Price Follows Value: Procter And Gamble

By Joe Ponzio on September 24, 2007  |  18 comments

Thanks all for your feedback—both in comments and e-mails. Let's start from the top: Babui asked for more examples on how price follows value and how buying and holding through drops can still allow you to come out ahead.

Today, let's look at another example: Procter & Gamble.

PG: A Fair Price For A Good Company

When the value of a business is growing, its stock price will generally follow in the long term. As such, it can be said that, over time, the markets are generally efficient; however, in the short-term, they can do crazy things. Such is the case with Procter & Gamble.

Take a look at the following chart (click the chart for the PDF version):

From 1993 to 2007, Procter & Gamble grew from a $50 billion company to more than $250 billion (assuming it remains business as usual). Over the long term, the stock price grew from about $50 billion to about $250 billion. Price follows value.

Still, stock prices can do crazy things. In 1997, the stock price really began to get away from the value. In 1999, the stock market was pricing this $90 billion at $220 billion. And then, in what seemed like an instant, PG dropped some 50%.

Why Procter & Gamble Stock Got Crushed

The gamblers were expecting ever increasing net income (earnings). PG's price to earnings (P/E) ratio grew wildly out of hand. But a $100 billion company can only deliver so much; so, when Wall Street's earnings came in fair for a $100 billion company, but lackluster for a then-priced $220 billion company, Wall Street sold and the price dropped quickly.

Avoiding The Loss

Could you have avoided the loss? That depends on whether or not PG was a permanent holding or not. Only the absolute best companies in the world should ever be permanent holdings. For Buffett, one of those companies is Coca-Cola.

If PG was a permanent holding of yours, you would have had to have bought it prior to 1993 (it was never on sale after that). Then, you would not have worried about the 50% drop because you would have gone on to see a 12+% annual return on the price plus an extra 2% or so in dividends.

If PG was not a permanent holding, you would have not been a holder of its stock during the run up and massive drop because it would have been at or above its intrinsic value. And you would not have lost a dime.

Missing The Boat

"Nice story, Joe. But not owning PG would have led to missing out on a very nice return!"

True. Still, only half of investing is making money. The other half is not losing money. Forget, for a second, the massive run up and drop and focus on the years where PG was fairly priced—priced more or less right around its intrinsic value.

If, at any time in those years, PG did not perform as we expected—if PG stumbled a bit—the value of the company would have had a setback. The price would have followed.

When you buy companies that are priced right around their intrinsic value because you think the stock price (and value) will grow, you assume more risk than if you waited patiently for great opportunities. When a company is deeply discounted, a lot would have to go wrong for you to lose money.

But Buffett Said...

It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

Instead of isolating Warren Buffett's individual quotes (as we tend to do), look to the spirit of the statement: You are better off owning wonderful businesses than mediocre ones.

Buffett isn't telling us to buy wonderful businesses or wait for a wonderful price. He's telling us to buy wonderful businesses and wait for a wonderful price. What would he be willing to pay for a mediocre business? Virtually nothing—which is why he avoids them in the first place.

It's The Same Old Story

Price follows value. Am I getting redundant yet? Good—that's the point. Procter & Gamble is another example of the rule. Might PG continue to grow and deliver shareholders a very substantial return? Perhaps. But "perhaps" is risk—and that's not a great way for us "little" investors to make money.

Also Filed Under "Companies Analyzed (Generals)"

• Buffett. Coca-Cola. 1988. Now I Get It.
• Buffett May Not Have Sold JNJ
• Wells Fargo and Wachovia, by Quarter
• Profiting from Fear