Nestle revisited

In the year 2001, the after tax EPS of Nestle was 87 sen. and its share price was trading between $19.30 to $21.20, with a P/E ranging from 22.2 to 24.4.

For someone who bought Nestle in 2001, where was the margin of safety of this company?

Margin of safety in a company comes from various sources.  Among these are the qualitative factors which are difficult to quantify mathematically.  Nestle has durable competitive advantage and economic moat.  The only assessment for the investor is to "guess intelligently" what its earnings growth will be over the next few years.  

Margin of safety concept can be applied in two ways.  One that is obvious is buying a company at a big discount to its intrinsic value.  Of course, intrinsic value is not easy to determine and does vary widely depending on the assumptions one makes in deriving this value.  Another method that is not obvious, is the margin of safety that exists too when the present price that you are paying is at a discount to its intrinsic value based on its growth projections, conservatively estimated.

Let's look at Nestle.  In 2001, you were paying 22.2 times for $1 of its after tax earnings.  Was this underpriced, fair price or overpriced relative to its intrinsic value, conservatively estimated based on its growth potential?  Growth projections are at best intelligent guesstimates.  Nestle was projected to grow its business profit at 8% per year at that time.  Therefore in 9 years from 2001, it was projected then to have an EPS of 2 x 87 sen = 174 sen.  

Assuming that Nestle in 2010 had the same PE of 22.2, its share price in 2010 should be 22.2 x 174 sen = $.38.63, or CAGR of 8%.  The average DY of Nestle was 4%.  Nestle paid out virtually all its earnings as dividends.  Therefore, its DY in 2001 based on historical cost was 4% but in 2010, its DY based on historical cost was 8% (dividend paid had also doubled).  This was an average dividend yield of about 6% per year for that period.  Should you have reinvested all the dividends back into Nestle, you would probably be able to compound your initial investment at more than 14% per year.

So, in 2001, Nestle's PE was 22.2x.  Yet, knowing its earning growth potential, conservatively estimated, there was margin of safety even buying at this price, with a reasonable degree of probability.  Using a conservative growth estimate in earnings of 8% per year, its earnings was projected to double in 2010.  Based on this EPS projection, its (future) intrinsic value would be higher and herein was the margin of safety demanded by the value investor.  

Such way of investing may not appeal to some investors.  It is too difficult for them to realise that growth creates value.  One should be happy to pay a higher PE to own a stock of higher quality, better earnings growth, lesser risk and greater certainty of a positive sustainable return.

Buying a wonderful company at a fair price has made those who know how, very rewarding and rich indeed.  There is no reason to change something that has worked consistently over 2 decades of investing.