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Investment and Security Analysis #1: Valuation Analysis of Merck
Introduction
Stock.com currently holds a significant amount of Merck’s stock in its portfolio. The
stock has appreciated significantly since it was purchased by the firm in 1994. Clients of
the firm are, however, concerned about its future prospects in light of the possibility of
health care reform. As an analyst with Stock.com Investment Management, you must
update the valuation of Merck and determine whether the firm’s current position in the
stock should be increased, held or liquidated. Merck is currently selling for around $70
per share.
Mathematics
to be supplied
Excel
to be supplied
Business Problem
Industry Background
Merck is a major player in the global pharmaceutical industry. As a first step in the
analysis of Merck, a number of industry trends need to be identified:
•
The industry depends critically on R&D. The research and development process has
long lead times, high costs, and high failure rates. Thus, pharmaceutical companies
survive on the basis of blockbuster drugs and the monopoly position obtained through
patent protection.
•
The demand for pharmaceuticals is relatively inelastic as drugs are a necessity and
third-party payers account for most of health care spending. Also, demand is
sensitive to demographic changes. The current increase in the over-65 segment of the
population translates into growing demand for pharmaceuticals.
•
In recent years, a number of mergers has reduced the number and increased the size
of pharmaceutical companies. The consolidation trend is motivated by the need to
achieve cost savings especially in research and development.
•
Health maintenance organizations (HMOs) have been growing and through their
buying power have put pricing pressure on the pharmaceutical companies.
•
The continuing expansion of cost-conscious HMOs and the patent expirations on
drugs have resulted in a large growing market for generic drugs.
•
Growing international competition for US pharmaceutical companies.
Answer the following questions on the pharmaceutical industry:
1. How sensitive is the industry to the economy? Is the industry recession resistant
and why?
2. What was the size of the pharmaceutical industry in terms of sales in 1999?
What percentage of sales was outside of the US?
3. Who are the major industry competitors to Merck and what were their level of
sales in 1999?
4. What mergers have occurred, or are pending, in this industry over the last two
years?
Financial Data
Financial statements are the main source of data for the company analysis. Financial
statements reflect the cumulative effects of all of management’s past decisions. The
financial information for the firm is contained in the annual report and is based on three
major financial statements: income statement, balance sheet and the statement of cash
flow. The financial data for Merck for the years 1993-1999 is provided in Tables 1-4.
Table 1 provides information from Merck’s income statement displaying the sales,
expenses and profits information on an annual basis. Table 2 provides financial data
from the balance sheet. Table 3 provides data on key financial variables on a per share
basis. These ratios are calculated from the income statement and the balance sheet.
In Table 3, compute earnings per share (EPS), cash flow per share (CFPS) and the
payout ratio for 1997 and 1998, where:
EPS= net income/ shares outstanding
CFPS= cash flow/ shares outstanding
Payout ratio = (Dividends per share/EPS) *100
Finally, Table 4 provides pricing data on Merck. Find the missing data for 1999.
Table 1
Merck: Income Statement
(Millions $)
Sales
Operating Income
Depreciation
Interest Expenses
Net profit
Shares Outstanding
(millions)
1993
10,498
4,262
377
84.7
2,166
2,304.3
1994
14,970
5,075
670
124
2,997
2,514.4
1995
16,681
5,262
667
99
3,335
2,472.2
1996
19,829
5,912
731
139
3,881
2,427.2
1997
23,637
6,701
1,034
130
4,614
2,409
1998
26,898
7,655
1,279
206
5,248
2,378.8
Table 2
Merck: Balance Sheet
(Millions $)
Current Assets
Total Assets
Current Liabilities
LT Debt
Total Liabilities
Shareholder Equity
Capital
Expenditures
1993
5,735
19,928
5,896
1,121
9,906
10,022
1,013
1994
6,922
21,857
5,449
1,146
10,718
11,139
1,009
1995
8,618
23,832
5,690
1,373
12,096
11,736
1,006
1996
7,727
24,293
4,829
1,156
12,323
11,971
1,197
1997
8,213
25,812
5,569
1,347
13,141
12,613
1,449
1998
10,229
31,853
6,069
3,221
19,051
12,802
1,973
Table 3
Merck: Per Share Data
Tangible Book
Value
Earnings
Dividends
Cash Flow
Payout ratio
1993
1.34
1994
1.57
1995
2.00
1996
2.17
1997
2.44
1998
1.91
0.94
0.53
1.10
57%
1.19
0.58
1.46
49%
1.35
0.64
1.62
47%
1.60
0.74
1.90
46%
?
