Stock valuation methods and approaches

Stock Valuation

The stock that I have chosen is Clorox (CLX), the bleach making company. I wanted to find a company that was about as classic a case of a no growth company as possible. Most of the high profile companies in the stock exchange are fast-growing companies, to the point where even those who have a flat domestic share are trying to grow internationally. I wanted to see if there was still a classic no growth company out there, and this was the first one I found.

Clorox is mostly a bleach company, but it has a few other brands that are also familiar to consumers. These include Brita, Burt's Bees, Glad, Pine Sol and Kingsford Charcoal. Most of these brands fit with the general corporate theme of slow-growing businesses in basic industries.

Clorox competes mostly in North America. The economy in the U.S. is the largest on the continent, though all three major ones are among the world's biggest. The U.S. economy is under condition of slow recovery from a major recession. GDP is growing, relatively slowly. This provides an uptick for demand for consumer products. The unemployment rate is coming down slowly, but remains at a relatively high level, historically speaking. Further, inflation is relatively low, indicating that there remains some room for economic improvement in the coming years and months.

Clorox produces bleach and related products, and basically competes in the consumer products industry. It competes against other companies that produce cleaners, so everyone from the household manufacturers like Johnson & Johnson, Procter & Gamble and even a company like Sysco that does it for the institutional market. I got my information basically from MSN Moneycentral and from Morningstar.

My company's strength lies in its brand. Bleach is an easy product to make, but consumers have a strong association between Clorox and bleach, so it is a trusted name. The product is, more or less, recession-proof, in that there is fairly steady demand for bleach products. An example of this is that in 2009 during the depth of the recession the company had sales of $5.4 billion and last year with the economy coming out of recession it also had $5.4 billion in sales, which only a little bit of change in between. The company also has healthy production capacity, and this allows it to produce for other companies as well as for its own brand. The business is simple and easy to run, and the branding insulates Clorox a little bit from competition.

The main weakness of Clorox is that it is basically a one-product firm. That is to say, it lacks diversification. Compared with its larger competitors in consumer products, Clorox has only a few lines, and none can be said to be rapidly growing, with the possible exception of Burt's Bees. Everything they do is in basic consumer products and has limited future growth potential. Another weakness, evident at the firm level, is that it has no equity. The company's debt is worth more on the balance sheet than its equity. This means that the value of the stock derives, most likely, from the dividends that it pays. Clorox is, then, a classic case of a dividend-oriented no-growth company. Another problem for Clorox is that it lacks diversification of markets. While other companies are growing through the process of globalization, Clorox is happy with its North American niche. This does, however, leave growth opportunities on the table. Also, Clorox prefers to expand its business by acquiring companies, indicating that it lacks inherent innovative capabilities. This lack of innovation also pegs it as a company that is going to struggle if it in future cannot acquire firms. A lack of in-house innovative capability can be considered a weakness though the firm's strategy appears to work around that.

Valuation Methods

The first valuation method for a no-growth company that is focused on dividends is the dividend discount model. While revenues have not been growing for Clorox, its dividends have. This allows us to use the constant growth dividend discount model, which equates the value of the company with the present value of the expected future dividends, those dividends being the only cash flows an investor can reasonably expect from the company. Clorox pays a consistent dividend, and has done so even through conditions of recession. Its business seems reliable going forward -- no major changes are expected in the demand for bleach any time soon. Thus, investors can reasonably expect the current dividend growth path to continue, and can therefore derive from those expected cash flows a present value.

The formula needs a current dividend, a dividend growth rate and a discount rate to determine a stock price, as such

(source: Investopedia).

The current dividend for Clorox is $2.84. The growth rate can be derived using the past dividend rates. The past dividends are $2.40, $2.20, $2.00 and $1.84. When we take the slope of these it is 0.24. Thus, for each year the expected increase in dividend is $0.24. Taken as a percentage of the current dividend rate, this is 8.45%, and that can be used to approximate the future growth rate of the stock.

The next step is to get a discount rate for the company. That can be derived from the capital asset pricing model, which is Ra = Rf + ? (Rm-Rf). The Rf is the risk free rate. We know from Yahoo! Finance that the six-month Treasury rate is 0.05%, given the rock bottom interest rates in the economy at present. The beta for Clorox is 0.36, not surprising given the stability of the returns on this stock and the reliability of the business. The market risk premium is around 7%, though the Internet gives a few different figures for this. The 7% figure is common and can therefore be used. Plugging these numbers into the capital asset pricing model, we derive the following:

R (CLX) = .05 + 0.36 (7) = 2.57%

This discount rate can then be used in the dividend discount model. The calculation should give you the value of the stock. This is

2.84 / (2.57-8.45), which of course has an intrinsic problem of a negative denominator. This should not be the case for a no-growth company. The problem here is that the company is steadily increasing its dividend even when its revenues are flatlined. It's net income has also flatlined, though with share buybacks the EPS is growing somewhat. Intuitively, it makes sense that the company should not be increasing its dividend to such a degree. Thus, the dividend increases are unsustainable.

