I have done some work on Nestle India that should be useful to you in understanding high quality stocks that seem to always trade at “high valuations”.
Nestle India – needs no introduction
Most of us have used Nestle’s products at least once in our lifetime, if not more.
From the ubiquitous Maggi noodles to Milkmaid to Munch chocolates. And how can I forget Nescafe which has become a generic word for coffee in India. If you have traveled in long-distance trains you have to choose between “chai” or “nescoffee”.
Nestle India owns very strong brands. The company enjoys high return on equity. They have strong cash flows. They share the spoils with shareholders in the form of generous dividends.
You might want to see their range of products in India. Read Nestle’s annual report for the financial year 2012 from page 10 onwards.
If the images in the viewer are blurred, you can download Nestle’s FY12 annual report.
Nestle India valuation
If you talk of Nestle’s valuation investors usually separate into two camps.
One view will be that it is overvalued and that it makes no sense. This camp will say that on price to earnings basis the market price usually suggests 25-30 times its earnings over many years. It seems like a very high number at first glance if you have never checked Nestle India’s valuation before.
In recent times, the P/E ratio has gone even higher. Upwards of 35-40 times earnings.
The other camp is usually ready in agreeing that it has always been expensive. And it will continue to be expensive because unlike many other companies, Nestle has a very strong moat (if you want to learn more about moats and many other concepts related to investing sign up for my free Start Stock Investing E-Course). Their moat gives them tremendous resilience.
If I ask you whether Nestle products will be around 20 years from today, most probably, you will reply in the affirmative.
If you say no, take a guess about the age of this company in India.
I don’t know many companies in India that have lasted that long and are still in the best of health.
If you are talking of growing cash flows and predictability of growing cash flows, this company fits the requirement.
The second camp will agree that they are paying for growth. Something that is in the future and inherently unpredictable.
The first camp might say, that a bird in the hand is worth two in the bush.
But the second camp is right in assuming that compared to an average company, in Nestle’s case you will have the comfort of knowing that growth plans are more likely to be achieved. That this company will be around for many years to come.
Hence the fact that it will look “expensive” if you look at it purely on P/E terms without considering the growth embedded in this stock.
Nestle India stock returns
I wanted to analyze the returns this stock has given over the long term and across different holding periods across the past 2 decades or so.
These were my findings.
A word of explanation is necessary.
I have taken rolling stock returns. For example if you bought Nestle in 2009 at Rs. 1,989 and sold in 2012 at Rs. 4,540 you earned a 32% compounded annual growth rate on your investment in three years.
Similarly, read the rest of the columns for rolling returns. Go one year back at a time.
|Financial year||EPS||Average Stock Price||P/E||Sales growth||PAT growth||Year on Year stock return||Rolling 3 year stock returns||Rolling 5 year stock returns|
Note: Average stock price is calculated for each year and divided by Earning per Share (EPS) for the year to calculate P/E ratio. One can obviously build a P/E valuation chart on a daily basis but for this study annual data is sufficient to understand the dynamics of Nestle’s valuation.
Observations on Nestle’s stock returns
- In times when the economy is unsteady or delivering low growth, Nestle sees a jump in P/E ratio. In other words, the arguments that you hear today about “consumption stocks” and why they deserve high valuations in an uncertain economic environment.
- Look at 1996-2000 and the high P/E ratio This was a period where India faced high interest rates and a real estate slowdown. Nestle traded at a high P/E.
- Growth does slow down for Nestle when the economy is not doing great, but Nestle at least grows. This is unlike cyclical businesses which start delivering losses.
- The stock has gone through extended periods of overvaluation even in the past as it is doing today. It can stay in an overvalued zone for multiple years. See 1996-2000.
- After the slowdown around 2000, when the economy started doing better, P/E multiples came down (almost halved in 4 years) even when profit growth was robust.
- Rolling returns are poor in the years following the end of a low-growth phase in the economy. See the returns for 2001-04 as an example
What if you also consider dividends?
That would be a fair question considering Nestle generates significant free cash flow which allows it to pay decent dividends to shareholders.
The table below contains two new columns which consider dividends in calculating rolling returns. For those who are technically more interested, I have not considered dividends to be re-invested or earning any interest in the bank. I have simply added them to get total returns to shareholders.
|Financial year||P/E||Dividend per share||Dividend yield||Rolling 3 year stock returns||Rolling 5 year stock returns||Rolling 3 year stock returns with dividends||Rolling 5 year stock returns with dividends|
Observations on total returns which include dividends
- The picture does not change too much.
- Interestingly, if I consider dividends, I see that a shareholder would not have made a loss in any 3 year holding period over 1996-12.
If you were a long term investor in Nestle India
Consider someone who bought into Nestle in 1997. Assume the investor bought one share for Rs. 259.
Dividends received over the next 15 years would add up to Rs. 422. This sum is higher than the purchase price by a big amount. In effect the purchase price is paid for over 15 years with just the dividends.
Rs. 259 would have grown to Rs. 4,540 in 2012. This is a gain of 1652%. In other words, the capital appreciation ensures that initial amount is multiplied by 17.5 times.
This is the benefit of holding on to high quality stocks for the long-term.
What is the stock outlook for Nestle?
As Mark Twain said,
History does not repeat itself, but it does rhyme.
Assuming the company continues to do well, present P/E ratios of over 40 suggest that returns over the next 3-5 years will not be great. This is based on long-term data that you see in the tables given above.
It might be wise to wait for lower valuations in Nestle India.
This can be a strong core holding in your portfolio that is truly for decade plus holding periods. But if one can time it and allocate more when it becomes attractively valued, why not?
This is not to say that one can take everything for granted. Do your checks on the business and how it is performing regularly. If the core business is not attractive then you need to re-consider. That goes without saying.
Share your thoughts
What are your thoughts on Nestle? Do you have a different point of view? Do you have more examples of wealth builders?
Don’t hold back.
Use the comments section below and share your views with the Capital Orbit community.