Recently, I began creating “quality snapshots” of companies. The snapshots are based on assessments from data providers that I respect.
Here is an example of a quick approach to creating a quality snapshot. It uses the following quality ratings:
• Value Line’s Safety Rating
• Value Line’s Financial Grade
• Morningstar’s Moat Rating
• S&P’s Credit Rating
• Simply Safe Dividend’s Dividend Safety Rating
I created the following scoring system.
What I wanted to find out is if any dividend growth company scored in the highest point category (5 points) on all of the metrics. In other words, are there any companies that get 5 points straight across the board?
It turns out that several did. Each of these companies scores the maximum 5 points on each of the quality metrics shown above.
There are just 8 such companies. It is a select group.
This month, I have selected one of these companies – Procter & Gamble (PG) – as May’s Dividend Growth Stock of the Month.
This is the 2nd time I have reviewed Procter & Gamble. In August, 2015, it was in the midst of a multi-year turnaround effort. The bulk of that initiative has been completed.
On the following 5-year price chart, you can see that PG has experienced a sharp decline in 2018.
As we often see, the recent price decline has improved PG’s valuation. So this seems like a good time to take another look at the company.
Procter & Gamble’s Dividend Record
At 3.9% yield, PG is what I consider a mid-yield stock. It yields far more than the S&P 500, and 56% more than the average Dividend Champion, but it does not reach the 5% threshold that I use to call a stock “high yield.”
PG’s annual dividend increases had been declining for several years prior to 2018.
This year’s increase of 4% was a jump up from last year’s 2.5%.
Both the string of declines and this year’s higher growth reflect PG’s turnaround situation and its progress in actually turning around.
PG gets a top-notch dividend safety score of 98 from Simply Safe Dividends.
That rates as Very Safe on their rating scale, shown below. (For more insight into dividend safety, see Dividend Growth Investing Lesson 17.)
Procter & Gamble’s Business Model and Quality
Procter & Gamble was founded in 1837 as a candle-and-soap company. It is now the world’s largest producer of consumer products, selling into 180 countries.
The company reports its results in 5 segments encompassing 10 product categories:
[Source of all slides: Procter & Gamble]
In the right-hand column of the chart above, you can see PG’s stable of world-class brand names, including Braun, Gillette, Crest, Tide, Cascade, Swiffer, Pampers, and Charmin. More than 20 of those brands are billion-dollar businesses in their own right, with some ranging up to $10 billion in annual sales. Twelve PG products hold the #1 position in market share in the USA.
PG’s customers include mass merchandisers, grocery stores, membership club stores, drug stores, high-frequency stores, and online retailers. Wal-Mart and its affiliates account for about 15% of PG’s total revenue. PG’s top 10 customers account for about 35% of total sales.
When I wrote about PG in 2015, it had already begun a long program of shedding less-promising products and focusing on its strongest core brands. It was deliberately shrinking itself to become stronger. It was also reorganizing for efficiency.
Since then, PG says it has become “a profoundly different company.” There are no food brands left. PG’s turnaround program has had 4 major areas of focus:
Portfolio Strengthening: PG used to have 170 brands in 16 categories. Now it has 65 brands in 10 categories.
Organizational Transformation: PG has greatly streamlined its organization from what it concedes was a “thicket” of reporting lines and structures. Its structure now focuses on the product category as its central organizing principle.
Supply Chain Transformation: Best shown by this map.
Productivity Improvement: In the 5 years through 2016, PG achieved $10 billion in productivity improvements. It is targeting another $10 billion of cost savings through 2021 by reducing overhead, designing products for lower material costs, creating efficiencies in product formulation, and increasing manufacturing and marketing productivity. The targeted result is a 45% increase in profit per employee.
P&G spends close to $2 billion each year on R&D, much more than its competitors. Its development projects aim to gain consumer insights and devise new/better product technologies.
PG has been known for many years as a strong marketing company. Its advertising budget regularly exceeds $7 billion per year (more than 10% of sales). The company is seeking more efficient marketing, with a greater shift toward digital from print.
PG’s challenges include:
• Slow growth. Many of its product categories are mature. The company has also lost market share to some smaller challengers, and of course its shedding of brands meant that it lost revenues from those products.
• Changing shopping habits, including the rise of digital promotion and e-commerce.
• Cut-throat competition from large rivals such as Unilever (UL), Kimberly Clark (KMB), and Colgate-Palmolive (CL), as well as smaller specialty producers and private store brands.
