Twice per year I like to update my valuation of the core holdings in my dividend growth portfolio. As I recently did with my valuation review of Johnson & Johnson (NYSE:JNJ), I like to keep an eye on each company and the price that company's shares are currently selling at. Additionally, I believe a discounted cash flow analysis (DCF) is an important way to evaluate companies with predictable earnings……as I recently wrote. Now, let's get to evaluating Procter & Gamble (NYSE:PG).
Procter & Gamble is a US corporation whose diverse product mix is known around the world. It was first incorporated in 1905 and has grown to the point where it currently sells consumer packaged goods in 180 countries. Not only is Procter & Gamble's client base diversified geographically, they are also diversified across the 5 business units in which they operate. These units include:
- Beauty products
- Grooming products
- Healthcare products
- Fabric and Home Care products
- Baby and Family Care products
Procter & Gamble's closing stock price on Friday was $80.95. At that price, it sells for a PE (Price to Earnings) multiple of 21.4, with a dividend yield of 3.10%. That PE is looking pretty pricey for a slow growth company the size of Procter & Gamble. As I first mentioned in a Seeking Alpha article back in the spring, I expect consumer staples companies to get "squeezed" over the next couple years. The headwinds I see are two fold: higher input (raw material) costs and a consumer with little discretionary income (because of limited wage growth). Some have also suggested that a weakening of emerging market currencies will be a problem for these multinationals. I am not particularly worried about emerging market currencies, because large multinational companies (like Procter & Gamble) are skilled at managing these fluctuations. So click the link above if you want to read about the headwinds these companies face, or keep reading if you want to my opinion of the current valuation.
Discounted Cash Flow Valuation
The primary method I use when valuing a company like Procter & Gamble is its discounted future cash flow, although I will discuss several other important metrics below. I completed my valuation spreadsheet below using historical data from GuruFocus.com. Over the past 10 years, Procter & Gamble's earnings-per-share (EPS) and free-cash-flow (FCF) have been growing at fairly similar rates. My problem is that the growth rate has been fairly slow.
In the table below, I assumed the future earnings growth rate would match the average 10 year growth rate for the company. I used the lower of the EPS and FCF average growth rates, which in this case is 5.2%, because so many companies try to play games and goose their earnings numbers. I discounted the future earnings at a rate of 5% because of the current ultra low interest rate environment and Procter & Gamble's solid credit. A 2.5% premium over the 10 year US government bond seems low, but appropriate at the current time. Given all of those assumptions, Procter & Gamble appears to be currently undervalued by about 6% ($86 vs $81).
I always look at any investment through the lens of its historical perspective. In keeping with that idea, below are some metrics for Procter & Gamble:
The current dividend payout ratio is 61%, which leaves the dividend well covered. In my opinion, without top and bottom line growth, dramatic dividend increases are unlikely. That being said, management will do everything in their power to keep Procter & Gamble's decades of dividend increases end. See the Gurufocus.com 10 year chart of dividend increases, below.
Procter & Gamble's current price to earnings ratio is 21.4, which is above its 5 year average. The shares also trade at higher price to book (3.2 vs 2.9) and price to sales (2.8 vs 2.5) ratios than the 5 year average.
Courtesy of Morningstar.com
Procter & Gamble's growth has been sluggish in recent years. In 2013 the former CEO returned and several top managers were replaced. They seem to be taking steps to restore growth and concentrate on top brands, which I think is a good thing. Still, this is a slow growth consumer conglomerate.
Based on the information above, I will continue to hold my shares in Procter & Gamble, but will not be adding additional shares at this time. I believe the shares are fairly valued, but I'm looking for undervalued companies I can hold long term. Perhaps a notably lower price per share will change my mind. Even though the dividend yield looks acceptable, the PE and price-to-cash flow metrics are concerning. The current interest rate environment has forced some income investors to buy stocks that I consider "bond proxies". Consumer Staples companies (like Procter & Gamble) and the utility sector are two of their favorites, because of the relatively high yields and low volatility. When/if these investors return to their bonds, there should be an opportunity in companies like Procter & Gamble.
Disclaimer: I own positions in all stocks mentioned in this article. This article is for informational purposes only and should not be considered a recommendation for anyone to buy, sell, or hold any equities. I am not a financial professional. The information above is provided by Yahoo Finance, Gurufocus.com and Morningstar.com.