What Kind of Return Can Investors Expect from This Stock?

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

One of the best things about investing in blue chip stocks is their predictable business results. It is near impossible to predict the future earnings of an exploration & production company with three wells out in the Gulf of Mexico, but it is not so difficult to foresee the general earnings level of an industry giant like Coca-Cola.

Many investors believe that if you just buy a handful of blue chip stocks you'll do well in the long run. However, simply buying great companies will not necessarily lead to great returns. Investors who think this way are missing the key component of investing: valuation. Valuation does not have to be complicated, but it must be done in order to know whether you are going to get a high return or a low return on a stock.

Let's take a look at 3M (NYSE: MMM), a component of the Dow Jones Industrial Average, and see if we can figure out what kind of return we'll earn if we buy it today.

Grows With Global Economy

3M is known for inventing Post-It Notes and Scotch Tape, among other things. It owns a diverse array of businesses, mostly involved in technology and manufacturing. It has a strong balance sheet and is able to borrow debt at extremely low rates of interest. This gives the company the flexibility to expand while not risking running out of money if a recession were to hit.

3M competes with a number of companies due to its diverse operations. One of its competitors in healthcare is Johnson & Johnson (NYSE: JNJ). Johnson & Johnson is a market leader in most of the markets in which it competes. Like 3M, Johnson & Johnson owns a diverse group of businesses that allows it to produce a predictable stream of income year after year.

However, 3M and Johnson & Johnson are so big and diversified that it is difficult for either one to grow faster than the general economy. Over the last ten years, 3M has grown sales at an annual rate of 6.83%. Johnson & Johnson grew sales at rate of 6.69% per year. These growth rates include sales added due to acquisitions, so the organic growth rates are somewhat lower. By comparison, U.S. grew GDP by just under 4% per year over this same timeframe. It is unreasonable to expect 3M to grow much faster than nominal GDP in the future.

Expected Return

Mature companies like 3M produce a lot of free cash flow. Since cash enables the company to pay a dividend and invest in growth, we want to base our valuation on free cash flow.

Since 2002, 3M has averaged a 14.44% free cash flow margin. This means that for every $100 in sales, 3M earns $14.44 after expenses. The great thing about 3M is that it nearly always turns $100 in sales into the same amount of free cash flow, meaning that we just have to predict what sales will be to know what free cash flow will be.

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3M had $29.6 billion in revenue over the last four quarters. In an average year, 3M would produce $4.27 billion in free cash flow from that level of sales (29.6 x 14.44%). The company's market capitalization is $68.3 billion. If you divide $4.27 billion by $68.3 billion, you get a free cash flow yield of 6.25%.

You can think of the free cash flow yield like the coupon on a bond. If 3M continues at the same level of sales, then investors who buy the stock today should expect a 6.25% return over the long run. However, 3M will probably grow sales at about 4%, so we can just add 4% to 6.25% and get an estimated investor return of 10.25%.

As a 'value' investor, I do not like to pay for growth. I want to earn 10% plus growth. So 3M does not look like an attractive investment to me.

However, if we apply the same methodology to Intel (NASDAQ: INTC), its stock has a free cash flow yield of 10.5% plus the future growth rate of Intel's sales.

Intel is the largest semiconductor company in the world. Its only real competition comes from Advanced Micro Devices (AMD). But Intel is much larger than AMD; Intel had about $54 billion in sales in 2011, while AMD had about $6 billion. Intel's size advantage allows it to spend much more on R&D, which is why AMD has never been able to eat into Intel's profits.

When a company has a moat as wide as Intel's, you can usually count on it to continue earning a lot of free cash flow in the future. The company is facing a rough PC market right now, which is why its stock is so cheap. But investors with a long time horizon will probably earn higher than a 10% annualized return on Intel's stock.

Bottom Line

Before investing, always make sure you know what kind of return to expect. Investors in 3M can expect a 6.25% return plus any growth that materializes, while investors in Intel can expect a 10.5% return plus growth.

But remember that growth can be negative, so always allow for a margin of safety before you invest. Always buy at a price that rewards you with a high return even if the company does not grow and consider any growth a bonus.

Have a question about investing? E-mail me at: investorquestions@gmail.com

titans8904 has no position in any stocks mentioned. The Motley Fool recommends 3M, Intel, and Johnson & Johnson. The Motley Fool owns shares of Intel and Johnson & Johnson. 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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