Kellogg’s stock now trades at its highest valuation this generation. Almost always, this has been a business that trades in the range of 15-16x earnings and offers a starting dividend yield over 3%. Today, at trades at $78 per share, offers a 2.5% dividend yield, and offers a starting P/E ratio of 21x earnings. This a business only growing earnings per share in the 4 to 6% range.
For the next five years, Kellogg shareholders will likely realize the following: 5% earnings growth, 5% dividends growth, and a P/E reversion to the 17x earnings range.
This means that earnings of $3.60 per share will grow to around $4.60 per share by around 2021. If the P/E ratio comes down from 21x earnings to 17x earnings, for a nearly 20% expected headwind, then this stock ought to trade at $78 per share five years from now. Right now, the price is trading at $77.50. That means you could be treading water for five years, earning no capital gains and only collecting dividend income while you wait for the valuation to adjust.
Normally, paying over 20x earnings for a large, non-cyclical business is tricky business because your future returns will almost certainly be less than the earnings per share growth rate over the long haul. This is tolerable when you stumble upon a business like Visa, Nike, or Brown Forman, as the quality of earnings and future growth prospects are high enough to warrant paying a price slightly higher than you’re comfortable with.
But when the expected future growth is in the mid single digits, then overvaluation eats up a larger chunk of future business results, and you don’t get the ability to “grow your way out of the problem.” When a company is growing at 13% annually, you have some “slack” to tolerate P/E compression as it’s no big deal if you “only” earn 11% annual returns due to the P/E compression effect.
When the business is growing at 5%, you don’t have a lot to give. If anything, you only want to consider these stocks when they are undervalued, as you will reap dividends + earnings growth + P/E expansion and have a strong fighting chance of earning adequate returns.
In order to get returns greater than the Kellogg dividend payment over the next five years, Kellogg stock investors must conclude that: (1) the P/E ratio won’t revert down towards 17, or (2) future earnings growth will be greater than 5%. That would mean that the history of the stock trading in the 16x to 17x earnings won’t be repeated, and/or the recent five year earnings growth of 3.5% will be dramatically improved upon. I wouldn’t want to hinge any actual money on those two latter arguments.
The earnings quality of Kellogg stock is spectacular. It is a nice company to own during a recession, as earnings don’t falter. The dividend is reliable. The management has been good at retiring shares through buybacks, as Kellogg would be reporting no earnings growth rather than 3.5% earnings growth over the past five years if it weren’t retiring shares. However, based on its current growth expectations, and its moderately high valuation, Kellogg stock should be looked at as a tool to preserve wealth rather than create wealth at this time.