3 Measures Say This Stock Is Undervalued

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

In the stock market there are fewer and fewer companies that investors can truly count on. Just as an example, General Electric shocked many investors during the Great Recession because they were forced to cut a dividend that had been raised for many years. There are many stocks that pay just a fraction of the yield that they paid before the financial crisis. However, there are a few companies that have not only managed to continue paying their dividend, but they also have raised their yield over the last several years. These stalwarts (as Peter Lynch used to call them), are companies that investors can count on during hard times, and though they might not be that exciting, over time they can deliver excellent returns.

One company that I believe is being undervalued in the current market is 3M Company (NYSE: MMM). If you look at the stock today, it's almost impossible to believe that just a few years ago this stock dropped from over $80 a share down to less than $42 at the height of the panic during the Great Recession. That being said, you have to look at that as an unusual event, and the ability to time these types of events is almost always a fruitless exercise. Instead what I prefer to do is look at these stalwarts and try to determine if one company has been left behind relative to others. This seems to be the case with 3M.

When you deal with companies as diversified as 3M, it's nearly impossible to come up with a perfect competitor. However, other stalwarts like Procter & Gamble (NYSE: PG) and Colgate-Palmolive (NYSE: CL) come to mind because they also are well diversified and offer products that tend to sell well no matter how the economy is doing. What is interesting is relative to these competitors, 3M seems to be doing better in several areas, and yet the market isn't valuing the stock as highly as the others. I believe the company suffers from an unfair thought process that I call “Europe-itis.” In other words, investors are so sure that the challenges in Europe are going to hurt the company's results, that they are missing how well the company is actually doing. Looking at the company's earnings report gives us a clue to how 3M is handling these challenges.

3M operates in six different segments, and it is true that in three of these divisions overall sales were down. However, if you dig a little deeper, the company's results were better than some might realize. What investors have to look at is organic sales, which excludes the effects of foreign currency. If you look at 3M's divisions in this light, all six showed positive sales growth, and 51% of organic revenues increased by at least 3.3%. Even more impressive is over 63% of the company's operating income grew by 9% or better. In short, without foreign currency challenges, 3M is growing revenue by single digits and the majority of operating income is growing by a high single digit rate. The bottom line is 3M is doing pretty well considering how the worldwide economy is doing, and if you look at a few other areas, 3M is a better value than its competition.

I know that everyone says that historical performance isn't necessarily indicative of future results. However, I can't help but notice how often companies that have grown in the past, continue to grow well in the future. If you look at the last three years, 3M was able to grow its net income by a total of 34.14%, and operating cash flow grew by nearly 7%. This doesn't sound tremendously impressive until you realize that Procter & Gamble managed net income growth of just 15.55% and Colgate-Palmolive increased net income by a total of just 6.11% in that same timeframe. What is more interesting is both Procter & Gamble and Colgate-Palmolive saw their operating cash flow decline during the last three years. Bottom line, 3M performed better than its competition in the last three years. So what's the chance this continues in the future?

If you believe analysts I would suggest the chances of 3M continuing to outperform are excellent. The average analyst expects 3M to grow earnings by about 9.7% in the next five years. By comparison, analysts are looking for just over 8.5% growth at Colgate-Palmolive and 8% at Procter & Gamble. What is even more interesting is the relative gap in valuation between the three companies.

3M currently sells for less than 14 times forward earnings projections, while Colgate-Palmolive sells for nearly 18 times earnings, and Procter & Gamble sells for 17.4 times earnings. In short, what you have is 3M expected to grow faster, but selling for a cheaper multiple. The fact that Colgate-Palmolive and Procter & Gamble both sell for a premium of at least 20% based on their P/E ratios, yet both are expected to grow slower, could suggest 3M is undervalued.

Last but not least, 3M has a history of increasing its dividend for over 50 years. While Procter & Gamble has a similar streak, and Colgate-Palmolive is no slouch either, there isn't a huge difference in the yield at each company. 3M currently yields about 2.47%, Colgate-Palmolive comes in at about 2.3%, and Procter & Gamble pays a yield of about 3.2%. With 3M paying a yield right in the middle between its two competitors, there doesn't seem to be a good reason for the stock to sell at a relative discount.

The bottom line is, you have a company in 3M that is expected to grow faster than two of its competitors. 3M sells for a multiple less than its competition, and yet pays a similar yield. The company has good organic growth that is being masked by foreign currency fluctuations, and has managed better growth in the last few years than its competition. With no discernible reason for 3M to sell for a discount, this could be a good buying opportunity for long-term investors.

MHenage has no position in any stocks mentioned. The Motley Fool recommends 3M Company and The Procter & Gamble Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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