When the financial meltdown was in full effect, I was scrambling to buy up as much as I could. As I don't like to do a whole lot of gambling in my portfolio, I was looking for good, solid businesses that were selling at serious discounts. Industrial powerhouse 3M
Since then, 3M's stock has performed admirably, climbing 60% and topping the returns from the S&P 500. But after that run, and with the stock now trading at nearly 17 times trailing earnings, is it time to cut 3M loose and look for better opportunities?
To figure that out, let's take a closer look at the returns that we can expect from the stock.
As I outlined in a previous article, a good way to get a baseline for growth expectations is to check what Wall Street analysts expect and how fast the company has actually grown in the past.
Annual Growth Rate
|Last 12 Months||8.1%|
Source: Capital IQ, a Standard & Poor's company. Historical growth based on operating earnings.
The first thing I need to note is that the historical numbers and the analyst estimates aren't exactly apples-to-apples because analysts typically work off of earnings-per-share growth.
Over the past decade, 3M has reduced its share count by roughly 1% per year. Because fewer shares mean each share is allocated a larger chunk of the earnings, this declining share count means that earnings per share grew faster than operating earnings. However, it should also be noted that over the past year, 3M's share count has actually increased, so we may want to be careful giving too much credit for share buybacks.
I generally assume that Wall Street analysts are overly optimistic, and I think that's definitely the case here. For my top-end estimate, I went with 9%, which is above historical rates, but below what analysts are expecting. For my mid-case valuation I used 6.5%, and I dropped it to 3% for my downside case.
Pinning down valuation
Valuations are a moving target that can be tough to predict, but, as with growth above, using a range of values can give us a view of our potential returns without requiring a Miss Cleo-type prescience.
In creating our range, a good place to start is where the stock is trading right now and what its historical trading range has been. Right now, 3M's stock changes hands at 16.7 times trailing earnings, which is near the lower end of its historical range. Going back to 2000, 3M's average annual price-to-earnings multiple has generally been between 15 and 25.
For broader context we can also look at how similar companies trade.
Price-to-Earnings / Growth (PEG)
Illinois Tool Works
Source: Capital IQ, a Standard & Poor's company.
While large, diversified industrial companies like 3M and the stocks above all have somewhat different flavors when it comes to specific business segments, this group should give us a pretty good sense of how investors think about this sector. Focusing specifically on the final column, 3M -- with a PEG of 1.1 based on a forward P/E of 14.8 and expected growth of 13.3% -- comes in toward the upper end of the group. So it'd be tough to say that the stock is seriously undervalued on a relative basis.
But what does this mean for 3M's future multiple? Turning back to trailing multiples, I don't think it's unreasonable to assume that its multiple creeps up a bit more, along with the multiples of its entire comp group. For my base-case scenario I assumed a multiple of 18. For the top- and bottom-end assumptions, respectively, I used 23 and 14.
Dividends and share count
Our final stop is to consider how much we'll get paid through dividends and whether changes in share count will impact our bottom line.
What worries me most about share count is that a company will issue boatloads of shares and dilute my ownership stake. While I noted that the share count has increased at 3M over the past year, given the company's solid historical track record of reducing the share count, I'm willing to bet that huge share increases aren't a concern here.
As for dividends, 3M is part of a very elite group of dividend payers, the S&P 500's Dividend Aristocrats. These are companies that have not only paid, but also raised, their dividend every year over the past 25 years. As such, I have very few concerns about the future of 3M's dividend.
But how much will that dividend grow? Optimistically, I'm assuming 7% per year, which is roughly the rate it's grown over the past five years. More likely, I see a rate of 5%, with the possibility that it could be as low as 3%, which is only slightly below the growth rate of the past three years and in line with my bottom-end earnings growth rate.
The verdict please!
The end result of all of this is the returns we can expect under the various scenarios. Here's what my three scenarios would look like.
Annual Earnings-per-Share Growth
Annual Dividend Growth
Expected Annual Returns
Source: author's calculations.
These aren't terribly impressive results. In order for me to get excited about a stock, I normally like to see returns above 12% in the mid-case scenario.
At the outset, I was wondering whether I should sell my 3M stock, and after running through the numbers, my answer is a definite "no." The mid-case return of 10% is still pretty respectable for a company as stable and high-quality as 3M, and if everything goes right, the top-end case would deliver more than a double over the next five years. However, for investors still on the sidelines, I'd say that there are better bargains out there, and so it could be worth waiting for a slightly better price to be a buyer of 3M.
Of course, the future is an ever-changing picture, so you need to keep on top of what's going on at 3M to see which set of numbers the company and stock are able to live up to. And you can do just that by adding the stock to your Foolish watchlist. Don't have a watchlist yet? Start one by clicking here.
Motley Fool newsletter services have recommended buying shares of 3M, Emerson Electric, and Illinois Tool Works. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.
Fool contributor Matt Koppenheffer owns shares of 3M, but does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.
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