Two factors right now are interacting to provide a distorted view of valuations for investors that make decisions based on historical P/E analyses of large U.S. stocks. On one hand, you have the growing trend of international profits contributing to the overall earnings of large U.S. multinationals. The average S&P 500 company currently generates 42% of its profits overseas. That matters because of our second factor: In the past twelve months, the United States dollar has gained almost 25% in value compared to the global basket of currencies index.
Normally, overseas profits do not require a separate distinction unless you are trying to analyze the amount of cash available for buybacks and dividends because foreign profits sometimes get trapped overseas to avoid the 35% repatriation tax. During the early 2000s, the United States dollar only lost about 5% in total against global currencies during the period 2002-2006 period between the end of the dotcom bubble and the eve of the financial crisis. And plus, managers of multinationals don’t like to talk about currency swings when the dollar is declining because a weak U.S. dollar makes the earnings reports look better.
That is not the case today. The P/E ratios are not what you think. When you look at Coca-Cola stock, you might see earnings per share reports of $2.10. But that number is somewhat illusory because Coca-Cola earns 80% of its profits outside the United States. On a currency neutral basis, the earning for Coca-Cola stock would be around $2.25 per share. The fluctuations in currencies have an effect of changing Coca-Cola’s P/E ratio from 18.76x earnings to 17.55x earnings. Usually, Coca-Cola trades around 20x normal profits. A currency adjustment can give you some certainty that you’re getting a little bit better than a fair deal if you choose to buy the stock at $39.40 per share today.
The biggest example of a stock heavily affected by currency swings is Philip Morris International. The terms of the 2008 spinoff from Altria forbade Philip Morris International from selling tobacco anywhere in the United States but gave the newly created tobacco giant the authority to sell tobacco products in the rest of the world. A consequence is that Philip Morris International is a U.S.-domiciled corporation with 100% international profits, causing current annual distortions of $0.80 per share when you look at the company’s reports.
It is an important reminder of how a company’s economic reality can easily become distorted. You look and sea earnings of $5 per share. But it is really $5.80 per share. And heck, imagine a scenario in which the dollar had grown weaker compared to other currencies in the past year. That would have given Philip Morris International reported earnings of $6.60 per share. A weak U.S. dollar would have given Philip Morris International a P/E ratio of 12 right now, compared to the 16x earnings figure that most online portal show. You need to be aware of how underlying reality can easily be distorted by extrinsic factors.
There are some large companies where what you see is what you get. Take something like Dr. Pepper. It earns 88% of its profits in the United States. It generates the other 12% of its profits in the Caribbean, Canada, and Mexico. It can’t expand internationally without creating joint ventures with Coca-Cola because Coca-Cola has a licensing claim on the international production of Dr. Pepper soft drinks. That 20.5x earnings valuation that you see in the portals is an accurate reflection of Dr. Pepper’s underlying reality.
Similarly, Hershey earns 80% of its profits in the United States. It has been slower than its international peers when it comes to branching out into new markets. My speculation on why Hershey has trouble expanding the signature brand outside the United States is because Hershey lipolyzes its milk which has the side effect of producing butyric acid. This tastes normal to you if you are from the United States, but will make you want to vomit if you are from Europe.
Making almost all of your money in the Unites States in underrated: Hershey has grown profits from $1 per share in 1998 to an estimated $4.50 by the end of this year. Quadrupling your profits in seventeen years, plus paying out a growing dividend, is nothing to lament. That’s why Hershey, even at today’s valuation of 21x earnings, can end up proving cheaper than many of the other things that you consider buying because it delivers such dependable sales growth that makes it a joy to be a shareholder because the dividends keep piling up and the regularly increasing earnings per share figure acts exerts a gravitational pull on the stock price, bringing it up higher almost every year.
None of these scenarios is better than the other. However, it is an important element to factor into your analysis. Companies like Coca-Cola and Philip Morris International may be moderately undervalued even when the P/E analysis doesn’t indicate that they are on sale, as you have to adjust for the effects of currency fluctuations. During periods when the U.S. dollar grows weaker, you need to understand why Dr. Pepper and Hershey will be reporting lower earnings per share growth than its more internationally diversified soft drink and candy peers. It won’t be a sign that the business is encountering difficulties—it just means that the numbers are being manipulated in a different way. Given the discrepancy between the United States dollar and the rest of the world’s currencies in the past years, I would adjust profits per share for currency fluctuations as the first step in considering any analysis of a prospective investment.