In part 1 of this analysis, I reviewed the qualitative elements of Brown Forman’s (NYSE:BF.B) spirits and wine business to determine if it had a durable competitive advantage. The strong fundamentals led me to believe that it does.
Brown-Forman vs. Uncle Sam
We’ll be assessing the valuation from three different angles. The first is only a comparative value look and doesn’t result in a firm price target. It pits the current earnings yield against the long-term Treasury bond. Brown Forman’s trailing twelve months earnings per share is $3.90. Dividing EPS by the current market price of $71.70 equates to an earnings yield of 5.4%, which beats the 30-year bond yield of 3.9%. In addition, based on analysts’ five-year earnings projections, Brown-Forman’s yield could grow 13% annually making it a clear winner over Treasury bonds.
Another way to look at valuation, and the one most likely employed by a majority of investors, simply takes the current EPS of $3.90 and multiplies it by analysts’ five-year growth projection of 13%, which equals earnings per share in the fifth year of $7.19. Multiply this by Brown Forman’s current P/E of 18 and we get a price target of $129. Adding in a 1.24 dividend growing at 9% annually, the total take is $136 for a CAGR of 13.6%.
Since I’m seeking investments in which I can virtually guarantee myself a CAGR of 15%, I will likely wait for correction before taking a position. Brown-Forman is a strong buy on any move into the 60’s.
The Incredible Expanding Coupon
Finally we’ll be viewing the stock as an equity/bond with an expanding coupon. Looking at Brown-Forman in this fashion, the initial investment of $31.30 a share would be seen as a bond yielding 5.4% (just like the first example above), but rather than grow at the EPS growth rate, the “coupon” would increase at the rate management is growing the equity base. This is where return on equity comes in.
Brown-Forman’s shareholders equity value, or book value, is $14.06. Dividing EPS of $3.90 by book value equates to a return on equity of 28%. Since Brown-Froman pays a dividend, all earnings are not retained for reinvestment and we must account for that. A payout ratio of around 39% means that 61% of earnings are retained. An ROE of .28 x .61 = .17 (17%) and this is the potential rate at which the equity base can grow. It follows that five years later we can expect a book value of $30.83. Multiply 30.83 by the ROE of .28 and you get projected earnings per share of $8.63. Multiple $8.63 by the current P/E of 18 and you obtain a five year price target of $155. Add cumulative dividends of 7.42 for a total of 162. This would mean a CAGR of 18% and represents Brown-Forman’s true potential for building shareholder wealth.
My five-year price target for Brown-Forman is 129 – 155 representing a CAGR including dividends of 14% to 18% respectively from current levels.