• Unfavorable foreign-exchange rates that can impact results from the 60% of its sales that come from overseas.
Morningstar awards PG a wide economic moat, which is its highest rating. They feel that the moat is created by PG’s brand assets, distribution network, and economies of scale.
Procter & Gamble’s Financials
Value Line gives PG its top Financial Strength Grade rating of A++. Let’s take a look and see if we agree. There are several categories to consider.
Return on Equity (ROE) is a measure of financial efficiency. ROE indicates how much return a company is generating per dollar invested in it. Per Bloomberg, the average ROE of the 10 largest companies in the S&P 500 is 19%. The average ROE among Dividend Champions is 24%.
The following chart shows PG’s ROE in recent years.
[Source of all yellow-bar graphs: Simply Safe Dividends]
PG’s ROE is about average for S&P 500 companies, and it has been quite stable over the years.
Debt-to-Capital (D/C) ratio measures how much the company depends on borrowed money to finance its activities. Most companies finance their operations through a mixture of debt and equity (shares sold on the open market) as well as their own cash flows.
All else equal, the higher the D/C ratio, the riskier the company is. Debt must be paid back, so debt repayments create a constant draw on the company’s cash flows. A typical D/C ratio for large companies is 50%.
PG rates well on debt. Its ratio of 33% is about 2/3 of the average large company. Its debt is quite stable. And as we saw earlier, S&P’s credit rating for PG is AA-, which is a very solid rating that helps to lower interest rates on the debt that PG takes on.
We reviewed PG’s efficiency programs earlier. Do they show up in PG’s margins?
Yes. Since PG’s turnaround program started in 2012, its operating margins have improved from 18% to 23%. That is a very healthy outcome.
According to CSIMarket.com, S&P 500 companies have an average operating margin of around 11%. PG’s margins now double that rate.
Earnings per Share (EPS) – that is, a company’s officially reported profits per share outstanding – is always of interest. We want to see if a company has had years when it lost money, or if its earnings are steadily declining.
PG has an admirable earnings record. Its earnings are steadily positive, and they have increased in 5 of the past 9 years.
We see there were downward earnings moves in the first years of the turnaround, which makes sense, because the company was shedding products and revenues. The recovery over the past 2 fiscal years is impressive.
Free Cash Flow (FCF) is the cash a company has left after paying its expenses. Excess cash flows allow a company to pursue investment opportunities, make acquisitions, repurchase shares, and pay/increase dividends.
As with earnings, the significant number to examine is the per-share amount, and again we look for trends.
PG has generated positive FCF per share over the past 10 years, even during the Great Recession. Growth has been bumpy (up in 5 of the past 9 years), but the amount has always been solidly positive.
The strong cash flow record is one of the major reasons that PG’s dividend is considered to be so safe.
Overall, this is a good financial picture. There are no warning flags, and many categories are above average, although none really stands out as being in the top echelon.
It’s impressive that PG has been able to keep so many financial categories stable while executing its turnaround programs. Positive financial outcomes from the turnaround are visible in the last 2 fiscal years.
I wouldn’t give PG a financial grade like Value Line’s A++, but it’s certainly above average.
Procter & Gamble’s Stock Valuation
My 4-step process for valuing companies is described in Dividend Growth Investing Lesson 11: Valuation.
Step 1: FASTGraphs Basic. The first step is to compare the stock’s current price to FASTGraphs’ basic estimate of its fair value.
The basic valuation estimate uses a reference price-to-earnings (P/E) ratio of 15 (the historical long-term P/E of the stock market), which is shown by the orange line on the following chart.
P/E x E = P, so the orange line shows what would be a fair price for PG. The black line shows PG’s actual price.
PG’s actual P/E is 17.8 (circled), so this valuation method suggests that PG is overvalued. PG’s price is above the orange fair-value reference line.
If we make a ratio out of the P/Es, we can calculate the degree of overvaluation: 17.8 / 15 = 1.19. In other words, PG’s current price is 19% above the fair price as estimated by this first method.
The fair price is calculated by dividing the actual price by the ratio 1.19. We get $74 /1.19 = $62 for a fair price.
Note that I round all dollar amounts off to the nearest dollar. That’s to avoid creating a false sense of precision in making valuation assessments.
Step 2: FASTGraphs Normalized. The second valuation step is to compare PG’s price to its own long-term average P/E ratio. This gives us a valuation estimate based on the stock’s own long-term valuation instead of the market’s long-term valuation.
