ALEXANDRIA, VA (Sept. 9, 1999) -- Wrigley (NYSE: WWY) trades at 28.3 times the consensus 1999 earning per share (EPS) estimate, and 25.8 times the year 2000 estimate. The aggressive long-term growth estimate attributed to the company is 11.67%. Wrigley has grown EPS 11.8% annualized the past five years. A fair trailing P/E for the company is exactly 15, not 28 or 25.
How ludicrous is it that Wall Street gurus often state exactly where a stock should trade, or when something is at fair value? Although valuation analysis is necessary to ascertain the approximate fair value of a company (or a range of attractive values), nobody can declare precisely what any company is worth. An analytical number projecting the future is always based on an assumption, which is always based on an opinion. An opinion is always fallible. For example, even if you model a company's future perfectly, there is no guarantee that Wall Street will agree with the valuation multiple that you suggest in your model.
The caveat aside that valuation models are fallible, valuation is similar to horseshoes. Being close counts. Being close in effect can win the game. With that in mind, we have always tried to approximate the value creation potential offered by our potential investments. With Johnson & Johnson (NYSE: JNJ) trading where it was in 1997, we foresaw market-beating value creation potential in years ahead. Ditto Intel (Nasdaq: INTC), as uncertain as its business is. Intel is a case where the company's potential to excel outweighed its potential to fall short, in our opinion, and at its initial price. On the other hand, when we considered Pfizer (NYSE: PFE) and Coca-Cola (NYSE: KO) the first time, it was more difficult to foresee market-crushing value creation given the price tags placed on the companies at the time.
Now as Brian and I wallow like pigs in mud for our second food and beverage study, we of course want to see in which camp each company in our study falls: the camp that should offer strong value creation for us over the years, or the camp that looks more questionable (even over the long term). The first criteria to consider, however, is always the quality of the business. If a business isn't top-notch, there is no point in seeing what sort of valuation prospect it presents. So, only once we are comfortable calling a business's quality "excellent" do we move to consider its valuation. Brian and I are both comfortable calling Wrigley an excellent business. In fact, we believe that Wrigley qualifies as one of the strongest brand-name food industry businesses existing.
The quality test surpassed, what price do we want to pay for Wrigley? You may remember the philosophy that Randy Befumo shared in the Drip Port's initial food and beverage study. It is relatively simple but surprisingly helpful at putting opportunities into perspective. It assumes that an investor can buy a low-, moderate-, or high-quality business, at either a low, moderate, or high valuation. All combinations exist. These examples from January, 1998, are still relevant:
Valuation Quality Campbell Soup Moderate to High High PepsiCo Moderate to High Moderate to High Philip Morris Low High Quaker Oats Moderate ModerateQuite simply, the ideal situation would be to buy a high-quality business at a low valuation. More realistically, one typically finds a high-quality business at a moderate to high valuation. But not always.
Of course, this model is based on opinion. Our opinion that Campbell Soup was at a moderate to high valuation, but was a high-quality business, may now be called inaccurate. The stock was certainly at a high valuation based on the company's performance since our decision. We were hoping for high-quality results -- which haven't happened yet -- and that caused us to allow for the possibility that the stock was only at a moderate to high valuation. Given the company's performance, the stock was actually at a high valuation, period, not moderate. Our other assumptions still seem to hold. I also still believe that Coca-Cola was (and perhaps still is) a high-quality business at a high valuation.
Thus far in our study, I would place the three companies that we've considered in the following camps:
Valuation Quality Coca-Cola High High PepsiCo Moderate to High Moderate to High Wrigley ?? HighAs far as valuation goes, we have looked at some of the returns that Wrigley is generating on its investments in Brian's recent columns (Part One and Part Two). We now need to consider how cash flow at the company is being valued and then we can hopefully decide, generally, how the company is being valued overall and how much potential value creation it holds for us.
Tomorrow we'll pull another tool out of our valuation tool chest and run a discounted cash flow model on the company. To bone-up on discounted cash flow models, visit our past look at Pfizer. Note, however, that in Pfizer's case (and in J&J's case), we used net earnings as a proxy for cash flow, and tomorrow with Wrigley we will use net operating profit after taxes for cash flow, since Brian points out that the two numbers are very similar over the years.