How Much Should You Pay For McCormick?

| About: McCormick & (MKC)


Previously, I highlighted why the recent share price decline in shares of McCormick may not be enough.

A natural follow-up question is: "If not today's price, then at what price does the security become interesting?".

This article addresses what a "fair" price could look like.

In a recent article, I indicated that "a 15% price decline was not spicy enough" for Maryland-based spice and flavor company McCormick (NYSE:MKC). What I meant by this phrase was that despite the share price coming down a bit as of late, investors could still have to deal with some valuation compression in the years to come.

McCormick has been the quintessential example of a high-quality business. Earnings and dividends march upward year after year, and the share price more or less follows suit over the long term. Price and value are attached at the hip in the long term. Yet, fairly often these two components become detached in the short term.

McCormick the business and security has been a fine example of this. From 1998 to 2002, earnings were up 83%, and yet the share price was up "only" 43%. From 2002 to 2004, earnings were up "only" 17%, and yet the share price increased 52%. And from 2004 to 2008, earnings increased 41%, and the share price actually declined by 18%. I could have told you the operating results and many would get the price action exactly wrong. And this happens time and again.

More recently - from 2008 to 2016 - earnings have increased by 77%, and yet the share price is now up 206%. In effect, the shareholders of the last nine years captured more than their "fair share" of performance.

Today, shares trade around 24 times earnings, still easily above the historical norm closer to 20 times, hinting at the possibility for future valuation compression. It's a great business, but not exactly a compelling valuation.

This brings up an interesting question: "If not at today at $90, what price would look attractive?". Or said differently, "what's a "fair" price for McCormick?".

The answer to this inquiry is going to depend a great deal on your expectations for the business, along with what you deem as being "fair." Yet, we can come up with a high level baseline to demonstrate the rough process.

On September 30th of 2016, McCormick increased its outlook, suggesting that the company was on pace to earn between $3.75 and $3.79 per share in adjusted earnings. Let's use $3.75. It depends on where you look, but estimates for the company's intermediate-term growth rate range from ~7% to ~9%. With caution in mind, we'll use 6% for this illustration.

After five years that would equate to an earnings-per-share number of about $5. At 20 times earnings, this would mean a share price near $100. When you add in the dividends - currently sitting at $0.47 per quarter and anticipated to grow - you'd be looking at another $11 or so in cash payouts. This equates to a total anticipated value of about $111 after five years.

You could make the argument that this is a touch conservative - after all you're dealing with a very high-quality firm - but you don't want to be overly optimistic either.

Ideally you'd like to complete this "back of the envelope" calculation prior to ever seeing the share price. We've already spoiled that, but it can be helpful to take emotion out of the equation nonetheless. In any event, the question is whether or not that $111 in future potential value is interesting or not.

As compared to a share price near $90, this would equate to an average compound gain of roughly 4.4% per annum. Notably its positive (it's the sort of thing that would turn a $10,000 starting investment into $12,500 after five years), but it's not exactly compelling.

One way to think about a "fair" price to pay is to back into it via the assumptions mentioned above. So perhaps instead of a 4% yearly gain, you believe a "fair" return is around 8% per year. At this rate, using the same assumptions, you'd need a current share price near $76 - roughly another 15% lower than where shares sit today.

The advantage of this method is that it takes the volatile everyday share price bids out of the equation; you're creating a baseline independent of the current quote. The disadvantage is that this is only one possibility out of many.

You could do the same sort of exercise for a 10-year period. Using the same 6% growth rate assumption, you'd come to a future earnings-per-share number of about $6.70 with $26 or thereabouts collected in cash dividends. At 20 times earnings, this would equate to a future share price of about $134 or a total value of ~$160.

The question is the same: "Is a $160 potential value interesting, and if not, what price makes it interesting?". Based on the current price near $90, this sort of future value would imply average compound gains of roughly 6% per annum. That's a bit better - the valuation "burn off" had a longer runway - but perhaps still not compelling.

In order for the security to generate 8% annual gains, using the same $160 future anticipated value, you'd need a current share price of about $74.

So using those two examples, a "fair" price based on slightly subdued expectations would be in the mid-$70s. You can call it $75, but really I like to think in ranges, say $70 to $80. That's the point, again on a high level and recognizing a wide range of possibilities, where reasonable growth and valuation expectations start to look interesting. It's not an absolute, it's a starting place.

The last time shares traded at that price was back in 2015. The last time shares traded near that valuation (around 20 times earnings) was back in 2012. So it's certainly possible to see that sort of price, but it never has to come about either. Shares could continue trading at 22, 24 or 26 times earnings and you'd be stuck waiting years for your "valuation pitch." There's nothing wrong with this, but it's paramount to underscore that just because you made a calculation does not then make it so.

And naturally from here you'd look into all sorts of things to see whether or not your thesis strengthens or weakens. Requiring higher returns, for instance, equates to demanding a lower price. Or wanting to own only the best businesses may tip the scales the other way.

For what it's worth, and just to illustrate the finicky nature of the process, a Morningstar analyst offers a precise $91 "fair" value estimate for McCormick. Yet, this is then followed by a range from $72.80 ("consider buy") to $113.75 ("consider sell"), leaving a 20% margin on either side. It's just not a perfect process. You get very precise outputs, but the unknowns far outweigh any precision in your calculations.

In short, I don't have a precise answer to the question, "what is a 'fair' price to pay for McCormick?". However, what I outlined above is how I'd start to think about it. First, I'd consider the quality of the firm and decide if I'd even want to own a portion of it at any price. McCormick certainly passes that test.

From there, I like to use reasonable, but perhaps understated expectations as a baseline. And then you start adjusting and come up with a range of possibilities to better prepare yourself for the inevitable pricing swings that are sure to come. McCormick has demonstrated itself to be an excellent business, but personally I would need a valuation that is still 15% or 20% lower to even begin to take a closer look.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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