Cosmetic giant Estée Lauder (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. Even that figure downplays the actual return since it ignores dividend cash paid out in that time.
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, yet invests around $3b per year in advertising. The upshot is huge amounts of brand equity, and that means folks paying big markups for its products. The company clears something like 80% of revenue as gross profit – that’s how much of a money 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. Including reinvested dividends, Estée Lauder stock has turned every $1,000 invested in March 2009 into roughly $14,800 today. That enormous level of wealth creation comes with a caveat: roughly half 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 profit growth, dividends and the change in valuation 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 change hands for around $140 each. Analysts also expect the business to earn around $4.85 per share in its FY19, which runs from June to June. All-in-all we are looking at a forward valuation of just under 29x annual profit. Let’s start with an optimistic assumption. We’ll assume that the most recent ten-year EPS growth rate – roughly 14% per year – will be replicated over the next decade too.
Under this scenario, EPS would grow from around $4.50 in FY18 to just under $17 in FY28. For simplicity’s sake I will apply the exact same growth assumption to the dividend, which came in at $1.48 per share last year. Under our assumptions, that figure would rise to $5.58 per share by 2028. 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, or annual returns of around 10%.
That sounds pretty good, but two points to bear in mind. Firstly, this falls under a rather optimistic EPS 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. If the PE ratio of Estée Lauder stock contracted to 18x earnings – not exactly an unrealistic proposition – it would be enough to wipe out any gains in real terms.
The goal here is not to predict how Estée Lauder’s business will do going forward. But 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 profit at a rate of 7% per annum for a decade – a very respectable number for a $50b consumer company – yet you wouldn’t see any real-terms increase in your wealth if the PE ratio contracted down to 18 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 multi-decade, or you are happy to assume the stock will either continue to command a high valuation or undergo an accelarion in EPS growth, then hold off. There are better value options in the consumer space right now.
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