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W.W. Grainger, Inc.


Using the Preferred Procedure to Forecast EPS



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Editor’s note: The following is an edited adaptation of an online stock study of W.W. Grainger, Inc. (ticker: GWW) conducted on Jan. 7 by Brian Altschul, a director of BetterInvesting’s New Jersey Chapter. You can view the entire presentation on the BetterInvesting website. The Stock Selection Guide completed by the participants is available, as are Value Line company and industry reports. Beginners to the BetterInvesting methodology might find it helpful to have the completed SSG handy when reading this article.
   
This article is for educational purposes only. No investment recommendation is intended. Readers are urged to conduct their own stock study of any company of interest using their own judgments. Our thanks to Brian and the other volunteers for their participation in this event, which attracted more than 600 members

Grainger provides products to keep a company’s facilities up and running. The customers are 1.8 million businesses in 150 countries. Obviously, all the businesses that they service are unique, so they always are looking to solve different problems for different companies. As of 2007, their sales were $6.4 billion.

They have three basic business segments:

•  Grainger Branch-Based. The Industrial Supply division provides facilities maintenance products in the United States. They also have a business in Mexico, and in September 2006 they opened their first location in China.
•  Lab Safety. This supplies safety and other industrial products in the United States and Canada.
•  Acklands-Grainger Branch-Based. This is Canada’s leading broadline distributor of industrial, fleet and safety products.
   
In the frequently asked questions section of the company’s website, we can see that their financial goals are for sales growth of 7 percent to 10 percent, operating margin of 11 percent to 15 percent and a return on invested capital of more than 20 percent. That’s good information, especially when we start completing an SSG.



Estimating Sales Growth

On the Grainger SSG, you can see that things look pretty good. In ’98 and ’99, there was a bit of a downturn, especially in profits (the pink line on Section 1 of the SSG) and earnings (the blue line). But they’ve certainly been doing well since 2000.
   
When you do an SSG, the first thing you want to look at is what’s going on with sales — that’s really the first decision you have to make. The 10-year sales growth has been 3.7 percent a year, but you can see that they’ve been doing very well over the last five or six years. Earnings have been growing significantly as well, especially recently.
   
When forecasting sales, one resource I like to look at is Value Line. In the new report, they’re projecting 7 percent annual growth for the next three to five years. In the Value Line report from three months before, the sales growth projection was actually 9 percent, and now they’re looking at 7 percent. Remember that Grainger is looking at 7 percent to 10 percent growth over the next three to five years. And at Yahoo! Finance, the analysts’ consensus estimate of earnings growth for the next five years is 11.7 percent.
   
Another resource is the Portfolio Evaluation Review Technique form (for tracking trailing-four-quarter trends in sales, pre-tax profits and earnings). We can see that they’ve certainly been doing a good job keeping those sales pretty steady and increasing.
   
So let’s get right into the poll for sales growth. The choices are:

•  3.7 percent, the 10-year growth rate
•  8.2 percent, the five-year growth rate
•  9.6 percent, the growth rate for the most recent four quarters as seen on the PERT form
•  11.7 percent, the analysts’ consensus estimate of long-term earnings growth at Yahoo! Finance
   
(Participants select 8.2 percent. With $6.9 billion in sales over the last four quarters, this means sales would be almost $10.2 billion in five years.)

Using Preferred Procedure for EPS Growth

Now we’re going to use the Preferred Procedure to estimate growth in earnings per share. This method takes the sales growth projection — in this case, 8.2 percent a year — and subtracts the expenses and taxes. What you’re left with are the earnings. Then you divide by the projected number of shares outstanding to determine the earnings per share (see table, left).
   
A projected growth rate of 8.2 percent will result in almost $10.2 billion in sales five years out. So now we take a look at the profit margin (what’s left over after expenses but before taxes are subtracted). In Section 2A of the SSG, which covers percent pre-tax profit on sales, we can see that they’ve been doing a very good job increasing the profit margin — 8.2 percent in 2003, 8.8 percent in 2004, 9.6 percent in 2005, 10.2 percent in 2006 and 10.6 percent in 2007. The average for the last five years is 9.5 percent.
   