A further point to mention here is that the lack of value for the stock is in line with the negative book value of the company's equity. In this case, the two figures do not have direct connection but any company with a negative equity value is not going to be able to sustain growing dividends forever. In all likelihood, the historic dividend growth rate is going to have to slow. Thus, the historic rate is likely misaligned with the future rate, creating this situation where the company has no value according to the dividend discount model. A valuation of $0 is far from the current stock price of $85.33, so we should conduct other valuations to try to understand what dynamic is taking place here -- Clorox is not as simple as it appeared on the surface.

Residual Income Model

The residual income model uses the EPS growth rate and the discount rate can derive the firm's absolute value. The first step is to derive the equity charge. The firm has no equity, so the cost of equity (2.57%) is multiplied by zero. Thus, only the cost of debt is relevant. The company pays $125 million in interest, which represents its cost of debt. Taken on a percentage basis, this is 2.78% of the total value of the firm's liabilities. Thus, the cost of capital in this instance is 2.78%.

The residual income model holds that with no equity charge, the residual income is simply the net income. This is $541 million. Given the lack of growth in earnings and revenue, this figure can be taken in perpetuity, and that value discounted back to present day. This gives a firm value of $541 / (.0278) = $19.46 billion. It's book value is $4.355 billion, so the excess value over book is $15.105 billion. This implies a share value of $114. This method gives us a value that is greater than that of the company, but relies on the distortion created by having no cost of equity as the result of having negative equity value. Thus, the equity charge calculation does not work as intended in this model, because of the unique balance sheet circumstances of Clorox.

P/E Ratio

The price/earnings ratio begins by predicting next year's EPS. The four-year trend for EPS is $4.14, $4.06, $4.28 and $3.82. The slope is .074, indicating relatively slow growth. Thus, the next year's EPS is expected to be 4.14 + 0.074 = $4.214. The next step in this methodology is to plug this into the average price/earnings ratio. Morningstar gives us the average P/E for each of the past ten years, but perhaps given current economic conditions only the past five years is applicable. The average P/E over the past five years is 16.78 (the five years are 20.1, 17.2, 16.5, 15.5, 14.6). Using this average P/E we get: 16.78 * 4.214 = $70.71. This slightly undervalues the company compared with the current stock price. However, the P/E has an upward trend given the improvements in the economy, however subtle they might be. If last year's average P/E is used (20.1), then the P/E ratio method would deliver a stock price estimate of 20.1* 4.214 = $84.70, which is very close to the current share price. This methodology appears to be more in line with what the market is using.

P/CF Ratio

The next methodology is the price/cash flow ratio. The current P/CF ratio from Morningstar is 14.7, a figure that is higher than the 10-year average but more in line with non-recession values from the mid-2000s. The next step in this methodology is to estimate next year's cash flow from operations. Last year's was $612 million, but this figure has been declining steadily. The slope of the cash flow from operations line is -49.9, implying that next year's cash flow from operations will be around $562.1 million. On a per share basis, this would be 562.1 / 131.66 = 4.269, so the P/CF for next year should be 4.269 * 14.7 = $62.75, a figure significantly lower than the current share price for Clorox.

P/S Ratio

The price per sales ratio last year from Morningstar is 2.0. This again compares more with current economic conditions than the other figures of the last five years, which were affected by the recession. The sales last year were $5.468 billion. These have remained steady over the past four years, so the slope is only 0.0051. Thus, the expected sales for next year are $5.473 billion. That equates to $41.56 per share. If we apply the P/S ratio to that we get 2.0 * 41.56 = $83.14 as the stock price of the Clorox company.

Conclusions

The five different methods give us a variety of results. Two results are close to the current stock price -- the P/S ratio ($83.14) and the P/E ratio ($84.70). The P/CF ratio ($62.75) is out of line with market expectations, and shows the company as being presently overvalued. This is perhaps a bit deceptive. The slope of the operating cash flow line is negative because of a past history over the last four years of declining cash flow from operations. However, the market is also taking into account that the company has reported three quarters from its latest fiscal year, the 2013-year. In those three quarters, Clorox has recorded a combined total of $1.018 billion in cash flow from operations. This is significantly higher than previous years and is already double the expectation based on the slope of the cash flow line. Thus, the market is pricing in the expected cash flow that includes the first three quarters of known flows -- these are different from the expected flows based on the previous four years' worth of data. The idea that Clorox is overvalued holds little water when the reality of significantly improved cash flow from operations is taken into account.