Archer-Daniels-Midland-Company (ADM) procures, transports, stores, processes, and sells agricultural commodities and products. It is a processor of oilseeds, corn, wheat, cocoa and other agricultural commodities and is a manufacturer of vegetable oil, protein meal, corn sweeteners, flour, biodiesel, ethanol and other food and feed ingredients. Archer-Daniels-Midland is a dividend aristocrat that has raised its dividend for 36 consecutive years.
A 10-year summary of Sales, Earnings Before Interest and Tax (EBIT), Earnings per share (EPS), yearly high and low stock price, corresponding high and low P/E (calculated by dividing high and low price by the EPS for the year), and average P/E (average of high and low P/E) is shown below in Table 1.
|Year||Sales (in Millions)||EBIT (in Millions)||EPS||High Price||Low Price||High P/E||Low P/E||Average P/E|
Table 1. Key 10-year data for Archer-Daniels-Midland.
From these data, we can plot Sales, EBIT, and EPS versus Year, as shown in Chart 1 below.
Chart 1. Sales (in Millions), EBIT (in Millions), and EPS versus Year for Archer-Daniels-Midland, from 2001-2010.
As evident from Chart 1, ADM has demonstrated quite predictable sales and earnings over the past 10 years. This allows us to predict EPS in the near future, say in five years (i.e. Year 2016), using the linear regression equation for EPS = 0.311 (2016) - 621.59 = 5.386.
A conservative average P/E estimate for the stock can be obtained as follows:
Signature P/E: A well established stock has a signature P/E, an average P/E it commands in the market based on its business. We can calculate this by averaging the Average P/E over the past 10 years, excluding any outliers (values that fall significantly beyond the other data points). From Table 1, we see that the Average P/E of 24.4 for Year 2003 is an outlier, as it significantly exceeds the other data points, so we average the Average P/Es from the other nine years to arrive at a signature P/E of 13.4.
Average half of lowest High P/E: this takes the average of five lowest High P/Es of the 10 High P/Es from the past 10 years, to give us a conservative estimate of a high P/E for the stock we can expect. The 5 lowest High P/Es from the past 10 years (see Table 1) are 10.7, 10.9, 13.4, 17.1, and 17.8, which averages 14.
Average half of lowest Low P/E: this takes the average of five lowest Low P/Es of the 10 Low P/Es from the past 10 years, to give us a conservative estimate of a low P/E for the stock we can expect. The 5 lowest Low P/Es from the past 10 years (see Table 1) are 5.9, 7.3, 7.9, 7.9, and 11.2, which averages 8.
Average P/E estimate: this takes the average of Average half of lowest High P/E and Average half of lowest Low P/E, thereby giving us a conservative estimate of an average P/E for the stock we can expect. Averaging 14 and 8 gives us 11.
Multiplying our EPS projection for 5 years hence by the average P/E estimate gives us a projected average price for the stock: $5.386 * 11 = $57.25. Compared with the current price of $29.07, this represents an annual stock price return = 19.5%. When we add in the 2.3% dividend yield, the total return expected is an annualized 21.8%, which will allow us to more than double our investment in 5 years.
Using a discount rate of 7%, our projected price of $57.25 in 5 years translates to a target price = $40.82 in today's dollars, which is about 40% upside potential from the current price of $29.07 for the stock. For a good margin of safety, investors are well advised to buy only if the current price is at least 20% below the target price. Since the current price is 28.8% below the target price, we have a good margin of safety to buy now.
Before considering this stock a buy, we should also determine how the stock's current P/E compares with its signature P/E, since established stocks tend to revert back to their respective signature P/E over time. Current EPS = 3.13, giving us a current P/E = 9.29. This is 69% of the stock's signature P/E of 13.4, which indicates the stock is currently undervalued. In general, we should look to buy when the current P/E is 80% or less of the stock's signature P/E.
Lastly, we calculate the Risk Index, calculated as (Current Price – Forecast Low Price)/ (Potential High Price - Forecast Low Price) to give an estimate of the risk: reward ratio. Risk index less than 20% is desired, which gives us +200% potential returns for every risk of 50% loss we assume.
The Forecast Low Price is calculated by multiplying the Average half of lowest Low P/E by the Forecast Low EPS, to give a conservative estimate of low price for the stock in 5 years, assuming zero EPS growth and low valuation. Forecast Low EPS is estimated by averaging the EPS over the past 5 years. For growth stocks with predictable earnings growth, EPS in 5 years should not be any lower than this conservative estimate. For ADM, forecast low EPS is equal to 2.96, so the Forecast Low Price = 8 * 2.96 = $23.79.
The Potential High Price is calculated by multiplying the Average half of lowest High P/E by the our projected EPS in 5 years, giving us a price target in 5 years if the stock should command a high P/E. For ADM, this equals 14 * 5.386 = $75.22.
Thus, Risk Index = ($29.07 - $23.79) / ($75.22 - $23.79) = 10.3%. Since this is comfortably below 20%, we have a favorable reward to risk ratio to recommend a Buy at current price.
Archer-Daniels-Midland-Company, currently selling at $29.07, has a target price = $40.82. Its current P/E of 9.29 is comfortably below the stock's historic P/E average, and its upside potential outweighs downside risk. Therefore, I rate the stock a Buy at current prices.
Disclaimer: Use this information as a starting point for your own due diligence, before buying any stock. If you do buy, be sure to read any annual reports (10-K) and quarterly reports (10-Q) to ensure that the fundamentals remain good and the stock is on target to reach its projected price. After holding for five years, repeat the analysis detailed in the article to decide whether to continue to hold, add, or reduce your position.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.