This changes the picture considerably.
PG’s 5-year average P/E ratio is 19.8 (circled), so the blue fair-value reference line shifts upwards from its position when 15 was used in the first step. Now PG looks undervalued.
The degree of undervaluation is calculated the same as in the first step: Make a ratio out of the P/Es. We get 17.8 / 19.8 = 0.90. So when viewed from this perspective, PG is 10% undervalued.
I would call this “fair” valuation. I consider any price within +/- 10% of fair value to be fair.
The fair price suggested by this 2nd approach is $82.
Step 3: Morningstar Star Rating. Morningstar approaches valuation differently. They use a discounted cash flow (DCF) process for valuation. Their approach is comprehensive and detailed. Many investors consider DCF to be the best method of assessing stock valuations.
In their DCF approach, Morningstar ignores P/E ratios. Instead, they make a detailed projection of all the company’s future profits. The sum of all those profits is discounted back to the present to reflect the time value of money. The resulting net present value of all future earnings is considered to be the fair price for the stock today.
Morningstar considers PG to be way undervalued, as shown by the 5-star rating on their 5-star scale.
Morningstar estimates that PG’s fair price is $98, which makes the stock 24% undervalued.
Step 4: Current Yield vs. Historical Yield. My last step is to compare the stock’s current yield to its historical yield.
This way of calculating fair value is based on the idea that if a stock’s yield is higher than usual, it may indicate that its price is undervalued (and vice-versa).
PG’s 5-year average yield is 3.1%, while its current yield is 3.9%. Again, we use a ratio to compute the degree of undervaluation: 3.1% / 3.9% = 0.79, or 21% undervalued.
When using this method, I cut off undervaluations at 20%, because this is an indirect way to approach valuation. Using 20% undervaluation, we get a fair price of $93 per share.
Now let’s average the 4 valuation methods.
Thus, I conclude that PG’s current price is about 12% below the stock’s fair price. That is an attractive situation. My estimate of PG’s fair price is $84 per share, while the stock is available now for $74.
We don’t usually see such a spread among the 4 valuation methods as we see with PG. As a comparison point, CFRA has a 12-month price target of $100 on PG, which is much higher than our fair value estimate and 35% above the stock’s current price.
Beta measures a stock’s price volatility relative to the S&P 500. I like to own stocks with low volatility for 2 reasons:
• They present fewer occasions to react emotionally to rapid price changes, especially sudden price drops that can induce a sense of fear.
• There is academic research that suggests that low-volatility stocks outperform the market over long time periods.
PG’s 5-year beta of 0.6 compared to the market as a whole (defined as 1.0) means that its price has been 40% less volatile than the index. This is a positive factor.
In their report on PG, CFRA shows the recommendations of 27 analysts who cover the company. Their average recommendation is 3.5 on a scale of 5. This translates to a “strong hold.” This is a neutral factor.
Share Count Trend
I like declining share counts, because the annual dividend pool is spread across fewer shares each year. That makes it easier for a company to maintain and increase its dividend. By buying back its own shares, the company is essentially investing in itself and making each remaining share into a larger piece of the pie.
What’s the Bottom Line on Procter & Gamble?
Here are PG’s positives:
• Good yield at 3.9% (compared to the S&P 500’s yield of 1.8%).
• Good dividend resume typical of a mature high-quality company: Proven commitment to its dividend with 62 straight years of increases; strong dividend safety.
• Stock is around 12% undervalued.
• High quality company with wide moat, great brands, world-wide presence, and outstanding distribution systems.
• Turnaround programs appear to be succeeding.
• Good financials, including steadily positive earnings and cash flows, relatively low debt, and good credit rating.
• Steadily declining share count for the past decade.
• Generally low-volatility stock.
And here are PG’s drawbacks:
• Slow dividend growth at around 4% per year.
• Company is in slow-growth businesses, with many mature product categories.
• Highly competitive consumer products markets, with competition from large and small rivals, store brands, and e-commerce distribution where consumers are very price-sensitive.
• Unfavorable foreign-exchange rates can impact results.
Overall, I see PG as a good investment opportunity at this time. I own PG in my Dividend Growth Portfolio. It supplies about 3% of the portfolio’s income.
That said, this is not a recommendation to buy, hold, or sell PG. Any investment requires your own due diligence. Always be sure to match your stock picks to your personal financial goals.
— Dave Van Knapp
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