Church & Dwight: When An Excellent Business Meets A Lofty Valuation

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About: Church & Dwight Co Inc. (CHD)
by: Eli Inkrot
Summary

Church & Dwight has put together an exceptional business and investment record in the last decade.

On the shareholder side, this was driven, to a large degree, by an increasing earnings multiple.

This article looks at what could happen when an excellent business meets a lofty valuation.

New Jersey-based consumer products company Church & Dwight (CHD), known for its leading Arm & Hammer brand, has been a terrific company. Earnings and dividends march upward year-after-year, without a down period since the turn of the century. The business has been a model of consistency.

Here's a look at how the business and security have performed during the last decade:

Data Source: Value Line

Note that I used reported results for the beginning periods but estimates (with three quarters in the books) for this year.

This is what I like to refer to as "5 Component Investing." You can see how the important metrics interact with one another to go from sales growth all the way down to total shareholder returns.

In this particular case, Church & Dwight has grown sales at a reasonable rate of about 5.5% per year. Yet, this gets much better as each component adds its input.

The net profit margin improved from 8.3% to 13.6%, allowing for 10.8% annual company-wide profit growth. That's a solid result for a well-established firm.

Of course, the returns get much better as we turn to the shareholder side. Church & Dwight was able to retire a bit over 1% of its shares per year, resulting in earnings per share growth that came in at over 12% annually.

Next, you have valuation, which jumped from 21 times earnings up to 29 times earnings, resulting in share price appreciation of over 16% annually. And finally, the dividend grew at an even faster rate, increasing the payout ratio and adding a bit of return. All told, an investor at the end of 2008 that held through today would be sitting on 17% annualized gains. As a point of reference, that's the sort of thing that would turn a $10,000 starting investment into ~$48,000 after a decade.

All five components worked together to generate substantial returns. The business performance was solid and shareholder returns started to get to the exceptional territory.

This is great for past investors, but it does bring up a bit of caution for prospective investors. We all know that past returns are not indicative of future results. Yet, I would take it one step further: past returns built on large improvements, especially as it relates to valuation, could actually work as a drag on future returns. In other words, the exact thing that generated outperformance in the past could be a hindrance moving forward.

To give you an idea of why this is the case, let's look at what would be required for Church & Dwight to repeat this lofty investment past in the next decade:

Data Source: Value Line

In the above table, I have provided the same historical information along with what would be required in the next 10 years to replicate this performance.

In a few words: it's a tall task. The net profit margin would need to jump to over 22% when something in the 8% to 14% range has been more typical. The share count would have to be retired at the same rate, despite a loftier valuation and higher payout ratio. Investors would have to be willing to pay 40 times earnings when something near 30 has hardly been seen (and indeed, something in the low-20s much more typical). And the dividend payout ratio would need to increase significantly.

This outlines a possible scenario; it's in the realm of things that could theoretically happen. Yet, I would argue that isn't especially prudent to rely on as an investment thesis.

A more cautious set of assumptions could look like this:

Data Source: Value Line

This table displays the same historical information along with a more cautious view of the future. Some may view this as too downbeat, that's Okay. There are two important takeaways and neither is related to the precise numbers calculated down to the nearest decimal.

The first is that it's important to come up with your own expectations. Just because an investment performed well in the past, this does not allow you to skip over the imperative piece of figuring out what you believe the business is worth today.

Second, this table clearly illustrates the importance of valuation. Here you have improvements in four of the five major areas. Revenues are still assumed to grow nicely, the net profit margin is still increasing, the share count is being reduced and the dividend is anticipated to add nicely.

The only negative assumption in the above table is the valuation dropping from close to 30 times earnings down to something that has been more typical over the last couple of decades. And this factor alone completely offsets an investment thesis. The business can perform well, the dividend can grow nicely and yet, shareholder returns would be set to come in on the low end of average.

Now granted, you could have made a similar argument a few years ago and so far that idea has not played out. If Church & Dwight continues to trade around 30 times earnings, investors will continue to see solid gains as the business performs. Yet, if that doesn't hold, the above illustration is the sort of thing that can happen when an excellent business meets a lofty valuation.

Warren Buffett has this quote: "When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact." Naturally, Church & Dwight does not have a "bad economics" business, but the idea can be carried through to valuation. When an excellent business meets a lofty valuation, it is usually the valuation that will have an outsized influence on future shareholder returns.

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.