Value Line doesn’t have a profit margin line, but they do have operating margin. The difference is that operating margin doesn’t take out the taxes and profit margin does. But you can see that Grainger has been doing a good job increasing the operating margin from 10.2 percent in 2003 to 12.5 percent in 2007. Value Line also projects the operating margin to go to 15 percent three to five years out. This is a pretty significant increase of 20 percent.
   
Now we have to make a decision about Grainger’s future profit margin. Our choices for the estimated profit margin are:

•  9.5 percent, which is the average of the last five years
•  9.9 percent, a weighted average that puts the most emphasis on 2007 and the least emphasis on 2003
•  11.3 percent, the profit margin over last four quarters
•  12.7 percent, using the growth in the operating margin suggested by Value Line
   
(Participants select 9.9 percent. With the rate of pre-tax profits at 9.9 percent, projected pre-tax profits on $10.2 billion of sales would be just over $1 billion. This means expenses would amount to $9.2 billion.)
   
The next line in the Preferred Procedure is the tax rate paid on the profits. The most recent year’s rate was 38.4 percent. I wouldn’t change that number too quickly because in general, it won’t change very much. Over the last 10 years, the rate has been as low as 35 percent and as high as 42 1/2 percent. Most U.S. companies will be between 35 percent and 40 percent.
   
The only time I would be sure about changing this number would be in instances where maybe the rate was currently at, say, 20 percent, much lower than in the past. I would say, well, I don’t have any knowledge this is going to continue; they must have gotten some kind of tax break or incentive to lower their tax rate. I would change it to somewhere between 35 percent and 40 percent, because that’s where I would suspect the rate would be in five years.
   
So in this case, I’m going to leave the 38.4 percent tax rate, which would subtract $387 million from net profits of $1 billion in five years. This would leave us with $621 million in projected earnings five years from now.
   
The next consideration is the number of common shares outstanding. Grainger has significantly decreased the number of shares outstanding. There were 94 million shares outstanding in 1998, then the number of shares went down to 84 million in 2006 and 79 million in 2007. The current number is 76 million. Value Line is projecting 75.5 million for 2008, 75 million in 2009 and 70 million going out three to five years.
   
I generally wouldn’t be too quick to change this number from the most recent figure, but in this case I’m going to use the Value Line forecast of 70 million. When a company says that they plan to buy back shares, they don’t always actually follow through. In this case, Grainger has obviously been following through, and there’s some feeling this will continue over the next three to five years.
   
Changing this number actually made a big difference in the EPS growth. Using the 76 million figure, annual EPS growth was 6.4 percent. When I input 70 million, the result is 8.2 percent growth, which very interestingly is actually our five-year projected sales rate. It doesn’t always work out that way, but it’s interesting that it did. So I’m going to go ahead and use that growth forecast, which results in EPS of $8.87 five years out (the starting point is the last four quarters of EPS — $5.98).

Forecasting High and Low P/Es

Now we’ll take a look at the price-earnings ratio history in Section 3. We can see that the spread between the high and low stock prices has been pretty consistent. We have a current price of $78.81, with a high in the past year of $94 and a low of almost $59. So the low this year was lower than in 2006 and 2007. We definitely want to keep that in mind as we go into Section 4.
   
Grainger’s stock has had very consistent P/Es. For the high P/Es, the highest was 21.6 in 2003; the lowest, 19.2 in 2005. On the high side, the average was 20.4. Similarly, the low P/Es have been very consistent. The P/Es in the first five years of the 10-year history were higher than what we’ve been seeing over the last five years, and over the last five years the high P/E has been much more consistent. This is good to know as we look at what we want to use for our average high P/E.
   
For the 10-year P/E history, one thing I like to do is eliminate the five highest high P/Es and low P/Es. For the high P/Es, the five highest are all from 1998 to 2002, so the average of the five remaining P/Es is the same as the five-year average. On the low P/E side, the average of the remaining five figures is 13.7.
   
