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Procter & Gamble (NYSE:PG) is one of the largest producers of household goods and products in the world with presence in over 180 countries and revenues in excess of $78 billion. In this article, I will determine the fair value of PG using the two-stage dividend discount model. PG has a well established record of returning cash to the shareholders using dividends and it currently yields just over three percent.

Valuation

  • Current EPS – $3.53
  • Current dividends – $1.92

High Growth Period

Length of high growth period – 5 years

Cost of Equity Calculation

  • Bottom-up beta for high growth period – 0.84
  • Risk free rate – 2.6% (10-Year Treasury bond)
  • Risk premium – 6.5% (5.1% US risk premium and 1.4% emerging market risk premium to account for the 34% of company revenues from the emerging markets)

Therefore, cost of equity during high growth period = 8.07%

Growth Rate Estimation

The growth rate for the high growth period was estimated based on fundamental analysis by considering the current and projected return on equity and the retention ratios.

  • Return on equity – 17%
  • Retention rate – 45%
  • Projected 5-year growth rate = 7.65%

This projected growth rate of 7.65% compares favorably to analyst average 5-year projected growth rate of 8.76%. It should be noted that S&P Equity Research projects a three (3) year growth rate of 7%.

The projected dividends during the high growth period are as follows:

  • Year 1 – 2.09
  • Year 2 – 2.25
  • Year 3 – 2.42
  • Year 4 – 2.61
  • Year 5 – 2.81

Present value of dividends in high growth period – $9.59

Stable Growth Period

Growth rate in stable period – 2.50% (to match the assumed long-term growth of the developed world economy). PG has maintained a fairly steady return on equity ratio for the last 5 years averaging approximately 18%. This is slightly below the average ROE for the household goods sector. The existing ROE of 17% was assumed for the stable growth period.

The projected retention rate for the stable growth period was calculated using the ROE and growth rate estimates. This yielded a retention rate of approximately 15%.

Finally, the value of beta for the stable growth period was assumed to be the same as the value for the high growth period. Therefore, cost of equity during stable growth period = 8.07%.

In Summary:

  • Growth rate during the stable growth period– 2.65%
  • Payout ratio during the stable growth period – 85.29%
  • Cost of equity – 8.07%

Therefore, present value of terminal price = $54.34

Fair Value

  • Present value of dividends in high growth period = $9.59
  • Present value of terminal price = $54.34
  • Fair value of stock = $63.93
  • Current market value of stock (as of September 7, 2010) = $60.14

Based on this analysis, at the time of writing, PG traded at a discount of approximately 6%.

Disclosure: No positions

Source: Procter & Gamble Trading at a Discount