Cosmetic giant Estée Lauder (NYSE: EL) has been one of the best performing consumer stocks of the past decade. To steal a phrase from Peter Lynch its share price has more than ten-bagged since the bull market began in 2009. In fact, every dollar invested back in March of 2009 would be worth at least twelve dollars today. Actually that figure downplays the total return since it doesn’t include the roughly $8.50 per share in dividend cash that Estée Lauder has paid out during that period.
Before addressing the substance of the piece let me say that the problem here is not business related. Indeed Estée Lauder has an absolutely fantastic underlying business. It spends a tiny amount on the chemicals that constitute its cosmetics but invests around $3 billion per year in advertising. The upshot is huge amounts of brand equity, and that means folks paying big markups for its products. I think the company clears something like 80% of revenue as gross profit. That is how much of a machine it is.
The problem here is the risk of a disconnect between the stock’s valuation and the prospects of the business. Take the performance figure I quoted in the opening paragraph as a good illustration. If you include reinvested dividends, then Estée Lauder stock has turned every $1,000 invested in March of 2009 into roughly $14,800 as of today. That enormous level of wealth creation comes with a caveat: roughly half of it had nothing to do with underlying operations. What exactly do I mean by that? Well, consider the three sources of shareholder returns. In no particular order these are earnings per share growth, dividends and the change in valuation attached to a given stock between two points in time. The first two factors only account for around $7,500 of our $14,800 total return.
Here’s how that might impact prospective shareholders going forward. Right now the shares are changing hands for around $140 each. Analysts expect the business to earn around $4.85 per share in fiscal year 2019 (it runs from June to June). All-in-all we are looking at a forward valuation of just under 29x annual profits. Let’s start with an optimistic assumption. We’ll assume that the most recent ten-year earnings per share growth rate – roughly 14% per year – will be replicated over the next decade too.
Under this scenario earnings per share would grow from around $4.50 (FY 2018) to just under $17 (FY 2028). For simplicity’s sake I’ll apply the exact same growth assumption to the annual dividend. Last year the company declared cash dividends worth $1.48 per share. In 2028 that figure would rise to $5.58 per share. The cumulative total – i.e. a decade’s worth of payouts – would stand at around $33 per share. Now, imagine we apply a valuation of 20x earnings to our $17 per share profit figure. In total, including cash dividends, we would be looking at a return of approximately $375 per share. Based on today’s share price that would equate to annual returns of around 10%.
That sounds pretty good, but bear in mind two points. Firstly, this is under a rather optimistic earnings per share growth scenario of 14% per annum for a decade. Secondly, you still ‘lose’ four percentage points in terms of annual returns unless the valuation multiple holds up. What if profits and the dividend only grew at a rate of 7% a year going forward? Well, in that case our terminal earnings and dividend figures would stand at $8.85 and $2.90 respectively (cumulative dividends per share would clock in at $21.90). If the P/E ratio of Estée Lauder stock contracted down to 18x earnings – not exactly an unrealistic proposition – it would be enough to wipe out any gains in real terms (i.e. after taking likely inflation into account you wouldn’t see any increase in your wealth).
The object here is not to predict how Estée Lauder’s business will do going forward. However it does show that the margin for error is quite small. I mean just dwell on that prospect for a moment. You could have a situation in which Estée Lauder manages to grow its high quality profits at a rate of 7% per annum for a decade – a very respectable number for a $50 billion consumer company – yet you wouldn’t see any real term increase in your wealth if the P/E ratio contracted down to 18x earnings or less. This is all because folks today are happy to pay $29 to own $1 of Estée Lauder’s upcoming annual profit.
Unless your outlook is honestly multi-decade, or you are happy to assume that the stock will either grow earnings at a rate higher than it has in this bull market or will continue to command a high valuation, then hold off. There are better value options in the consumer space right now.