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Summary

  • Procter & Gamble's dividend and cash flow make it a bond equivalent.
  • This, along with ZIRP, has caused PG's earnings multiple to reach nosebleed levels.
  • PG is expensive but is still yielding 3.2%, so no one cares if it's overvalued.

Procter & Gamble (NYSE:PG) is the quintessential American consumer staples company. The company thrives on dozens of well-known, steady brands that provide the company with recurring profit streams. Shares have languished over the past year with very little price movement. After oscillating between $76 and $85, shares have traded in a very tight range around $80 where we find them today. Given PG's business, dividend and earnings prospects, are shares a good value here? In this article we'll take a look at PG's valuation to determine if it has a place in your portfolio.

To do this, I'll use a DCF-type model you can read more about here. It uses inputs such as earnings estimates, which I've sourced from Yahoo!, dividends, which I've set at four percent growth annually, and a discount rate, which I've set at the 10 year Treasury rate plus a 6.5% risk premium.

 

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

       

Prior Year earnings per share

 

$4.22

$4.46

$4.81

$5.23

$5.68

$6.18

x(1+Forecasted earnings growth)

 

5.70%

7.80%

8.72%

8.72%

8.72%

8.72%

=Forecasted earnings per share

 

$4.46

$4.81

$5.23

$5.68

$6.18

$6.72

        

Equity Book Value Forecasts

       

Equity book value at beginning of year

 

$25.12

$27.01

$29.15

$31.59

$34.39

$37.56

Earnings per share

 

$4.46

$4.81

$5.23

$5.68

$6.18

$6.72

-Dividends per share

 

$2.57

$2.67

$2.78

$2.89

$3.01

$3.13

=Equity book value at EOY

$25.12

$27.01

$29.15

$31.59

$34.39

$37.56

$41.15

        

Abnormal earnings

       

Equity book value at begin of year

 

$25.12

$27.01

$29.15

$31.59

$34.39

$37.56

x Equity cost of capital

9.00%

9.00%

9.00%

9.00%

9.00%

9.00%

9.00%

=Normal earnings

 

$2.26

$2.43

$2.62

$2.84

$3.09

$3.38

        

Forecasted EPS

 

$4.46

$4.81

$5.23

$5.68

$6.18

$6.72

-Normal earnings

 

$2.26

$2.43

$2.62

$2.84

$3.09

$3.38

=Abnormal earnings

 

$2.20

$2.38

$2.60

$2.84

$3.08

$3.34

        

Valuation

       

Future abnormal earnings

 

$2.20

$2.38

$2.60

$2.84

$3.08

$3.34

x discount factor(0.09)

 

0.917

0.842

0.772

0.708

0.650

0.596

=Abnormal earnings disc to present

 

$2.02

$2.00

$2.01

$2.01

$2.00

$1.99

        

Abnormal earnings in year +6

      

$3.34

Assumed long-term growth rate

      

3.00%

Value of terminal year

      

$55.63

        

Estimated share price

       

Sum of discounted AE over horizon

 

$10.05

     

+PV of terminal year AE

 

$33.17

     

=PV of all AE

 

$43.22

     

+Current equity book value

 

$25.12

     

=Estimated current share price

 

$68.34

     

As we can see the model is stating that PG's fair value as of today, given the inputs I described above, is a mere $68. That is a large deficit to the current price of $81+, so is the model recommending a sell? Maybe. But before we make that decision we need to understand what's driving the difference.

As I stated, the model produces a fair value and not a price target; they are different. Basically, the model is saying that the present value of PG's future earnings stream is $68 given the inputs I modeled in. That stands in stark contrast to the $81 shares are trading for and I think there is a good reason for the discrepancy.

PG is currently trading for around 17 times next year's earnings, a princely sum considering the anemic growth PG posts each year. When I say PG's growth is anemic, I'm not attempting to be derisive. The company is a consumer staple supplier and when you sell things people need but don't necessarily want, anything but matching earnings growth with population growth can be challenging. The fact that PG is growing profits at all is reasonably impressive by itself. Posting mid-single digit growth is all the more impressive. This isn't to say PG is dysfunctional or something; I'm simply stating that if this company was someone other than PG, it likely wouldn't have a 17 forward multiple on ~5% earnings growth.

We know that companies like PG and Coca-Cola (NYSE:KO) are assigned premium multiples - what I would refer to as a growth multiple - because of their predictable earnings, cash flow, and dividends. Thus, PG is assigned a much higher multiple than its earnings growth would generally allow. That is why PG is selling for a nosebleed multiple amid very little profit growth. And by extension, that is why it is expensive relative to the present value of its earnings stream.

So does this mean we should sell? It depends. PG having a nosebleed multiple isn't new and it also isn't likely to go away anytime soon. This is despite the fact that analysts have been bringing earnings estimates down in recent weeks and the fact that shares are already expensive. The fact is that PG is viewed, like many other consumer staple names, as a bond equivalent. As long as the dividend is coming through and raises are at least annual, investors will bid up PG shares to a particular yield. At this point that particular yield is about 3.2%, a very nice yield and in particular, in this environment.

Also, considering analysts are currently looking for nearly 9% earnings growth in the out years, I'd say there is downside risk to the $68 fair value produced above. If earnings estimates continue to come down we could be looking at a fair value in the low $60s pretty easily. In other words, the risk to the fair value is down and not up, potentially further exacerbating the gap between it and the current price. I'm wondering where 9% earnings growth will come from for PG but that is a different story. For this analysis, we're assuming PG will hit its earnings growth targets and even at that, shares are expensive.

So the question of whether or not you should hold PG depends on your objective. If you're looking for capital appreciation, look elsewhere; this is not the stock for you. However, if you want a steady payout that comes from a stable source that isn't subject to the whims of consumers' discretionary budgets or complex financial instruments, PG is likely worth a look. Just know that if earnings growth rates stagnate and dividend raises become smaller or cease, you could see an unpleasant revaluation of shares that see its earnings multiple contract. I don't think that's likely but it is a risk considering PG's premium valuation. Other than that, it's a great vehicle for stable income…and that's pretty much it.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Source: Procter & Gamble: Expensive But No One Cares