Now we’ll select the high P/E. The choices are:

•  24, a 20 percent expansion from the most recent year’s high P/E
•  22, a 10 percent expansion from the most recent year’s high P/E
•  20, the high P/E from the most recent year
•  17.5, the average of the high and low P/Es over the past five years
•  16, a 20 percent deflation from the most recent year’s P/E
   
(The choice of 22 has replaced 20.4, which was both the five-year average high and the average of the lowest five high P/Es in the past 10 years, because 20.4 is so close to 20, the third choice. Participants select 20.)
   
On the low P/E, we have:

•  14.7, the five-year average low
•  13.7, the average of the lowest five low P/Es for the last 10 years
•  12.5, the current P/E
•  10, a 20 percent deflation from the current P/E
   
(The choice of 13.9, the low P/E for the most recent year, has been removed because it’s so close to 13.7, the second choice. Participants select 13.7.)

Setting a Low Price

We selected 13.7 as our low P/E. We then multiply this by the most recent year’s earnings to determine a choice for the low price. In 2007 the EPS was $4.94, but we can also take a look at this based on the last four quarters of EPS ($5.98), which I’m going to go ahead and do. That results in $81.90.
   
Now, that’s significantly high, being that the low this year was $58.90. It’s also higher than the present price and a lot higher than the low price of the last couple of years.
   
We have other choices here. The average low price for the past five years was $53.50. The recent severe market low was $58.90, which is also the 52-week low. The price a dividend will support is $82, but you can see that the yield is less than 2 percent. So it isn’t a stock people are specifically going to buy for the dividend.
   
In our final poll, the choices for the low price are:

•  $81.90, the result of multiplying the low P/E by the low EPS
•  $53.50, the average low for the past five years
•  $58.90, the recent severe market low
•  $82.10, the price the dividend will support
•  $47.10, 20 percent depreciation from the 52-week low
   
My idea with the final choice is that this is something you may want to consider if you think the price is going to continue to go down. If you honestly believe that the price will go down by more than 20 percent, you probably aren’t all that interested in the stock and should look elsewhere.
   
(The result is a tie between $53.50 and $58.90. $58.90 is used for the SSG.)

Studying Potential Return

The result of the projections is that the current price of $78.81 is in the Buy zone, with $58.90 being at the low end of the range and $88.50 at the high end. The middle range goes up to $147.80, and the Sell zone goes up to $177.40 (the result of multiplying the high P/E of 20 by the high EPS of $8.87).
   
With an average yield of 1.3 percent and total annual price appreciation of 17.6 percent, we’re looking at a compounded rate of return of 19 percent.

Assessing Grainger’s ROE and Debt Levels

We already took a look at the company’s profit margin (see the section on Preferred Procedure), so I won’t go too much more into that. Section 2B of the Stock Selection Guide is for the percent earned on equity, or the return on equity. This is basically the ability for the company to invest in itself.
   
Grainger has been doing well here. The ROE was 17.8 percent going back to 1998. It dropped to 12.1 percent in 1999 and 11.2 percent in 2000, but since then they’ve been doing very well. The rate was 18.7 percent in 2007, and the average of the last five years is 15 percent. So the trend is up. That’s terrific; they have the ability to take the money they have and reinvest it in themselves.
   
Grainger has also done a terrific job in reducing their debt. They didn’t have very high debt to begin with. The debt-to-equity ratio was between 7 percent and 10 percent, but most recently it has been 0.2 or 0.3 percent.
   
This isn’t necessarily the end of the story, however. In the Capital Structure box of the Value Line report, I can see they recently increased long-term debt to almost $500 million. Value Line is projecting they will continue to reduce this debt, which they actually have been doing already.
   
It does bring up kind of a red flag — why are they taking on this debt, especially in this economy? — but it isn’t really a lot of debt for a company of this size. Also, the company is saying they’re using this debt for their expansion into Mexico and especially China.




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