0.87
?
?
?
0.94
?
?
1998
$80.88
$50.69
$73.75
33,4X
1.3%
1999
$76.13
$60.94
$67.19
?
?
Table 4
Merck: Market Data
High Price
Low Price
Year End Price
Year End P/E
Dividend Yield
1995
$33.63
$18.19
$32.91
24.3X
1.9%
1996
$42.13
$28.15
$39.81
24.9X
1.8%
1997
$54.09
$39.0
$53.00
27.7X
1.6%
Valuation Tasks
Armed with the above financial information, complete the following tasks in valuing
Merck:
1) Growth rates
Compute the 5-year average annual growth rate in sales, operating income, net income,
cash flow and dividends
The growth rates are calculated as follows:
(((data for 1998/ data for 1993)^0.2)-1)*100
Summarize the growth rates in a Table. Interpret the meaning of the growth rates.
2) DuPont Analysis
Evaluate Merck’s performance over time using the DuPont ROE analysis. The DuPont
formula examines the determinants of profits terms of ROE. The equation is given by:
ROE = (net income/sales)( sales/assets) ( assets /equity) =
(net profit margin) (asset turnover)( leverage factor)
Complete the information in the following Table for Merck:
Table 5
ROE Analysis
Financial ratio
Net profit
margin
Asset turnover
1993
?
1994
?
1995
?
1996
?
1997
?
1998
?
?
?
?
?
?
?
Leverage
factor
ROE
?
?
?
?
?
?
?
?
?
?
?
?
Next, do the following:
•
Using Excel graph ROE and the net profit margin for the years 1993-1998.
•
Interpret the above financial ratios. What do they suggest about Merck?
•
Go to Value Line and conduct a similar analysis for Bristol-Myers Squibb for
the years 1997 and 1998 and compare it to Merck.
3) Risk Analysis
Use the capital asset pricing model (CAPM) to assess the riskness of Merck relative to
the overall market and to its peer pharmaceutical firms. Use the following as inputs for
the CAPM:
Inputs for CAPM
Risk-free rate (Long-term US T bond rate on January 21,2000)
6.7%
Historical average equity market risk premium
7.0%
Beta
Find in Value
Line
The CAPM is given by the following equation;
Required Return = Risk-free rate + Beta * equity market risk premium
Compute the required return for Merck and two peer pharmaceutical companies.
Compare the riskiness of Merck with the market and its two peers.
4) Dividend Discount Model (DDM)
Calculate Merck’s intrinsic value by using the dividend discount model. Then, compare
the intrinsic value to the current market price of Merck to determine whether Merck is
under or overvalued.
The Dividend discount model is given by the following:
Intrinsic Value = D1/(k-g).
and D1= D0* (1 + g)
Where k is the required rate of return, g is the estimated growth rate in earnings and D0 is
the current dividend paid.
Therefore, the intrinsic value of a stock depends on the values of k and g. The required
rate of return is estimated by using the capital asset pricing model. For g, three different
methods are used:
1) Use the average annual growth rate in net income over the last 5 years. This was
computed in a previous section.
2) Use the DuPont formula modified as follows:
g = retention rate* net profit margin * asset turnover*(assets/equity)
Calculate the above for 1998.
3) Use the market consensus estimate for earnings growth for Merck as provided by S&P
and I/B/E/S. This data is available on the internet.
Calculate the intrinsic value for Merck using the three different earnings estimates.
Thus, there will be three separate calculations. Evaluate and compare these
estimates.
Finally, what is the impact on Merck’s intrinsic value if the required return rises by
1%?
5) Conclusions
Prepare an investment recommendation for Merck and justify your conclusions. Answer
whether Stock.com Investment Management should hold the Merck stock in its portfolio,
sell the stock, or buy more.
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Additional Problems
to be supplied