Risk Report Card: Procter & Gamble

"Rule No. 1 is never lose money. Rule No. 2 is never forget rule No. 1."

That's not Brad Pitt from Fight Club -- that's Warren Buffett, explaining the most important rule in investing. It's what separates investors from speculators, and professionals from the merely lucky. But following the first and second rules of Buffett Club isn't easy. As superinvestor Seth Klarman says, "It can be hard to concentrate on potential losses while others are greedily reaching for gains ... yet the avoidance of loss is the surest way to ensure a profitable outcome."

So how do we do it?

Step 1: Assess the risk factors
Like snowflakes and cheese balls, no two companies are exactly alike, but a look at common risk factors is a good way to cover our bases. Procter & Gamble (NYSE: PG  ) is one of the most well-known consumer goods manufacturers in the world. What risks does it face?

A. Profitability: Companies that are making money, as opposed to losing it, are less likely to fail or wither away. (You'd be surprised how many people forget this.)

Metric

As % of Revenue

Risky? (1-lowest to 5-highest)

Net Income Margin

16.2%

1

Free Cash Flow Margin

16.1%

1

These margins really show how P&G struts its stuff. The power of its brands, from its Gillette razors to its Pampers diapers, gives it premium pricing power and an edge over its competitors.

B. Diversification: You don't want all your eggs in one basket. Especially if that basket is flammable.

Metric

Description

Risky? (1 to 5)

Customers

Top 10 customers accounted for 30% of total volume in 2009

1.5

Suppliers

Diversified vendor base

1.0

While people from across the world use P&G's products, the company's direct customer base is actually more concentrated than one would initially imagine. Still, most of these customers are stalwarts like Wal-Mart (NYSE: WMT  ) , which don't present much credit risk. Moreover, P&G itself is so large, so widespread, and so desired that there will always be retailers willing to distribute its products.

C. Debt: Someone once said that debt was a lot like gasoline: You don't want to be carrying it if you're afraid of catching on fire.

Metric

Value

Risky? (1 to 5)

Interest Coverage Ratio

16.2

1

Debt-to-Capital Ratio

31%

2

Cash-to-Debt Ratio

0.2

3

Debt-to-Free Cash Flow Ratio

2.3

2

It's not uncommon for a company as large as P&G to be carrying some debt, but we wouldn't mind seeing some more cash to offset it in case of unexpected events. Because of the strength of the company's free cash flow, however, it would be able to pay off all of its debts straight from operations in just more than two years.

D. Valuation: "Price is what you pay; value is what you get." -- Ben Graham.

Metric

Multiple

Risky? (1 to 5)

P/E

16.8

2

P/FCF

14.0

2

PEG Ratio

1.8

5

While the company isn't trading at exorbitant levels, for a behemoth its size, it may be difficult to live up to the market's current expectations.

E. Opportunity Cost: While it's difficult to really give a grade here (which explains why there isn't one), it's important to remember that investment decisions aren't made in a vacuum. A company's risk profile must be considered relative to its competitors and other opportunities like it.

Company

Market Capitalization
(in billions)

Net Income Margin

Debt/Capital

P/FCF

Colgate-Palmolive (NYSE: CL  )

$41.5

14%

53%

17

Clorox (NYSE: CLX  )

$9.3

11%

94%

15

Kimberly Clark (NYSE: KMB  )

$26.8

10%

56%

10

Unilever (NYSE: UL  )

$82.1

9%

44%

16

Seeing P&G next to its peers really provides some context. It's hard to find another company at its scale that is as well-capitalized or earns margin as high. That scale and those margins help boost P&G's competitive position against each of its rivals.

Step 2: Tally and score

Weighting

Category

Final Grade

20%

Profitability

1.0

20%

Diversification

1.3

40%

Debt

2.0

20%

Valuation

3.0

100%

Total Score

1.9

 

Final Grade

A-

A few months ago, Procter & Gamble debt yielded less than U.S. Treasuries -- the market's way of saying that P&G was a safer place to put money than the United States. Whether compared to its peers or our debt-laden government, the company can't seem to be beat. But we're not interested in relative safety; we want actual long-term capital preservation. On that basis, P&G still scores very highly. But debt is a volatile beast, and the company's risk rating gets mildly dinged accordingly.

Step 3: Learn more
We've covered a lot here, but no system will ever be complete. Macro trends in both the general economy and the specific industry, management's effectiveness and history (or lack thereof) of responsibly managing shareholder capital, and the general competitive landscape in which a company operates are all potential cracks in the hull.

At the end of the day, the biggest risk is you, the investor. Over time, apathy and ignorance will destroy any investment thesis. Fortunately, that's one risk you can control. Investors know what they're getting into. Speculators just get lucky.

For more information about Procter & Gamble, check out our Stock Cheat Sheet on the consumer-goods giant.

Motley Fool Rule Breakers analyst Sean Sun owns shares in Procter & Gamble. Wal-Mart is a Motley Fool Inside Value recommendation. Unilever is a Motley Fool Global Gains selection. Clorox, Kimberly Clark, P&G and Unilever are Motley Fool Income Investor picks. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


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