In his seminal book The Intelligent Investor, Warren Buffett's mentor Benjamin Graham highlighted seven criteria for a defensive investor to use in stock selection:
- Adequate size
- Sufficiently strong financial condition
- Earnings stability
- Dividend record
- Earnings growth
- Moderate price/earnings (P/E) ratio
- Moderate ratio of price to assets
The first five criteria speak to the quality of the company without reference to the stock. The last two speak to valuation -- that is, the price that the investor pays for an ownership stake in the company. Let's see how these criteria apply to Accenture (NYSE:ACN).
Applying Graham's seven criteria
Accenture was established in 2001 when the consulting arm of Arthur Andersen was spun off. The company is a leading provider of management consulting, technology services, and consulting. It serves 91 of the Fortune 100 companies as well as 75% of the Global Fortune 500. Certainly, on the face of these credentials, Accenture looks like it meets the quality threshold, but let's look below the surface using Benjamin Graham's filters.
Size certainly isn't an issue. With 480,000 employees located in 52 countries, Accenture has scale and a truly global footprint. The company also ranks 44th in the S&P 500 index with a market capitalization of over $120 billion and sales in excess of $40 billion.
Its financial health is superb, with no meaningful debt on its balance sheet. The company is a cash-generating machine with free cash flow of $5.4 billion in 2018, easily covering dividends ($1.8 billion) and share repurchases ($2.6 billion).As a capital-light business, Accenture only required $0.59 of assets to generate $1 of revenue in 2018. Compare this to General Motors, which required $1.50 in assets to generate $1 of revenue.
What about its earnings and dividend record? Since its inception in 2001, Accenture's diluted earnings per share (EPS) has risen sevenfold. During this period, there were four years where earnings per share fell year over year but the company has never generated a loss.
On an adjusted earnings per share basis – which excludes one-time, nonrecurring charges or benefits – the trend is even more consistent: There was only one year where earnings per share fell -- by only 1% -- during the aftermath of the Great Recession. This is a remarkable record of earnings growth. And it's likely to continue if analysts' consensus estimates are accurate, with adjusted EPS forecasted to rise 6%, 10% and 9%, respectively, over the next three years.
This earnings record is a tribute to Accenture's wide moat, which Morningstar attributes to high switching costs -- clients are loathe to switch services on large complex projects that are Accenture's bread and butter business. Accenture reports that 98 of its 100 largest clients have been clients for at least 10 years. The company now has 200 Diamond clients --- defined as customers who generate at least $100 million in annual revenues – up from 140 in fiscal 2014. Moreover, 46% of Accenture's revenue is attributable to managing outsourcing processes, engagements which are often multi-year contracts. These factors enhance the stability of Accenture's earnings.
Dividends were initiated in 2006 and have grown every year since. In the last 14 years, total dividends have increased nearly 900%. Benjamin Graham mandated uninterrupted dividend payments for 20 years to meet his quality benchmark. However, given Accenture's relatively short history as a public company, its record of dividend growth shouldn't disqualify it vis-a-vis Graham's criteria. Moreover, with a dividend payout ratio of only 30% as of 2018, Accenture has the wherewithal to continue growing its dividend in the foreseeable future.
High quality.... and a high price
The discussion above would suggest that Accenture easily meets Graham's quality standards, as implied in the first five criteria. We know that Accenture is a good company, but is it a good investment? To answer this question, we need to address Graham's last two criteria. Unfortunately, this is where Accenture falls short.
Graham mandated a P/E ratio no higher than 15 times the prior three years' average earnings and a price-to-book ratio not exceeding one and a half times. Accenture shares trade at approximately 30 times earnings and nine times its book ratio. In addition, Accenture is expensive relative to its own historical valuation range: Its average P/E ratio has historically been around 18.
Does this disqualify Accenture as an investment? Not necessarily, for a couple of reasons. First, valuations should not be viewed in a vacuum but in context with other factors, such as interest rates. Even Graham acknowledged that the earnings yield should roughly equate to high-grade corporate yield. Low interest rates should justify higher valuations for stocks, everything else being equal. Second, a long term investor with a multiyear horizon could still find Accenture an attractive investment as the stock would ultimately track Accenture's growing earnings.
Accenture is an attractive company on many different levels: Its financial health, earnings consistency, and dividend growth put it in an elite class of companies. However, the price an investor would have to pay for those attributes is steeper than its average historically. A lower entry point would make it a more compelling investment. But it's important to remember Warren Buffett's investing advice: "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."