Everything Warren Buffett: GURU FOCUS: Valuation of Guru Holdings: The Procter & Gamble Company

Tuesday, October 13, 2009

GURU FOCUS: Valuation of Guru Holdings: The Procter & Gamble Company

Oct. 12, 2009 | Filed Under: PG

This article will highlight the gurus tracked at GuruFocus that own P&G. It will then highlight some of the reasons that the gurus may like The Procter & Gamble Company and conclude with a discussion of value.

Guru Holdings

The Procter & Gamble Company is currently held by 15 gurus. Of note is Warren Buffett.

The important thing to note is that only one guru Ron Baron has reduced his holding in the most recent quarter while 6 have increased their position. 8 have kept their positions unchanged for the most part in the most recent quarter.

Wallace Weitz has recently increased his position by 250%. Donald Yacktman increased his position by about 200%. And Arnold Van Den Berg has increased his position by about 40%.

Most notably however is Warren Buffett who manages 96,316,010 shares as of 06/30/2009, which accounts for 10.05% of the $48.95 billion portfolio of Berkshire Hathaway.

By following the holdings of gurus at GuruFocus, one can find potential investments.

Company Information

P&G is focused on providing branded consumer products to a global market. Their goal is to provide quality and value to consumers. P&G has products which are sold in 180 countries. Their primary end points are mass merchandisers, grocery stores, membership clubs, drug stores and convenience stores. On a global level, P&G is focusing on expanding by having more products placed on the shelves of these end points.

As of the recent quarter P&G had 32% of sales come from beauty products. 21% of sales came from house and well being business units. And 47% of sales are from the household care segment.

P&G operates in advantageous business segments. With the threat of inflation looming in the US, P&G should be able to raise prices with inflation over the long term. Some consider P&G to be a hedge against inflation.

Regarding shareholder friendliness, it is interesting to note that P&G appears to have its eyes on cash flow, not only earnings. Free cash flow is what can be used to pay dividends and reinvest in the business. From their financial reports, the following phrase can be found over and over again:

“Free cash flow is also one of the measures used to evaluate senior management”

This is a very important factor to note as it is company policy to keep its eyes on cash.

Also, interesting to note is that PG has an internal measure called Free Cash Flow Productivity. This is the ratio of free cash flow to net earnings. The companies’ long term target is to generate free cash at or above 90% of net earnings.

To further demonstrate shareholder friendliness, refer to page 31 of the 2009 annual report:

Throughout MD&A, we refer to measures used by management to evaluate performance, including unit volume growth, net outside sales and net earnings. We also refer to a number of financial measures that are not defined under accounting principles generally accepted in the United States of America (U.S. GAAP), including organic sales growth, free cash flow and free cash flow productivity. We believe these measures provide investors with important information that is useful in understanding our business results and trends.

In 2009, 41% of earnings came from international business and 59% came from business in the United States.

Valuation

Two valuation methods will be discussed. PE ratio and more importantly DCF. Be sure to read this section in its entirety.

First, Earnings per share. Over the past 5 years, P&G has reported earnings of $3.58 (2009), $3.64, $3.04, $2.64 and $2.66 (2005). That is an average of $3.11. A PE of 15 would tell us that P&G is worth $46.68. Earnings are not a reliable measure however. This is an easy to calculate number. That doesn’t mean that it makes sense. P&G did recently announce that it expects 2010 EPS to be just over $4/share however. With a PE of 15, this would be $60/share.

Now a note on free cash flows. At the end of the year, free cash flow is what is left over to reinvest in the business or give out as dividends. As an owner, this is the number to concentrate on. Concepts like depreciation and amortization make earnings an unreliable number. If P&G were to buy a machine in year one, the cost does not appear under year one alone. The cost is spread out over many years and this does not give a true picture of what happens in any one given year. This is called depreciation. Free cash flow analysis attempts to look at what actually happens in a given yea in the same way a small business owner would gauge success.

Also, a Discounted Cash flow valuation was done. P&G is wonderful at reinvesting their free cash flows. Over the past 10 years, P&G has grown free cash flows by about 14%. For my assumptions, I used a starting free cash flow of $11.6B and grew it by 11% the first year, 10% for years 2 and 3. 9% for years 4 and 5. Then 8% for years 6-10. Growth of 4% was used for years 10-20. By discounting these future free cash flows by 9% and adding in a total equity of about $60B, it was determined that P&G is worth about $272 billion. This is what the market cap should be. The front page of the recent 10-Q tells us that there are 2,914,701,790 shares outstanding. Simple division tells us that P&G is worth about $93 per share.

P&G closed on Monday at $57.50. This is a discount of about 38%. Perhaps now is a good time to buy. Buying at a discount of at least 25% is always desirable. The reason is two fold. First, it reduces the risks to the assumptions that were made and secondly, it should increase your return over the long term.

Disclaimer: The author of the article does not currently own PG. This article is not a recommendation to buy or sell. As always do you due diligence prior to investing.

Other company specific articles by this author can be found here:

Johnson & Johnson (JNJ)
General Electric Company (GE)
Microsoft Corporation (MSFT)

Karl is currently a software engineer in Connecticut with a bachelors of science in electrical engineering from Clarkson University. He has been investing since 2001 and interested in value investing since 2005. Karl is continually striving to learn more about investment.