Introduction
With Procter & Gamble (PG) disappointing shareholders by lowering expectations for 2012, and activist investor William Ackman pressing for management changes in P&G, the company has been relatively volatile as of late. But even though current share price of$65 is close to a three year high, I still don't believe that this represents the fair value of the company. According to my estimations the share price should be closer to 80 than 70.
Source: Morningstar.com
Methodology
In this analysis I will value Procter and Gamble through a DCF model, in which I estimate average future revenue growth, operating margin, sales/capital ratio and WACC. After subtracting the investments from the after tax operating profit I obtain the free cash flow, which I discount (to get the present value), and by adding the present value of the budget period and the terminal period, I can calculate the market value of the company. To get the value for the shareholders I subtract the cash and the book value of debt.
Revenue growth rate
From 2002-2011 P&G has averaged a growth rate of 7.9% and a compounded annual growth rate of 10.9%. As can be seen in the below graph, the majority of the growth came in 2004-2006. Over the last four years P&G has only averaged a growth rate of around 4%.
As most people who follow Procter and Gamble probably know by now, the company has revised their forecasted earnings for 2012 downwards. Originally they had expected that foreign currency exchange changes would have a positive impact on revenues, but as the dollar has risen, the management now expects the opposite to be the truth. Therefore, the organic growth rate for 2012 has been revised down from 5% to 3%. Over a 10 year period I expect the macroeconomic environment to be improved which will have a positive impact on the organic growth rate. I believe it is possible that organic growth rates of 5% can be achieved and the total growth rate (including acquisitions) to be up to 10%+, but I prefer to use somewhat conservative estimates, and I will therefore use an average revenue growth rate of 6% from 2013-2021. In the terminal period I estimate that the company will grow at the risk free rate of 2%.
Operating margin
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Procter & Gamble has averaged an operating margin of around 19% from 2002 to 2011. In the future I think the operating margin will be slightly lower - I calculate with an operating margin of 17% over the period.
Sales to capital ratio
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Capital is calculated as equity + debt - cash. The average sale to capital ratio has been 0.9. This means that every time P&G increases capital invested by $1, revenue increases by $0.9. This is obviously not sustainable, and I expect this ratio to average around 1.15 in the future, which is closer to the average ratio for the toiletries/cosmetics industry of 1.2
The discount rate
The implied market premium on the S&P 500 is 7.7%. P&G has an extremely low regression beta of 0.44, which indicates that P&G should be seen as a low risk company. This is probably because P&G's products are not very price elastic and the company is diversified due to their different products. But in general there are a lot of shortcomings with using regression betas. I would prefer to use companies with a similar operational risk as P&G and adjust the beta to take capital ratios into account. Unfortunately I think it's very difficult (if not impossible) to find comparable firms, so I will stick with the regression beta, but I will bias it upwards (as I prefer to be conservative). Therefore, I will assume that P&G has a beta of 0.65.
P&G pays an average after tax interest rate of 2.08% and given the capital structure of P&G, the WACC is 5.52%.
The value of P&G
As can be seen below, I estimate that the fair value of 1 share is equal to 77. The largest uncertainty in this analysis is the beta. If the true beta is 0.8, the share price is fairly valued. If the true beta is above, the company is expensive. But I still think P&G is a pretty cheap company and I expect it to be able to produce a decent rate of return for shareholders over the long-term.
Terminal cash flow | $ 12268 |
Terminal cost of capital | $ 0 |
Terminal value | $ 348095 |
PV(Terminal value) | $ 203316 |
PV (CF over next 10 years) | $ 64509 |
Sum of PV | $ 267825 |
Debt | $ 29246 |
Cash | $ 2768 |
Value of equity | $ 241347 |
Estimated value /share | $ 82 |
Price | $ 64.81 |
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in PG over the next 72 hours.