. FY 2014 guidance was kept the same, with 3-4% YoY organic sales growth and core earnings per share growth of 3-5% YoY. Management also announced an increase in the quarterly dividend from $0.6015 to $0.6436 per share, or 7%.
Procter & Gamble is well-diversified across its business segment and geographically. In FY 2013, developed markets made up 61% of sales, while developing markets contributed the other 39%. The developed markets, the United States, Western Europe, and Japan, continue to be a battle ground where gains are being made in better productivity/cost-cutting measures, as well as taking market share away from competitors. Developing markets provide an opportunity for faster growth, and PG is the leading household and personal care business in those markets.
The stagnant growth of Procter & Gamble over the last five years has led to declines in free cash flow and earnings per share. That, coupled with continued dividend increases has put Procter & Gamble in a situation where I don't expect stellar dividend growth going forward, but somewhere in the neighborhood of 5-7% annual increases over the next few years. If operations continue to improve and the dividend increases are kept in the 5-7% range, then there would be a lot more coverage between the earnings per share and free cash flow and the dividend, which should provide a larger cushion whenever the economy inevitably heads south again.
Overall, I think Procter & Gamble still represents a solid core holding for most dividend growth portfolios. While the dividend growth might be a bit lower over the next few years, the increases are almost 100% guaranteed. However, the quality of the company and dividend growth prospects is completely unrelated to the value that the shares represent. At the current price, I wouldn't be opposed to buying shares if I were looking to invest capital right now, but you must do so knowing that the value isn't exactly the best. I don't normally have a problem with paying up for quality, but given the recent struggles of Procter and Gamble, I'd prefer to buy shares in the mid $70s range. That would provide a larger margin of safety, which is needed given the concerns about growth. For me, Procter & Gamble is a solid hold, and the shares aren't going anywhere from my portfolio, but I'm also not excited about adding to my current position.
What do you think about The Procter & Gamble Company as a dividend growth investment? How do you think the long-term dividend growth prospects are?
A full list of my holdings can be found here.
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.
Additional disclosure: I am not a financial professional and all thoughts/ideas here are my own and for entertainment purposes only. Investing involves risks. Please consult a financial professional and do your own due diligence before investing. The author is not responsible for losses of any kind by readers. All charts/images and data are sourced from my personal stock analysis spreadsheet, Morningstar, Yahoo! Finance, or Procter & Gamble's Investor Relations page.