Procter & Gamble: Upside Potential Outweighs Downside Risk

| About: The Procter (PG)

Procter & Gamble (NYSE:PG) provides consumer packaged goods. The company's products are sold in more than 180 countries primarily through mass merchandisers, grocery stores, membership club stores, drug stores and high-frequency stores, the neighborhood stores, which serve many consumers in developing markets. Procter & Gamble is a dividend aristocrat that has raised its dividend for 55 consecutive years.

A 10-year summary of sales, earnings before interest and tax (EBIT),earnings per share (EPS), yearly high and low stock price (adjusted for stock splits), corresponding high and low P/E (calculated by dividing the high and low price by the EPS for the year), and average P/E (average of high and low P/E) is shown below.

Key 10-year data for Procter & Gamble

Year Sales (in Billions) EBIT (in Billions) EPS High Price Low Price High P/E Low P/E Average P/E
2011 82.56 15.19 3.93 67.7 57.6 17.2 14.7 15.9
2010 78.94 15.05 3.53 65.3 59.3 18.5 16.8 17.6
2009 76.69 14.41 3.39 62.6 45.5 18.5 13.4 15.9
2008 79.26 14.89 3.4 73.2 58.8 21.5 17.3 19.4
2007 72.44 13.66 2.84 74.2 61 26.1 21.5 23.8
2006 64.42 11.65 2.45 64.2 53.9 26.2 22.0 24.1
2005 53.21 6.38 2.28 59.5 52.1 26.1 22.9 24.5
2004 51.41 8.91 2.15 56.6 49.1 26.3 22.8 24.6
2003 43.38 7.53 1.85 49.5 40.4 26.8 21.8 24.3
2002 40.24 6.38 1.54 47 37.2 30.5 24.2 27.3
Click to enlarge

From these data, we can plot sales, EBIT, and EPS versus year, as shown in the chart below.

Sales (in billions), EBIT (in billions), and EPS versus year for Procter & Gamble, 2002-2011

As evident from the chart above, PG has demonstrated quite predictable sales and earnings over the past 10 years, allowing us to predict EPS in the near future, say in five years (i.e. year 2016), using the linear regression equation for EPS = 0.2619 (2016) - 522.85 = 5.1404. The R-squared value of 0.9786 for the EPS linear regression fit suggests that we can be about 98% confident about this EPS estimate.

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 calculate this by averaging the Average P/E over the past 10 years, excluding any outliers (data points that fall significantly beyond the other data points). There are no significant outliers, so we average the Average P/Es from the past 10 years to arrive at a signature P/E of 21.8.

High P/E estimate: a conservative high P/E estimate can be calculated by averaging the five lowest high P/Es of the 10 high P/Es from the past 10 years. Averaging the 5 lowest high P/Es from the past 10 years gives 20.4.

Low P/E estimate: a conservative low P/E estimate can be calculated by averaging the five lowest low P/Es of the 10 high P/Es from the past 10 years. Averaging the 5 lowest low P/Es from the past 10 years gives 16.7.

Average P/E estimate: this takes the average of the high P/E estimate and the low P/E estimate, as calculated above, to give a conservative estimate of an average P/E for the stock we can expect. Averaging 20.4 and 16.7 gives us 18.55.

Target Price

Multiplying our EPS projection for 5 years hence by the average P/E estimate gives us a projected average price for the stock: $5.1404 * 18.55 = $95.35, which represents an annual stock price return of 9.63% from the current price = $66. When we add in the 3.15% dividend yield, the total return expected is 12.8% a year, which means an investment in PG today is expected to double in about 5-6 years.

Given a beta = 0.46 for PG, a risk-free rate = 2% (using the yield on 10-year Treasury bond as a benchmark), and estimated risk premium of about 5% for the general stock market, we have a discount rate = 2% + 0.46*(5%) = 4.3%. Applying this discount rate of 4.3%, our projected price of $95.35 in 5 years translates to a target price = $77 in today's dollars, which is 17% upside from the current price of $66 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, which means a buy price of $62.

Market Expectation

What is the market's expectation of PG's growth rate given its current market price = $66? Since stock price = dividend * (1 + growth rate) / (discount rate - growth rate), we have growth rate = ((stock price) * (discount rate) - dividend) / (stock price + dividend). Plugging in stock price = $66, dividend rate = $2.08, and discount rate = 4.3%, we get growth rate = 1.1%. This seems low, given that PG has grown its revenue by 5.1%, its earnings by 7.5%, and its dividend by 11% annually over the past 5 years. The growth rate is supposed to slow down a bit as a company matures, but a market price implied growth rate of 1.1% is significantly lower than the company's historic growth rate over the past 5 years. Low expectations bode well for the stock, because they make it easier for the company to beat these expectations. The caveat is that low discount rate is used, so if interest rates go up, or the stock becomes more volatile (higher beta), or if the market demands a significantly higher risk premium than 5%, the discount rate would go up, and the implied market expectation would go up accordingly.

Current P/E Compared With Signature P/E

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/Es over the long term. The current EPS = 3.64, giving us a current P/E = 18. This is about 83% of the stock's signature P/E of 21.8, again suggesting the stock is undervalued. To provide some margin for error, we should look to buy when the current P/E is 80% or less of the stock's signature P/E, which means a buy price around $63.

Risk Index

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 low P/E estimate 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 PG, the forecast low EPS is equal to 3.418, so the forecast low price = 16.7 * 3.418 = $57.18.

The potential high price is calculated by multiplying the high P/E estimate by the projected EPS in 5 years, giving us a price target in 5 years should the stock command a high P/E. For PG, this equals 20.4 * 5.1404 = $104.71.

Thus, the Risk Index = ($66 - $57.18) / ($104.71 - $57.18) = 19%. Since this is lower than 20%, the stock has a favorable reward to risk ratio at the current price, suggesting a buy.


Procter & Gamble Co, currently selling at $66, has a target price = $77. Its current P/E of 18 is lower than its historic P/E of 21.8, and its upside potential outweighs its downside risk. Therefore, I rate the stock a BUY right now. For more conservative investors, a pullback to $62 would provide a great entry point for adequate margin of safety.

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.