3 Reasons This Stock Is Overvalued

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

Some investors have such blind faith in certain companies that they can't fathom their stock could be overvalued. This seems to be a particular problem when it comes to old-school companies that have been paying and raising dividends for a long time. However, as Peter Lynch once said, one of the most important keys to buying a “stalwart” stock is not paying too much. I know the company's fortunes have improved recently, but based on three different measures, Procter & Gamble (NYSE: PG) looks overvalued.

It's Not The Company, It's The Stock
I know that Procter & Gamble has been around forever and they have raised their dividend for a long time. I also know that I have many of their products sitting in my home right now. None of that is the point. The point is, the stock at today's prices seems like a bad deal relative to its peers, and one in particular. 

The businesses that Procter & Gamble operates in have undergone massive changes because of the Great Recession. Customers won't flock to a product because of its brand name anymore. The economic turmoil of the last few years taught shoppers to look at prices. What many shoppers found is that store brand or competitors' products were worthy substitutes for Procter & Gamble's brands.

Innovation Is Key
In the current quarter, Procter & Gamble reported “core earnings up 12%” on a net sales increase of 2%. There was a consistent theme across the board -- where the company innovated, they saw volume growth, where they did not, volume growth was flat or declined. In the company's Beauty and Grooming segments, volumes were flat, and down 2%, respectively. In Health Care, Fabric, and Baby Care, volumes increased by 3%, 2%, and 6%. In each of these three cases, the company said this strength was from “new innovations” or “new product launches.”

A great example of one of these innovations is the company's Tide Pods. These can be thrown in the washing machine and they dissolve and wash the clothes. This saves customers from having to pour messy detergent into the cap, measure it out, then pour it into the machine. The company is able to charge slightly more for Tide Pods, but customers appreciate the convenience.

So What Are the Issues?
To start with, Procter & Gamble is expected to have lower revenue growth compared to each of their large competitors. Colgate-Palmolive (NYSE: CL) is Procter & Gamble's main competitor in the Home Care and Grooming segments, with the Colgate and Palmolive lines. In the next year, analysts are calling for 4.5% revenue growth at Colgate-Palmolive versus just 1.4% at Procter & Gamble. 

Another large competitor is Kimberly-Clark (NYSE: KMB), whose Kleenex, Scott, and Huggies brands go head to head with Procter & Gamble every day. Though Kimberly-Clark's 1.8% expected revenue growth won't make headlines, this tops Procter & Gamble as well. Finally, Unilever (NYSE: UL) and their Dove brand, competes with multiple Procter & Gamble offerings, and this company is expected to lead the pack with revenue growth of 8.4%.

If Procter & Gamble had the best gross margin in the industry, their anemic revenue growth might not be a big deal. Procter & Gamble's gross margin of 50.9%, does beat out both Kimberly-Clark's gross margin of 33.66%, and Unilever at 42.11%. However, they can't match Colgate-Palmolive at 58.4%. Since Colgate-Palmolive has an equally impressive history of raising their dividend, this higher gross margin and better revenue growth makes two categories for Colgate-Palmolive over Procter & Gamble.

Valuation Is Important
One of the bigger issues I have with Procter & Gamble is their current valuation. The stock tends to get ahead of itself periodically, and I believe it is today. To compare companies that all pay good dividends, we need something beyond the PEG ratio that incorporates their dividend yield as well. I think the PEG+Y ratio that Peter Lynch used makes the most sense. 

The PEG+Y is sort of like a reverse PEG ratio. The formula is the company's expected growth rate, plus their dividend, divided by their P/E ratio. This allows investors to compare companies including both their growth and yield, relative to their valuation. With this ratio, the higher the number the better. A higher number means more growth and income relative to the P/E ratio.

Procter & Gamble's ratio is comprised of their 8.03% expected growth rate, plus their 2.94% yield, divided by their forward P/E ratio of 18.78. This gives the result of 0.58. By comparison, the only one of their peers that scores worse is Unilever with a PEG+Y of 0.51. On the other hand, Colgate-Palmolive looks better at 0.67, and Kimberly-Clark looks better still at 0.83.

While Kimberly-Clark and Unilever have their own attractive attributes, it's the comparison with Colgate-Palmolive that makes me think investors are overpaying for Procter & Gamble. Colgate-Palmolive is expected to have better revenue growth, has a better gross margin, and their stock is more reasonably valued than Procter & Gamble. Like I said before, I like Procter & Gamble's products, but the stock seems overvalued at current prices.

MHenage has no position in any stocks mentioned. The Motley Fool recommends Kimberly-Clark, Procter & Gamble, and Unilever. 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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