3M At Cyclical Highs, Shares Appear Expensive

| About: 3M Company (MMM)
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Summary

3M shares have been bid up relentlessly in recent years.

The company's fundamentals don't support its current valuation.

The dividend is decent but is not enough to justify the high valuation; I think shares have moderate downside on valuation alone.

3M (NYSE:MMM) shareholders have been well rewarded for being patient through the financial crisis after shares hit $45; they trade for $162 as I write this. The stock has gone straight up in the past three years, taking only brief pauses on the way up and making enormous amounts of money for those that hold it. The industrial company that makes, well, just about anything you can think of has produced high quality earnings growth that investors love and a solid dividend to boot. But after doubling in three years and making new all-time highs nearly every day recently, is MMM expensive? In this article I'll take a look at MMM's valuation to see if it's still worth a look for your dividend portfolio.

To do this I'll use a DCF-type model you can read more about here. The model uses inputs including earnings estimates, which I've sourced from Yahoo!, dividends, which I've set to grow at three percent annually, and a discount rate, which I've set at the 10 Year Treasury rate plus a risk premium of 5.75%.

 

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

             

Prior Year earnings per share

 

$6.72

$7.48

$8.20

$9.15

$10.21

$11.39

x(1+Forecasted earnings growth)

 

11.30%

9.60%

11.60%

11.60%

11.60%

11.60%

=Forecasted earnings per share

 

$7.48

$8.20

$9.15

$10.21

$11.39

$12.72

               

Equity Book Value Forecasts

             

Equity book value at beginning of year

 

$25.24

$29.30

$33.97

$39.49

$45.97

$53.51

Earnings per share

 

$7.48

$8.20

$9.15

$10.21

$11.39

$12.72

-Dividends per share

 

$3.42

$3.52

$3.63

$3.74

$3.85

$3.96

=Equity book value at EOY

$25.24

$29.30

$33.97

$39.49

$45.97

$53.51

$62.26

               

Abnormal earnings

             

Equity book value at begin of year

 

$25.24

$29.30

$33.97

$39.49

$45.97

$53.51

x Equity cost of capital

8.00%

8.00%

8.00%

8.00%

8.00%

8.00%

8.00%

=Normal earnings

 

$2.02

$2.34

$2.72

$3.16

$3.68

$4.28

               

Forecasted EPS

 

$7.48

$8.20

$9.15

$10.21

$11.39

$12.72

-Normal earnings

 

$2.02

$2.34

$2.72

$3.16

$3.68

$4.28

=Abnormal earnings

 

$5.46

$5.85

$6.43

$7.05

$7.72

$8.43

               

Valuation

             

Future abnormal earnings

 

$5.46

$5.85

$6.43

$7.05

$7.72

$8.43

x discount factor(0.08)

 

0.926

0.857

0.794

0.735

0.681

0.630

=Abnormal earnings disc to present

 

$5.06

$5.02

$5.10

$5.18

$5.25

$5.32

               

Abnormal earnings in year +6

           

$8.43

Assumed long-term growth rate

           

3.00%

Value of terminal year

           

$168.69

               

Estimated share price

             

Sum of discounted AE over horizon

 

$25.61

         

+PV of terminal year AE

 

$106.30

         

=PV of all AE

 

$131.92

         

+Current equity book value

 

$25.24

         

=Estimated current share price

 

$157.16

         

As you can see the model produced a fair value of $157, about $5 lower than where shares trade as I write this. That would imply that shares are currently slightly overvalued but what does that mean? The model is intended to provide investors with a price at which a margin of safety can be achieved when getting long. If the price is above the fair value, as it is with 3M, that implies the stock is overvalued. However, with 3M, we are only $5, or about 3%, higher than the fair value, so the difference is minimal. So what does that mean for the stock? Let's take a look at the valuation.

MMM is expected to grow earnings at about 11% annually for the next few years. While that is certainly not world-beating, that is robust growth for an industrial with a market cap of more than $100 billion. This is more problematic because MMM is only supposed to grow sales at three or four percent per year, about all one could expect from such a company. And while I think that level of sales growth is totally acceptable for MMM, it isn't nearly enough to produce 11% worth of EPS growth. So where is it coming from?

One potential source of outsized EPS growth is margins. However, MMM isn't growing margins and hasn't for a very long time. It has excellent margins; the levels are not the problem. However, it has produced virtually flat gross and operating margins for years now. That means that margins, while strong, are not a source of EPS growth.

The last source of potential EPS growth is buybacks. By simply reducing the number of shares the company has outstanding the same level of nominal earnings produces a higher level of EPS. MMM is perennial buyer of its own stock and has retired billions upon billions of dollars of its own stock. This has reduced share count substantially and is a yearly source of EPS growth. Buybacks have been somewhat choppy but for reference, the last three years have seen roughly 2%, 1% and 3%, respectively, of the float retired. Those are great numbers and will benefit shareholders for the long term but with sales at 3% to 4% growth, flat margins and perhaps 2% of the float being retired, we are well short of 11% EPS growth. That would indicate to me that the stock is expensive based on estimates that are too high.

Given all of that, I think 20 times forward earnings is a very rich multiple. The company's earnings don't support that multiple so I think the valuation is a function of too much money chasing stocks in general and a forming bubble in high quality dividend stocks. 3M is certainly a high quality dividend stock with predictable earnings and a safe payout, but its average yield over the past five years has been 2.4%, 300 basis points higher than its yield today. That is another indication to me that this stock may be getting expensive. Barron's even mentioned RBC thinks the stock is expensive relative to the market.

This chart shows 3M against the DJIA (NYSEARCA:DIA) over the past three years. Notice the marked, steady outperformance of MMM over that period and in particular, the ramp following the October selloff. 3M heavily underperformed during the selloff but afterwards, has taken off higher not only on a nominal basis, but relative to the Dow as well. That doesn't mean a crash is coming or something but it does warrant some extra caution to avoid chasing it higher.

On a valuation basis I just don't see much to like here. I think 3M has been bid up unreasonably in recent months and that it is expensive relative to the market, which I also think is expensive. 3M is a world class company and the business is certainly not the issue for me; I just think the price you have to pay for it right now is too high. I also find earnings expectations to be a couple of percent too high for the next few years and that they will likely be ratcheted down unless 3M performs a miracle. If I'm right about earnings coming in at ~8% instead of 11%, 3M is worth something like $140 per share. That level would give it a 2.4% yield, right in line with its historical average. I'd like to be long MMM but I won't pay $160 for it.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.