One of the best things about investing in blue chip stocks is their predictable business results. It is near impossible to predict the future earnings of an exploration & production company with three wells out in the Gulf of Mexico, but it is not so difficult to foresee the general earnings level of an industry giant like The Coca-Cola Company (NYSE:KO).
Many investors believe that if you just buy a handful of blue chip stocks you'll do well in the long run. However, simply buying great companies will not necessarily lead to great returns. Investors who think this way are missing the key component of investing: valuation. Valuation does not have to be complicated, but it must be done in order to know whether you are going to get a high return or a low return on a stock.
Let's take a look at 3M Co (NYSE:MMM), a component of the Dow Jones Industrial Average, and see if we can figure out what kind of return we'll earn if we buy it today.
Grows With Global Economy
3M is known for inventing Post-It Notes and Scotch Tape, among other things. It owns a diverse array of businesses, mostly involved in technology and manufacturing. It has a strong balance sheet and is able to borrow debt at extremely low rates of interest. This gives the company the flexibility to expand while not risking running out of money if a recession were to hit.
3M competes with a number of companies due to its diverse operations. One of its competitors in healthcare is Johnson & Johnson (NYSE:JNJ). Johnson & Johnson is a market leader in most of the markets in which it competes. Like 3M, Johnson & Johnson owns a diverse group of businesses that allows it to produce a predictable stream of income year after year.
However, 3M and Johnson & Johnson are so big and diversified that it is difficult for either one to grow faster than the general economy. Over the last ten years, 3M has grown sales at an annual rate of 6.83%. Johnson & Johnson grew sales at rate of 6.69% per year. These growth rates include sales added due to acquisitions, so the organic growth rates are somewhat lower. By comparison, U.S. grew GDP by just under 4% per year over this same timeframe. It is unreasonable to expect 3M to grow much faster than nominal GDP in the future.
Mature companies like 3M produce a lot of free cash flow. Since cash enables the company to pay a dividend and invest in growth, we want to base our valuation on free cash flow.
Since 2002, 3M has averaged a 14.44% free cash flow margin. This means that for every $100 in sales, 3M earns $14.44 after expenses. The great thing about 3M is that it nearly always turns $100 in sales into the same amount of free cash flow, meaning that we just have to predict what sales will be to know what free cash flow will be.