Unilever still looks overvalued

After the surprisingly good results for the third quarter of this year. The shares still look worryingly overvalued on the ratio of earnings to share price. They look too high to buy at the moment. This level, in terms of recent share price performance history, seems to be the level at which to sell the shares, not buy them!

As an investment, the Anglo-Dutch company Unilever is a bit of an enigma. It has not looked what I call cheap for a long while and often looks dear. I suppose that I have been on the bearish side in recent times about Unilever, precisely for that reason.

The Unilever valuation enigma

On the one hand, the shares, on the basis of market consensus estimates, are valued on a prospective price to earnings multiple of 21.4 times this year’s forecast earnings. That suggests evidence of past, present or future of very strong earnings growth. The five year record does not show that, according to the market consensus estimates of past and expected annual percentage earnings growth. Apart from the exceptional post world banking crisis recovery year of 2010 (when Unilever’s earnings per share rose 14% according to the consensus record), there has been nothing approaching a 21% annual growth in Unilever earnings per share. Since and including the year 2011 there has been no single year in which earnings growth is shown to have been more than 8%. Last year – to December 31st 2014 – earnings increased by only 1%, and by 3% in the year prior to that.

Evidently, the high 21.4 times multiple Unilever share valuation is related to forward, prospective estimates of earnings growth! But turning to the consensus figures, you find forward estimates of earnings growth of only 8% for this year and 6% for next year. In consequence, Unilever shares are on traditional price to earnings growth ratios (PEGs) of 2.6 and 3.5. That folk law (I was once told by a Sloan fellow of the London Business School, that there was no empirical evidence to support the validity of the PEG) says that this year’s and next year’s estimated earnings per share are 160% and 250% overvalued. A pretty big premium for some reason or another.

The justification for such a premium valuation of Unilever shares is self evidently attributable to the following factors:

·         That Unilever will be one of the beneficiaries of China’s growth into a regular consumer economy. Just as the mining companies were the best and obvious way of investing in China’s earlier infrastructure growth stage. It plans to sell them ice cream, body care and food products just as it sells them to consumers already in other parts of our constantly consuming globe.

·         That Unilever is as a global provider of consumer staples, essentially an earnings growth share and not a cyclical one.

·         That the share is consequently relatively more reliable and predictable when compared with other shares and sectors.

·         That the record shows that Unilever has been a share to be in longer term, compared to the market as a whole. Over five years the FTSE100 Index has risen by 12%; in contrast the Unilever share price has risen 60% – five times the increase in the Index of shares.

The trading statement Q3

For those of us who were cautious about Unilever’s prospects this year, the Q3 trading statement was a bit of surprise. The market liked what was reported. The share price jumped up on the news that Group turnover increased a whopping 9.4% to 13.4 billion euros and volume rose 4.1% – just the sort of  results that a highly rated share like Unilever needs. Emerging markets, which importantly include China, showed a strong recovery. These Q3 results improved and influenced the results for the nine months to September when sales revenue increased 11%.

But hey up lad, don’t take these figures too easily at face value, even if they do reflect management talent and effort. Part of that was attributable to the part played by the weak Euro rather than ‘organic’ management achievement, as good as it is. In other words, the company says that 7.6% of that reported 11.1% improvement in turnover for the nine months was down to exchange rate movement. Good to have, but not the product of the company’s efforts.

Moreover, there were some other special factors that flattered the results, including destocking in China and in Latin America pre-empting expected price rises. These seem likely to have affected Q3 only, and are not expected to have anything like the same impact in Q4. So do not suppose that any of that is the start of a trend. The mature consideration judgement seems to be that these were exceptional results rather than indicative results.

Since the beginning of this year, the Unilever share price has been in a trading range of between just over 2,400p and just over 3,000p – or about 25%. So, the share price at 2,917p (last seen) after the rapid rise appears close to the top of that range. Stepping back a pace or two to have the wider perspective of a five year chart, there appears to be a lot of long standing overhead resistance at around this sort of level going back to 2013. Have a look for yourself.

Clearly, the share will break out of this trading range in due course. So the question is, is it likely an upside breakout or a downside breakout? The estimated dividend yield of 3.1% for this (3.3% is estimated for next year) should restrain any downside, should it happen. Nevertheless, it is always worth remembering the old market wisdom that high valuations brook no disappointment; and Unilever is highly valued. In the statement for Q3 is a rather intriguing warning; that the company is being investigated in several jurisdictions by the local competition authorities. That should be remembered as a potential trigger to disappointment. We are told nothing else, beyond that bald cautionary statement. I see that Unilever Group operating and net margins on published results for last year were 14.4% and 10% respectively. That seems good! Is it something that gives cause for competitive concerns?