As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In the combined Abbott's (ABT) case, we think the firm is fairly valued at $76, higher than where it is currently trading.
At Valuentum, we think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from one to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors (we like firms that fall in the center of the diagram below). We like stocks that score nine or 10 on our scale.
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If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Abbott Laboratories posts a VBI score of four on our scale, reflecting our "fairly valued" DCF assessment of the firm, its attractive relative valuation versus peers, and very bearish techinicals. We compare Abbott to peers Eli Lilly (LLY), Merck (MRK), and Pfizer (PFE).
Our Report on Abbott Laboratories
Abbott is a healthcare company that is dedicated to discovering new medicines/therapies and new and innovative ways to manage health. The firm's product lineup spans the continuum of care, from nutritional products through pharmaceutical therapies.
- Abbott Laboratories' business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively.
- The firm is trading at attractive valuation multiples relative to peers, but our DCF process indicates a less compelling opportunity. We'd wait for a clearer signal on valuation before jumping into the firm's shares.
- Abbott Laboratories has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 22.8% in coming years. Total debt-to-EBITDA was 1.6 last year, while debt-to-book capitalization stood at 38.7%.
- The firm's proprietary pharmaceuticals segment will become AbbVie on Jan. 1, and we think powerful sales from Humira (under patent protection until 2016) and AndroGel (protected until 2021) will provide the firm with plenty of cash to invest in its pipeline when it becomes a standalone business.
- The new Abbott, also to be formed Jan. 1, will have some strong businesses of its own. For example, the nutritionals segment is home to some well-known brand names such as EAS, Myoplex and ZonePerfect.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Abbott Laboratories' three-year historical return on invested capital (without goodwill) is 26.3%, which is above the estimate of its cost of capital of 10%. As such, we assign the firm a ValueCreation™ rating of Excellent. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Abbott Laboratories' free cash flow margin has averaged about 21.2% during the past three years. As such, we think the firm's cash flow generation is relatively strong. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. (For more information on the differences between these two measures, please visit our website at Valuentum.com.) At Abbott Laboratories, cash flow from operations increased about 30% from levels registered two years ago, while capital expenditures expanded about 37% over the same time period.
Our discounted cash flow model indicates that Abbott Laboratories' shares are worth between $61.00 and $91.00 each. The margin of safety around our fair value estimate is driven by the firm's low ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $76 per share represents a price-to-earnings (P/E) ratio of about 22.1 times last year's earnings and an implied EV/EBITDA multiple of about 13.5 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 3.4% during the next five years, a pace that is lower than the firm's three-year historical compound annual growth rate of 9.6%. Our model reflects a five-year projected average operating margin of 26.2%, which is above Abbott Laboratories' trailing three-year average. Beyond year five, we assume free cash flow will grow at an annual rate of 2.1% for the next 15 years and 3% in perpetuity. For Abbott Laboratories, we use a 10% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $76 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Abbott Laboratories. We think the firm is attractive below $61 per share (the green line), but quite expensive above $91 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Abbott Laboratories' fair value at this point in time to be about $76 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Abbott Laboratories' expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in year three represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $95 per share in year three represents our existing fair value per share of $76 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements