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Summary

  • Often articles and reports give a single concluding number such as a $98 price target or 9% annual expected returns.
  • This is a solid baseline, but lacks the ability to be easily adjusted or tested against varying hypotheses.
  • This article tries to create two valuation shortcuts for the reader to independently determine what they believe the future return prospects of Procter & Gamble might be.

In an effort to share concise and workable investment ideologies, many authors skip the background math and cut right to the punch line. I am no exception. Often, within the content of an article, I'll suggest something along these lines: "If these estimates formulize, McDonald's (NYSE:MCD) could return between 7% and 13% annually over the next half decade." It's useful information if you believe my assumptions are sensible, but statements like these lack the ability to easily adjust the inputs.

This article is meant to begin a series of easy to use valuation shortcuts. Specifically, the numbers I regularly refer to are simply a baseline -- I want you to be able to see a "range of reasonableness" and come up with conclusions on your own. A big part of evaluating potential investment partnerships is scenario analysis; you never want to rely on a single data point.

To introduce you to the topic, I'll work with Procter & Gamble (NYSE:PG) as an illustration.

Tracing its roots back to 1837, Procter & Gamble was founded by -- wouldn't you know it -- two guys with the last names of Procter and Gamble (William and James). Today, the company is best known for its worldwide products: Tide, Bounty, Dawn, Gillette, Crest and 20 other billion-dollar brands. Among the dividend crowd, P&G is probably best known for its streak of not only paying but also increasing its dividend for 58 consecutive years.

If you look at the company's last earnings report, you would see $4.22 in core (non-GAAP) earnings per share and a dividend paid of just less than $2.45. We'll take the most recent payout instead, calling it $2.57 as a baseline moving forward.

If both earnings and dividends were to grow at 6% moving forward, this would indicate about $15 in dividend payouts received and underlying earnings power of about $5.60 in 5 years' time. Using a 3% future dividend yield, this would indicate a roughly 9% expected annualized total return. Using a 20 P/E ratio would signify roughly the same anticipation.

That's where most commentaries stop. They tell you the punch line -- P&G might return 9% annually -- without also addressing other likelihoods. To correct for this, I'd like to provide two additional tables that better illustrate the range of possibilities.

The first table will use just a single observation -- a company's dividend yield -- to provide a range of potential expected returns. Procter & Gamble presently pays out $0.6436 per share per quarter, or $2.5744 on an annual basis. This number is neither the amount paid in the last 12 months nor the amount expected to be paid in the next 12 months, but it is nonetheless a starting point.

At the time of this writing, shares of Procter & Gamble exchanged hands at $83.38. This would indicate a yield around 3.1%.

In my example, I suggested that 6% dividend growth and a 3% yield would not be unreasonable in the future for P&G. If those estimates come to fruition, this would indicate expected total annual returns of about 9%. However, that is certainly not the only possibility. Below I have provided the different expected return results for various levels of dividend growth and end of period dividend yields.

5-Year Total Expected Return (with future dividend yield)

End Yield ->

1%

1.50%

2%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

Div Growth

0%

26%

17%

11%

7%

3%

1%

-2%

-3%

-5%

1%

28%

18%

12%

8%

4%

2%

-1%

-3%

-4%

2%

29%

19%

13%

9%

5%

3%

0%

-2%

-3%

3%

30%

21%

14%

10%

6%

4%

1%

-1%

-2%

4%

31%

22%

15%

11%

7%

4%

2%

0%

-2%

5%

33%

23%

16%

12%

8%

5%

3%

1%

-1%

6%

34%

24%

18%

13%

9%

6%

4%

2%

0%

7%

35%

25%

19%

14%

10%

7%

5%

3%

1%

8%

36%

26%

20%

15%

11%

8%

6%

4%

2%

9%

38%

27%

21%

16%

12%

9%

7%

5%

3%

10%

39%

29%

22%

17%

13%

10%

8%

6%

4%

11%

40%

30%

23%

18%

14%

11%

9%

6%

5%

12%

41%

31%

24%

19%

15%

12%

10%

7%

5%

The y-axis includes possible future dividend growth rates ranging from 0% to 12%; while the x-axis shows potential period end (in this case 5-year) dividend yields moving from 1% to 5%.

