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Is Procter & Gamble A Value Play?

Summary

  • Does the share price decline for Procter & Gamble prove to be a solid entry point?
  • Procter & Gamble is still struggling to grow the company with just 1% organic sales growth seen year over year.
  • Shares of The Procter & Gamble Company offer a current yield of 3.71% with 59 consecutive years of dividend increases.

Volatility has spiked over the last week with large swings in share prices both lower and higher. This could lead some to take up defensive positions for their portfolio. That means consumer staples and how many consumer staples can spout a 59 consecutive year dividend growth streak? The Procter & Gamble Company (NYSE:PG) closed trading on Thursday, August 27th at $71.48 giving a current yield of 3.71%.

The following tables/graphs are taken from my personal stock analysis spreadsheet. Data for the stock analysis was sourced from The Procter & Gamble Company's investor relations page, Morningstar, and Yahoo Finance.

Historic Growth Rates:

Over the last decade, owners of Procter & Gamble have earned fairly poor returns. According to longrundata.com, PG has delivered investors a total return of just 71.0% or 5.5% annualized returns over the last 10 years. Those numbers are market returns at specific snapshots in time and aren't necessarily indicative of the business results over the same time period. Looking at the historic growth rates for per share dividends, earnings, revenue, and free cash flow gives a better idea of the true operational results that Procter & Gamble has delivered.

I also like to look at the growth in the total amount of dividends, earnings, revenue, and free cash flow over the same time periods to compare to the per share growth numbers.

The growth in the total amount and per share numbers across all metrics except for dividends has been very disappointing. When you look at the growth numbers it's not surprising to see that Procter & Gamble has been a relative disappointment for investors over the last 10 years. Of course, these are past results and they're no guarantee of the future, rather just a guide. So let's look at what the future could potentially have in store for investors in Procter & Gamble.

Discounted Earnings:

Analysts followed by Yahoo!Finance expect Procter & Gamble to grow earnings 7.3% per year over the next 5 years. I then assumed that PG could grow earnings for 3 years at 5.8% (80% of 7.3%) and at 4.5% per year thereafter. Running these numbers through a discounted earnings analysis with a 10% discount rate and summing over 30 years yields a fair value price of $69.24.

Gordon Growth Model:

As a dividend growth investor, I'm primarily concerned with the growth of the dividend since capital appreciation is too volatile in the short term. Using a simple Gordon Growth Model calculation starting with the current annual dividend of $2.65, a required rate of return of 9%, and a dividend growth rate of 5%, Procter & Gamble's fair value is calculated to be $69.60.

You can also rearrange the formula to solve for the required growth rate based on the current price. Using the current annual dividend of $2.65 and the current price of $71.48, PG would need to grow the dividend by 5.1% per year to provide a 9% rate of return.

The required/estimated dividend growth rates are lower than what Procter & Gamble has provided over the last 10 years. However, I expect that future dividend growth will be lower moving forward as I'll explain later barring a return to more rapid growth of the company

Dividend Discount Model:

For the DDM, I assumed that Procter & Gamble will grow dividends at 6.0% per year for the next five years and then at 5.0% per year in perpetuity. To calculate the valued I used a discount rate of 9%. Based on the DDM, shares of Procter & Gamble are worth $73.66.

Dividend Safety:

Of course we all want dividend growth from the companies we own because in general that means there's growth of the underlying business. However, dividend growth at all costs is not sustainable. Over the last 10 years, the payout based on earnings has ranged from a low of 38.5% to a high of 106.2% with an average payout ratio of 54.3%. The free cash flow payout ratio has ranged from 37.7% to 70.4% with an average of 53.8%.

You can see the historical payout ratios based off both earnings and free cash flow in the following chart. Over the last decade the payout based on both earnings and free cash flow have been fairly close to the same. However, the trend for both of them is not what I want to see at all. The dividend is still well covered by both earnings and free cash flow; however, going forward there's not much room to grow the dividend faster than the underlying growth in both earnings and free cash flow.

