Shares of global consumer staples giant Procter & Gamble (NYSE:PG) have had a great 2019, surging almost 30% year-to-date to fresh all-time highs. The company has been firing on all cylinders, across all of its markets, against a favorable consumption backdrop wherein consumer confidence and spending levels are at historic highs.
Sounds like a winning combination, right? It has been. PG stock is up huge on the year. But, here’s a sobering reality for bulls: At current levels, PG stock is woefully overvalued.
I get the bull thesis here. Although the global industrial economy hit a rough patch in late 2018 which continued into the first half of 2019, the consumer economy globally remained healthy and vigorous during that time, supported by strong labor market conditions and supportive central bank policy. Now, thanks to trade headwinds reversing course, the industrial economy should bounce back. As it does, the whole economy should start firing on all cylinders again. Recession fears will ease. Consumers will grow even more confident.
All that means more spending on consumer staples products. Procter & Gamble is the king in the consumer staples industry. As such, it also means more spending on P&G products. More spending means bigger revenues, which means bigger profits, and a bigger PG stock price.
That all makes sense. But, it misses a very important element — valuation.
At 23 times forward earnings, the valuation on PG stock is as rich as it’s been in the past decade, by a mile. Sure, the growth trajectory is also better today. But, not that much better. Instead, it appears that the valuation on PG stock has sprinted ahead of fundamentals in the near to medium term, and that valuation friction will ultimately short-circuit the big 2019 rally in PG stock.
Procter & Gamble’s Fundamentals Are Strong
Procter & Gamble’s fundamentals are undeniably strong, and only getting stronger.
Big picture, this is a consumer staples giant which sells various consumer and household products for which demand is secular and largely unwavering, so long as the consumer backdrop remains healthy. As such, as goes consumer spending, so goes Procter & Gamble’s revenues.
Over the past several quarters, consumer confidence levels globally have surged to historic highs. As they have, retail sales have surged higher, and consumer spending has similarly skyrocketed to historic highs. This has created a huge upswing in Procter & Gamble’s organic sales growth trends. Over the past two quarters, P&G has reported organic sales growth of 7% — which by historical standards is a very big number for P&G — paced by growth across all 10 of the company’s global product categories.
This upswing in growth should persist. While the consumer economy has been on fire, the global industrial economy has slowed over the past several quarters due to rising trade tensions. This industrial slowdown has sparked recession fears. Now, trade tensions appear to be in the early innings of permanent deescalation. Thus, the industrial economy should rebound over the next few quarters. As it does, recession fears will disappear, and fading recession fears will provide a boost to an already hot consumer economy.
The result? Consumer spending will only go up over the next few quarters. As it does, P&G’s already supercharged revenue growth rates will remain supercharged. At the same, disciplined cost control on top of supercharged revenue growth is leading to rapidly expanding core profit margins. This should continue, too.
P&G projects as a healthy single-digit revenue grower with upside margin drivers over the next few years, versus its historical standard of low single-digit revenue growth and stagnant margins. This favorable uptick in growth prospects is behind PG stock’s 30% surge in 2019.
Valuation Is Too Rich
As PG stock’s growth prospects have moved higher, so has the valuation. The problem here is that the valuation has ticked up more rapidly than the growth prospects have, so even though the company’s fundamentals are improving, PG stock is overvalued here.
At the beginning of the year, Procter & Gamble stock was trading at around 20 times forward earnings. Today, the stock trades at 23 times forward earnings. That’s a 15% rise in the stock’s forward earnings multiple, meaning that most of the rally in PG stock year-to-date has been driven by multiple expansion.
At 23 times forward earnings, though, Procter & Gamble stock doesn’t have much more room for multiple expansion. The stock’s five-year average forward earnings multiple sits around 20. Over the past decade, the stock has never featured a forward earnings multiple this big. Meanwhile, the consumer staples sector trades at 20 times forward earnings, a marked discount to P&G’s forward multiple. Sure, the household products and personal products industries are trading at 24 times and 29 times forward earnings, respectively. But, those two industries are also trading at their richest valuations since 2000.
The big idea? PG stock appears to be part of a broader overvaluation trend that has hit the entire household and personal products category. This overvaluation is a byproduct of the improving fundamentals which I outlined earlier. But, this will be a case wherein reality falls short of expectations. That is, consumer spending will move higher over the next few years and boost revenues across this whole category. But, not by as much as is priced into these stocks.
Once that reality sinks in, PG stock will likely fall from these all-time high levels.
Bottom Line on PG Stock
I understand the qualitative bull thesis on PG stock. But, from a quantitative standpoint, that bull thesis just doesn’t add up. This is a single-digit profit growth company, trading at nearly 23 times forward earnings. That’s just too rich. To put it in perspective, both Alphabet (NASDAQ:GOOG, NASDAQ:GOOGL) and Facebook (NASDAQ:FB) project as 20%-plus profit growers. Those stocks trade at less than 25 times forward earnings.
All together, then, PG stock up at a similar multiple just doesn’t make sense. The stock is overvalued, plain and simple.
As of this writing, Luke Lango was long FB.
