Does Procter & Gamble Deserve a Spot in Your Portfolio?

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As investors, we always want our investments to generate a healthy return. However, investors often forget that returns stem from two, not one, extremely important factors:

  1. The business' ability to generate profits
  2. The price you pay for one share of those profits

This idea of price versus returns provides the bedrock for the school of investing known as value investing. In this series, I'll examine a specific business from both a quality and pricing standpoint. Hopefully, in doing so, we can get a better sense of its potential as an investment right now.

Where should we start to find value?
As we all know, the quality of businesses vary widely. A company that has the ability to grow its bottom line faster (or much faster) than the market, especially with any consistency, gives its owner greater value than a stagnant or declining business (duh!). However, many investors also fail to understand that any business becomes a buy at a low enough price. Figuring out this price-to-value equation drives all intelligent investment research.

In order to do so today, I selected several metrics that will evaluate returns, profitability, growth, and leverage. These make for some of the most important aspects to consider when researching a potential investment.

  • Return on equity divides net income by shareholder's equity, highlighting the return a company generates for its equity base.
  • The EBIT (short for Earnings Before Interest and Taxes) margin provides a rough measurement of the percent of cash a company keeps from its operations. I prefer using EBIT to other measurements because it focuses more exclusively on the performance of a company's core business. Stripping out interest and taxes makes these figures less susceptible to dubious accounting distortions.
  • The EBIT growth rate demonstrates whether a company can expand its business.
  • Finally, the debt-to-equity ratio reveals how much leverage a company employs to fund its operations. Some companies have a track record of wisely managing high debt levels, generally speaking though, the lower the better for this figure. I chose to use five-year averages to help smooth away one-year irregularities that can easily distort regular business results.  

Keeping that in mind, let's take a look at Procter & Gamble (NYS: PG) and some of its closest peers.

Company Name

Return on Equity (5-Year Avg.)

EBIT Margin (5-Year Avg.)

EBIT Growth (5-Year Avg.)

Total Debt / Equity

Procter & Gamble16.79%19.94%3.78%47.08%
Colgate-Palmolive (NYS: CL) 88.27%22.28%10.89%159.45%
Avon Products (NYS: AVP) 69.43%11.88%-0.16%158.63%
Kimberly-Clark (NYS: KMB) 31.36%14.71%3.05%127.78%

Source: Capital IQ, a Standard & Poor's company.

We see a lot of commonalities here. We also see a lot of why investors like Warren Buffett love strong consumer products companies such as these above. Their impressive portfolio of branded products give them some consumer loyalty and pricing power in a tough, competitive industry, as illustrated by these really impressive returns on equity and operating margins. Already established and dominant in their main markets, many of these companies have struggled to fully tap into new sources of growth. Out of the four, Colgate-Palmolive somewhat distances itself from the pack in the three performance metrics, although I dislike its leverage. Procter & Gamble looks by far the safest with the only debt-to-equity ratio under 1. However, this only makes up one part of the price/value equation.

How cheap does Procter & Gamble look?
To look at pricing, I chose to look at two important multiples, price to earnings and enterprise value to free cash flow. Similar to a P/E ratio, Enterprise Value (essentially debt, preferred stock, and equity holders combined minus cash) to unlevered free cash flow conveys how expensive the entire company is versus the cash it can generate. This gives investors another measurement of cheapness when analyzing a stock. For both metrics, the lower the multiple, the better.

Let's check this performance against the price we'll need to pay to get our hands on some of the company's stock.

Company

Enterprise Value / FCF

P / LTM Diluted EPS Before Extra Items

Procter & Gamble19.9815.51
Colgate-Palmolive18.3617.41
Avon Products50.5912.01
Kimberly-Clark19.3015.42

Source: Capital IQ, a Standard & Poor's company.

Especially given their strong pasts, some of these companies look pretty intriguing at their present prices. On the earnings front, Procter, Colgate, and Kimberly-Clark pique my interest. At the same time, no company here looks like a steal from a cash flow perspective.

We'll need to look in greater detail to really see if these stocks have what it takes. In general, I like them, especially Colgate and Procter. With concerns about the health of the economy rattling markets lately, waiting to see if these come down somewhat in price could make for an even more illustrious buying opportunity.

While Procter & Gamble stock may not look like a stock for your portfolio right now, the search doesn't end here. In order to really get to know a company, you need to keep digging. If any of the companies mentioned here today piques your interest, further examining a company's quality of earnings, management track record, or analyst estimates all make for great ways to further your search. You can also stop by The Motley Fool's CAPS page where our users come to share their ideas and chat about their favorite stocks or click HERE to add them to My Watchlist.

At the time this article was published Andrew Tonner holds no position in any of the companies mentioned in this article.Motley Fool newsletter serviceshave recommended buying shares of Kimberly Clark and Procter & Gamble. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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