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3M (Minnesota Mining and Manufacturing) Company (MMM), founded in 1902, is a diversified technology company and operating in six segments: industrial and transportation; health care; display and graphics; consumer and office; safety, security and protection services; and electro and communications. 3M is a dividend aristocrat that has raised its dividend for 53 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 in the table below.

Key 10-year data for 3M

Year Sales (in Millions) EBIT (in Millions) EPS High Price Low Price High P/E Low P/E Average P/E
2010 26662 5755 5.63 91 76 16.2 13.5 14.8
2009 23123 4632 4.52 83 41.83 18.4 9.3 13.8
2008 25269 5108 4.89 85 54 17.4 11.0 14.2
2007 24462 6115 5.6 96 73 17.1 13.0 15.1
2006 22923 5625 5.06 88 68 17.4 13.4 15.4
2005 21167 4828 4.03 87 71 21.6 17.6 19.6
2004 20011 4303 3.56 89 75.88 25.0 21.3 23.2
2003 18232 3657 3.02 84 61 27.8 20.2 24.0
2002 16332 3005 2.5 65 54 26.0 21.6 23.8
2001 16054 2186 1.79 61.5 43.5 34.4 24.3 29.3

From these data, we can plot Sales, EBIT, and EPS versus Year, as shown below.

Sales (in Millions), EBIT (in Millions), and EPS versus Year for 3M, 2001-2010

As evident from the chart above, 3M 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 = 0.3952 (2016) - 788.42 = 8.3032.

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). The Average P/E of 29.3 for Year 2001 and 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 18.2.

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 16.2, 17.1, 17.4, 17.4, and 18.4, which average 17.3.

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 9.3, 11.0, 13.0, 13.4, and 13.5, which average 12.1.

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 18.2 and 12.1 gives us 14.67.

Multiplying our EPS projection for 5 years hence by the average P/E estimate gives us a projected average price for the stock: $8.3032 * 14.67 = $121.82. Compared with the current price of $83, this represents an annual stock price return = 10.1%. When we add in the 2.6% dividend yield, the total return expected is an annualized 12.7%, which will allow us to double our investment in about 6 years.

Using a discount rate of 7%, our projected price of $121.82 in 5 years translates to a target price = $86.85 in today's dollars, which is about 4% upside potential from the current price of $83 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 close to the target price, we do not have a good margin of safety to buy now. A pullback to $69 would give enough margin of safety to buy.

As an additional consideration, 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 = 5.63, giving us a current P/E = 14.7. This is 81% of the stock's signature P/E of 18.2, 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 3M, forecast low EPS is equal to 5.14, so the Forecast Low Price = 12.1 * 5.14 = $61.96.

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 3M, this equals 17.3 * 8.3032 = $143.55.

Thus, Risk Index = ($83 - $61.96) / ($143.55 - $61.96) = 26%. Since this is a little above 20%, we have a slightly unfavorable reward to risk ratio, which argues against a Buy at current price.

Conclusion
3M Company, currently selling at $83, is selling close to its target price = $87, suggesting that the stock is fairly valued. On the other hand, its current P/E of 14.7 is below the stock's historic P/E average of 18.2, which suggests that the stock is undervalued. The risk index suggests the downside risk slightly outweighs upside potential. Given these mixed signals, I rate the stock a Hold at the current price of $83. If fundamentals remain intact, I recommend buying on a pullback to $69.

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

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.

Source: 3M Company: Stock Analysis