(click to enlarge)

Cash Flow:

Earnings grab the headline attention, but cash flow is the life blood of any company. Procter & Gamble has seen operating cash flow decline by 1.9% per year since the end of FY 2010, dropping from $16.072 B to $14.608 B for FY 2015. Capital expenditures have seen an uptick over the same time growing from $3.067 B to $3.736 B or 4.0% per year. Since capex has been growing while operating cash flow has declined free cash flow has seen a fall as well. Free cash flow in FY 2010 was at $13.005 B and for FY 2015 it sat at just $10.872 B. That's a 3.5% annual decline.

Since dividends are a cash expense let's see what the free cash flow after paying the dividend, FCFaD, looks like. FCFaD has declined quite precipitously from $7.547 B in FY 2010 to $3.585 B in FY 2015. That's a very concerning 13.8% annual decline. Free cash flow after the dividend and buybacks, FCFaDB, has also seen a decline, dropping from $2.264 B in FY 2010 to $1.807 B in FY 2015. That's a 4.4% annual decline.

(click to enlarge)

Cash flow can be rather volatile due to the timing of cash expenses so it helps to look at things over a period of time rather than at points in time. The silver lining is that Procter & Gamble has still been cash flow positive across all three metrics over the last 5 years. The following table shows the total cash flows for FCF, FCFaD, and FCFaDB has been from FY 2011 to FY 2015.

Balance Sheet:

It's also important to analyze the balance sheet to determine the safety of the dividend. Procter & Gamble has maintained fairly conservative balance sheet over the last five years and even better is that the levels are fairly steady from year to year.

(click to enlarge)

As of the end of FY 2015, Procter & Gamble's total debt level was $30.350 B. Based on the average net income of the last 3 years, $9.997 B, PG could use its cash stockpile of $6.845 and repay all of its debt with 2.4 years worth of net income if they desired. I consider anything less than 5 years to be safe and Procter & Gamble is well below that mark. Given the struggles that Procter & Gamble has seen over the last decade it's pretty encouraging to see that the balance sheet hasn't suffered. Net income still covers interest expense 11.2 times over so while the total debt level is fairly high, the interest expense is not a drag on the company.

Relative Historical Valuations:

Another thing I like to look at before investing in a company is where it currently sits compared to some common valuation ratios. Companies tend to stay within certain ranges as long as nothing has fundamentally changed with the company. The following table shows the high and low end of the 5 and 10 year historical averages for dividend yield, P/E ratio, P/S ratio, and EBITDA per share as well as the FY 2016 estimate for each metric with the corresponding price targets. The reason for using the low end of the common ratios is because we are targeting to buy shares of the company at its cheapest valuation.

The current share price is trading just above the mid point of the historic ranges across the different metrics. The average low valuation price target comes to $63.43 while the average high valuation price works out to $76.12.

Since the end of FY 2010, Procter & Gamble has been effective at reducing the share count decreasing the number of shares outstanding each year. At the end of FY 2010 the diluted weighted shares outstanding were at 3.099 B and by the end of FY 2015 they sat at 2.884 B. Management has reduced the share count by 7.0% over the last five years with an annualized decrease of 1.4% per year.

(click to enlarge)

A negative number for the % change value means shares were bought back by the company and a positive value means the shares outstanding increased.

While I enjoy share buybacks as a way to return capital to shareholders, it's also important to look at how effective those buybacks have been. Procter & Gamble has spent a total of $16.258 B on share buybacks since the end of FY 2010. The share count has been reduced by 215.3 M shares over that time. Calculations for buyback effectiveness takes into account the net cash used for buybacks, share buybacks, shares issued for acquisitions or stock options.

If Procter & Gamble's share count remained the same as at the end of FY 2010, 3.099 B, earnings per share for FY 2015 would have been $2.27. Since PG actually earned $2.44 per diluted share in FY 2015, the effect of the buyback has been $0.17 ($2.44 - $2.27) per share. Management used $5.25 per share worth of equity value for the repurchases which represents a 3.2% return ($0.17 / $5.25). Management has earned decent returns on the share repurchase program; however, it hasn't been as effective as it could have been due to rather large share dilution to raise capital and stock options granted to employees and executives.