Here you can see the intersection of the 6% dividend growth rate and 3% future dividend yield to find the aforementioned 9% expected total returns. However, look at the additional scenario analyses that are now available. For instance, a 5% dividend growth rate and a 3.5% future yield would equate to 5% annual expected total returns. On the other hand, a 7% dividend growth rate coupled with a 2.5% future yield would compute to about 14% yearly expected total returns over the next half decade.

Of course these calculations assume linear growth, but it remains as a solid beginning tool towards one's analysis. Often the media quibbles over a percent share price move one way or the other. Yet in viewing something like the table above, you can ignore these short-term worries. You would instantly see that Procter & Gamble would need to have much slower dividend growth rate or else a much higher "current" yield in order to work out as a poor investment. If the company keeps chugging along as it has, it's plain to see that reasonable returns are offered.

You can create the same type of "range of reasonableness" by using an end price-to-earnings value as well. This one loses a touch of the simplicity because you have to make assumptions about both the future earnings and dividends. However, we can make things easier by assuming a constant payout ratio. Here's what Procter & Gamble's expected returns would look like with varying P/E ratios and earnings growth rates:

5-Year Total Expected Return (with future P/E)

End P/E ->

14

15

16

17

18

19

20

21

22

EPS Growth

0%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

1%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

2%

-1%

0%

1%

2%

3%

4%

5%

6%

7%

3%

0%

1%

2%

3%

4%

5%

6%

7%

8%

4%

1%

2%

3%

4%

5%

6%

7%

8%

9%

5%

2%

3%

4%

5%

6%

7%

8%

9%

10%

6%

3%

4%

5%

6%

7%

8%

9%

10%

11%

7%

3%

5%

6%

7%

8%

9%

10%

11%

12%

8%

4%

6%

7%

8%

9%

10%

11%

12%

13%

9%

5%

6%

8%

9%

10%

11%

12%

13%

14%

10%

6%

7%

9%

10%

11%

12%

13%

14%

15%

11%

7%

8%

10%

11%

12%

13%

14%

15%

16%

12%

8%

9%

10%

12%

13%

14%

15%

16%

17%

Here, the y-axis marks potential earnings-per-share growth, while the x-axis includes possible future P/E ratios. You can see the intersection of a 20 P/E and 6% growth leads to roughly 9% expected total annual returns. Again, this certainly isn't the only possibility -- or perhaps even the most likely for that matter. A 17 future P/E coupled with 5% would lead to 5% 5-year annualized expected returns. On the other hand, a growth rate of 8% coupled with a 21 P/E could mean 12% yearly expected returns. It all depends on your perspective.

This is how I would begin thinking about the relative valuations of my investment options. Of course, there are a few caveats. For instance, while these tables greatly expand upon your available thinking range, they certainly aren't comprehensive -- a P/E of 25 or 13 is certainly possible. Moreover, the tables assume linear growth and constant payouts -- something that is easy to adjust, but requires more specificity.

When you read analysis reports and articles or use financial software, it spits out a number: 9% annual expected returns or a price target of $118. These are reasonable starting points, but not altogether intuitive. You can't say, "well sure, that seems reasonable, but what happens if I don't think the company can grow that fast?" Here, I simply wanted to provide a "range of reasonableness" to supplement such notions.

I don't know what the business of Procter & Gamble or share price will do in the next 5 years and neither do you. However, what I do know is that using tables such as the ones above can give you a clearer picture as to what you might be able to expect. In making unknown (but largely profitable in the aggregate) decisions, the best we can do is come up with a ballpark figure, partner with what we perceive to be wonderful companies at reasonable times and keep our logical wits about us when all does not follow exactly to plan.

Source: Procter & Gamble Valuation Shortcuts