The shares of consumer packaged goods giant Procter & Gamble (NYSE:PG) dipped slightly recently after the company reported mixed second-quarter numbers. Its profits topped analysts’ average expectations, its gross margins expanded, and PG increased its full-year sales and profit guidance. But PG’s organic volume and sales growth slowed versus Q1, its expense/revenue ratio rose year-over-year, and the growth of its operating margin slowed versus Q1. PG’s results were mixed, but PG stock was priced for perfect earnings.
PG now carries very real valuation risks, since its shares are about as richly priced as they’ve ever been. Sure, PG deserves a higher-than-average valuation due to its higher-than-average growth and low interest rates. So as long as Procter & Gamble continues to generate higher-than-average growth and interest rates remain low, PG stock can grind higher.
But I’d be careful with PG for two reasons. First, the company’s growth is slowing, and history indicates that this trend will continue. Secondly, even if the company’s growth doesn’t keep slowing, PG stock is fully valued, so any further gains by the shares will probably be limited in the near-term.
Procter & Gamble’s Big Red Flags
There were two big red flags in Procter & Gamble’s Q2 results.
Specifically, its volume growth, excluding acquisitions, fell from 4% in Q1 to 3% in Q2, and its sales growth, excluding acquisitions, dropped from 7% in Q1 to 5% in Q2.
Even more alarming, this is the first time Procter & Gamble’s sales growth, excluding acquisitions, has dropped versus the previous quarter in two years.
Thus, it appears that Procter & Gamble’s growth is slowing for the first time in a long time.
That seems to run counter to macroeconomic fundamentals. After all, global labor markets remain healthy, while monetary policies are becoming more and more supportive and trade tensions are easing.
But it pays to remember that, throughout the last decade, Procter & Gamble’s sales growth, excluding acquisitions, rose by an average of 3%. Between 2010 and 2018, the company’s sales growth, excluding acquisitions, never came in above 5%. Thus, the last few quarters in which Procter & Gamble’s top-line growth, ex. acquisitions, has been 5% to 7%, have been unusual.
Given that the demand for Procter & Gamble’s flagship household and beauty products is usually steady, its exceptionally high sales growth probably won’t continue. Instead, it is far more likely that the company’s growth will return to a more normal level of roughly 3%.
PG’s Q2 numbers suggest that this slowdown has begun. If that’s the case, PG stock could be in trouble.
Procter & Gamble Won’t Rise Much Further
A growth slowdown could spell big trouble for Procter & Gamble because its shares are not priced for a slowdown.
Specifically, Procter & Gamble’s present valuation is way above average. The stock is trading for 25 times analysts’ average 2020 earnings per share estimate. (In other words, the shares are trading at a forward P/E multiple of 25.) Over the last five years, the average forward P/E multiple of PG stock is 21. Going back to 2010, the average forward P/E multiple of PG stock is closer to 15. Excluding 2019, the highest forward P/E multiple of the shares in the 2010s was about 22.
The shares’ valuation is high mostly because, as mentioned earlier, Procter & Gamble has been growing at the fastest rate in a long time. Over the past four quarters, its sales growth, excluding acquisitions, has been 5% and up, whereas from 2010 to 2018, they were stubbornly below 5%.
But if this high-growth era comes to an end, the high multiples of the shares could also be over. And, with sales trends slowing for the first time in two years and tough growth comparisons on the horizon, it increasingly appears that Procter & Gamble’s era of 5% and higher sales growth is over.
As this high-growth chapter comes to a close, the forward P/E multiple of PG stock will likely decline from today’s elevated 25 level to a level closer to 20. That means that PG poses meaningful risks.
The Bottom Line on PG Stock
Procter & Gamble is a good company. But its shares are priced for perfection, and the high-growth streak which Procter & Gamble has been on for several quarters will end in 2020. As it does, the high P/E ratio of PG will gradually drop, keeping the shares from trending much higher.
As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.