Procter & Gamble's Pricing Power Is Favorable, But Its Valuation Is Less So

| About: The Procter (PG)
As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Procter & Gamble's (NYSE:PG) case, we think the firm is worth just under $60 per share. Our full reports on Procter & Gamble and hundreds of other companies are available on our website.
We think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.
If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. We think our methodology and broad coverage universe is largely responsible for the meaningful outperformance of the portfolio in our Best Ideas Newsletter.

Our Report on Procter & Gamble

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Investment Considerations

We rate every company in our coverage universe on 13 unique measures. To get started, we show Procter & Gamble's below:

Investment Highlights

We think Procter & Gamble will be successful as it seeks to target both the high-end and low-end consumers separately, instead of taking a middle-of-the-road approach as it has traditionally done. The firm's organic growth measures are also picking up, with the best performance of last fiscal year (ending June) occurring in the last quarter (its most recently reported).

We're particularly fond of companies with pricing power, and Procter & Gamble continues to demonstrate an ability to price ahead of inflation. The firm expects pricing to add 3 to 4 percentage points to revenue expansion this year, levels we think are achievable. For fiscal 2012, we're forecasting sales expansion north of 7, with volume accounting for the balance.

Procter & Gamble earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. We expect the firm's return on invested capital (excluding goodwill) to expand to 24% from 23.4% during the next two years.

The firm is trading at attractive valuation mulitples relative to its peers, but our DCF process indicates a less compelling opportunity. We'd wait for a clearer signal on valuation before jumping into the firm's shares.

Procter & Gamble has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 13.5% in coming years. Total debt-to-EBITDA was 1.7 last year, while debt-to-book capitalization stood at 32.5%.

Although we think there may be a better time to dabble in the firm's shares based on our DCF process, the firm's stock has outperformed the market benchmark during the past quarter, indicating increased investor interest in the company.

The firm sports a very nice dividend yield of 3.4%. We expect the firm to pay roughly half of next year's earnings to shareholders as dividends.

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Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Procter & Gamble's 3-year historical return on invested capital (without goodwill) is 20.4%, which is above the estimate of its cost of capital of 9.1%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

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Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Procter & Gamble's free cash flow margin has averaged about 13.1% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Procter & Gamble, cash flow from operations increased about 9% from levels registered two years ago, while capital expenditures expanded about 2% over the same time period.

Valuation Analysis

We think Procter & Gamble is worth $58 per share, which represents a price-to-earnings (P/E) ratio of about 14.8 times last year's earnings and an implied EV/EBITDA multiple of about 10.9 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 4.9% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 0.3%.

Our model reflects a 5-year projected average operating margin of 19.4%, which is below Procter & Gamble's trailing 3-year average. Beyond year 5, our valuation model assumes free cash flow will grow at an annual rate of 2% for the next 15 years and 3% in perpetuity. For Procter & Gamble, our model uses a 9.1% weighted average cost of capital to discount future free cash flows.

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Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $58 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock.

In the graph below, we chart thes probable range of fair values for Procter & Gamble. We think the firm is attractive below $44 per share (the green line), but quite expensive above $73 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Procter & Gamble's fair value at this point in time to be about $58 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Procter & Gamble's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence.

This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $70 per share in Year 3 represents our existing fair value per share of $58 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.