Nestle India is worth Rs.1,060 b now. Based upon its reported earnings of 2017, never mind the subsequent nine months, of Rs.12 b, it works out to a pe multiple of over 85. It has never been quoted that high at least in the last decade. Sorry, it did once in 2015 when it was priced at a high pe of 128, and a low pe of 94 during the year. Even from a market price of Rs.723 b (high) in 2015, the annual market return to date is more than 15%. And it has effectively doubled in market value from its low price of Rs.530 b in 2015.
Of course there was an anomaly because 2015 was an exceptional year for Nestle. There was a charge of Rs.5 b to its income statement due to the Maggi episode. If we remove this as one-off, the net earnings for 2015 would be Rs.10 b, and the high and low pe multiples fall to 68 and 50 respectively. That means, investors who bought in 2015 and sold now made money thus: buy at pe 68 or 50 and sell at 85 after a 15% rise in Nestle's earnings. Cool deal. But the catch is that if the pe multiple now is same as it was in 2015, i.e. 68, the returns would be paltry if bought at 68 times, and more than 15% if bought at 50 times.
I call this hope-based investing. When we rely entirely upon the multiple expansion rather than earnings and cash flows expansion, we need to sit and pray.
Let's talk about good part of the story first. In 2007, Nestle's market cap was Rs.160 b (high) and Rs.84 b (low), and earnings were Rs.4 b. In 2012, it was Rs.484 b and Rs.378 b, and earnings were Rs.10 b. Investors benefited twice: earnings more than doubled during the period; and the pe multiples expanded from 38 (high) and 20 (low) to 45 (high) and 35 (low).
Now look at what happened during the subsequent five years. Earnings increased from Rs.10 b (2012) to Rs.12 b (2017); that is an annual increase of 2.79%. But the market value of equity more than doubled from Rs.484 b to Rs.1,060 b now. Nestle distributed about Rs.30 b in dividends in the past five years.
Revenue growth has been 3.73% (5-year annualized) and 11% (10-year period). Earnings per share growth has been 2.79% and 11.47%.
Let's make a bull-case scenario for Nestle. Let's assume that eps and dividends will increase at 12% per annum over the next 5 years; then eps would be Rs.224 per share in 2022. Dividends per share in 2017 was Rs.86. At the current price of Rs.11,277 per share, investors will lose close to 12% annually if we price the business at a pe multiple of 25 in 2022. There has to be some premium to the business, after all it is Nestle. Let's keep going. Even at the multiple of 45, investors will lose 1.20% annually over the 5-year period. At 50x, they will make less than 1%. At 60x, the investment returns will be less than 5%. Even at 80 times 2022 earnings, the returns will be 10.50%; the market index should be able to give that probably. If the expected return is say, 12%, the business should be priced more than 85 times earnings.
Nestle's operating margins have been 17%. It also enjoys a very high return on equity and return on capital. The business does not require a lot of capital to operate. There has been no dilution in equity: 96.415 m shares have remained constant for a long time. Yet there is a moral in its story: A great business isn't always a great buy. There is a price for everything. Price is what you pay, value is what you get.
Nestle has been generating solid free cash flows; for 2017, they were Rs.17 b. Nestle has not spent big on its capex other than in 2011 and 2012 for plant expansion. It is safe to assume that Nestle has the capability to generate average fcff of Rs.15 b annually. Although the growth rates in the past have been higher (5-year 20%; 10-year 17%), let's assume that fcff will grow at 12% over the next 5 years. If the expected returns are 12%, Nestle will have to be priced 70 times its 2022 fcff to get the present value of the 5-year cash flows equal its current market price.
Is it possible to earn decent returns from Nestle? Of course it is possible. But for that, investors will have to say prayers every day during their investment period: Oh, Lord, keep the pe up, and up. Is Nestle an exception? Of course not, there are lots of fantastic businesses priced egregiously by the market. Was it a buy in 2004? Heck yes.
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