Revenue and Net Income:

Since the basis of sustained dividend growth is revenue and net income growth, we'll now look at how Procter & Gamble has done on that front. Revenue has declined between FY 2010 and FY 2015 by 0.70% per year. Net income has seen a steeper fall over the same time with an annual decrease of 11.2%. This has led to a decrease in net income margin of 16.1% in FY 2010 to just 9.2% for FY 2015. Assuming that net income margin for FY 2016 matches that of FY 2015, 9.2%, net income would come in at $6.396 B based on FY 2016's estimate of $69.340 B in revenue.

(click to enlarge)

Forecast:

The following chart represents the earnings per share forecast used in the discounted earnings valuation from above and the typical P/E ranges that shares of Procter & Gamble have traded for. Shares appear to be undervalued currently as the FY 2016 forward P/E ratio estimate sits at 18.6. However, it's important to remember that these are just forecasts and if PG is able to grow earnings at a faster or slower rate than my assumptions the valuation could be very different. There's also the possibility that the market in general will change its normal P/E range for Procter & Gamble, leading to P/E compression or expansion.

(click to enlarge)

Conclusion:

The average of all the valuation models gives a target entry price of $63.25 which means that shares of Procter & Gamble are trading at a 13.0% premium. I've also calculated it with the highest and lowest valuation methods thrown out. In this case the high dividend yield and Graham Number valuations are removed and the new target entry price becomes $63.70. Shares are currently trading for a 12.2% premium to this price. The average valuation price works out to $71.12 and the high valuation price is at $76.46.

According to Yahoo!Finance, the 1 year target estimate is $84.50 suggesting that the share price is undervalued and has 18.2% upside. S&P Capital IQ has Procter & Gamble as a 3 star hold and has a 1 year target price of $82.00 suggesting 14.7% upside with a fair value of just $66.00. Morningstar has Procter & Gamble rated as a 5 star stock meaning it's trading well below their fair value estimate.

Consumer staples make excellent dividend growth investments precisely because the very nature of their business is that the demand for their products doesn't fluctuate much with the fortunes of the economy. That's why you'll see plenty of consumer staples companies with long track records of dividend increases and Procter & Gamble is no exception amassing an impressive 59 year streak of higher dividends. However, that streak is in the past although I do believe that management will do everything in their power to keep the streak going.

The dividend is safe here since it is still covered by both earnings and dividends. However, since management has been increasing dividends faster than the underlying growth, actually a decline, of the company the dividend just doesn't have much more room to expand.

(click to enlarge)

Earnings and free cash flow still haven't shown growth since FY 2008 for earnings and FY 2010 for free cash flow. However, dividends continued to grow which led to increases in the payout ratios based on both earnings and free cash flow. Dividend growth is likely, at best, to track earnings growth going forward although I would prefer to see management grow the dividend at a slower pace to build in more cushion.

As a consumer staple powerhouse with a global reach Procter & Gamble hasn't been able to escape the rising dollar. For FY 2015, PG saw an 11% improvement from FY 2014 in constant currency core earnings per share when in reality core earnings per share decreased 2%. That's a huge swing just due to currency valuation, but that comes with being a large multinational company. Eventually the dollar will lose some of it's strength and PG will begin to reap the benefit of a cheaper dollar.

Overall I still like PG for my portfolio and would consider adding to my position if the share price dips to the mid to low $60's, subject to capital availability and other opportunities. But at current prices I'm in no hurry to add to my stake. The company has done very little for investors other than dividends and share buybacks since the financial crisis and I don't see a clear cut path to a change in their fortune on the horizon. Procter & Gamble remains an excellent company and the dividend should continue to grow going forward but investors expecting a return to 10%+ dividend growth will probably be disappointed.

Additional disclosure: I am not a financial professional and all thoughts/ideas here are my own and for entertainment purposes only. Investing involves risks. Please consult a financial professional and do your own due diligence before investing. The author is not responsible for losses of any kind by readers. All charts/images and data are sourced from my personal stock analysis spreadsheet, Morningstar, Yahoo! Finance, or The Procter & Gamble Company's Investor Relations page.


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