Shares of Pfizer (PFE) have returned 21.8% over the past 12 months. At $26.61 per share, the stock is now trading very close to its 52-week high of $26.88, and offers an attractive expected dividend yield at 3.6%. Does Pfizer deserve a buy rating after the significant price appreciation? In this article, I will walk you through my valuation analysis, which may assist you in formulating an investment decision.
From a relative valuation perspective, Pfizer's valuation remains attractive based on the company's financial performance relative to its peers' (see comparable analysis chart below). Sell-side analysts on average predict the firm's revenue, EBITDA, and EPS to rise by 2-year CAGRs of -0.9%, -2.1%, and 10.8%, respectively, over the next 2 fiscal years. Those consensus growth estimates only slightly underperform the averages of 0.3%, -1.4%, and 13.8%, respectively, for a peer group consisting of Pfizer's primary competitors listed in the U.S. market. Similarly, Pfizer's EBITDA margin is forecast to compress by 1.2% over the same period, fairly in line with the average estimate of 1.3% for the comparable companies. On the profit side, Pfizer has demonstrated a superior margin performance, as all of the firm's relevant metrics are above the par. Pfizer's capital return measures, including ROE and ROIC, are below the peer averages, but the difference is not significant. The company carries a relatively higher level of debt as reflected by the above-average debt to capitalization and debt to EBITDA ratios. In terms of liquidity, Pfizer's trailing free cash flow margin is markedly above the peer average. Due to the relatively high leverage, the firm's interest coverage ratio is below the peer average, but the figure remains at a healthy level on an absolute basis. Both Pfizer's current and quick ratios are above the par, reflecting a solid balance sheet performance.
To summarize the financial comparisons, Pfizer's relatively weaker growth potential would likely be the primary drag on the stock's valuation. However, given that the gap is not significant and the company has a superior profitability and cash flow performance, I believe the stock's fair value should be fairly close to the peer-average level. Nevertheless, the current stock valuations at 7.4x forward EV/EBITDA and 12.3x forward P/E represent an average discount of 13.8% to the peer-average trading multiples (see chart above), suggesting the stock is somewhat undervalued.
Moreover, Pfizer's forward P/E multiple of 12.3x is currently trading at a 12.4% discount to the same multiple of the S&P 500 Index, which stands at 14.0x (see chart below). Although Pfizer's long-term estimated earnings growth rate at 3.8% is considerably below the average estimate of 8.0% for the S&P 500 companies, the trading multiple discount appears to be somewhat exaggerated, provided that the company has been able to maintain a robust free cash flow margin and offers an above-average dividend yield.
To support my view, I also performed a DCF analysis, which incorporates the market's consensus revenue and EBITDA estimates (see DCF chart below). Other free cash flow related items, including depreciation, tax expense, capital expenditure, and net working capital investment, are projected based on their historical figures relative to the revenue. The terminal revenue growth rate is set to 0.0% for conservatism. The EBITDA margin from fiscal 2015 to the terminal year is assumed to decrease gradually from 47.9% (the market's average estimated margin from fiscal 2012 to fiscal 2014) to 45.0%.
A company-specific risk premium of 5.0% is applied in the cost of equity calculation to account for the financial projection risk. Instead of using the currently depressed 10-year U.S. Treasury Bond yield, a normalized 10-year risk-free rate is used. As such, based on a WACC of 9.0%, a terminal growth rate of 0.0%, and an implied terminal EBITDA multiple of 7.8x, the DCF model yields a stock value of $28.52, which is 7.2% above the current share price at $26.61. According to the sensitivity tables, an extreme combination of -1.0% terminal growth rate and 10.5% WACC would result in a stock value of $22.79, which is only 14.3% below the current share price. Similarly, a mix of -1.0% terminal growth rate and 43.0% terminal EBITDA margin would suggest a stock value of $25.35, representing just a 4.7% downside.
From a dividend standpoint, the stock price appears to be somewhat supported by the solid dividend yield, which can be sustained by the company's robust free cash flow generation. In December 2012, Pfizer boosted its annual dividend per share by 9.1% from $0.88 to $0.96. Since 2010, the company has raised the dividend by 11.1% and 10.0%, consecutively. According to a chart shown below, Pfizer's annual free cash flow considerably outsized the annual dividend payment in the past few years, suggesting that there remains an ample capacity to substantiate the current pace of the dividend growth. In addition, I believe the upside for the stock's 3.6% dividend yield would be limited given the strong investor demand for high-yield assets under the current low-interest environment. Therefore, assuming a target dividend yield from 3.5% to 4.3%, and supposing that Pfizer would raise the annual dividend per share by 8.0% from $0.96 in 2013 to $1.04 in 2014, this scenario would suggest a stock value range from $24.47 to $29.71, representing a tempting price return range from -8.0% to 11.6%, without considering the 3.6% dividend yield.
Morningstar's research analyst, Damien Conover, elaborated on his long-term bullish view on Pfizer in a recent research note (sourced from Thomson One, Equity Research):
"With several major patent losses slowing Pfizer's sales potential, we expect flat sales growth during the next couple of years. However, even with a poor growth outlook, the company's valuation looks favorable. Further, several underappreciated factors, such as expansion into emerging markets and aggressive cost-cutting, should play well into the firm's long-term potential. As emerging markets are demanding health-care products at an accelerating pace, sales of Pfizer's blockbuster drugs could increase dramatically. Additionally, Pfizer is significantly cutting its cost base not only because of cost synergies created by the Wyeth acquisition and less marketing support for drugs losing patent protection, but also due to a structural realignment by the company to improve R&D efficiency. Further, Pfizer's pipeline is developing into one of the best in the industry, setting the foundation for strong long-term growth."
In addition, JPMorgan's research analyst, Chris Schott, has the following investment thesis for the stock (sourced from Thomson One, Equity Research):
"We see Pfizer offering an attractive mix of 1) inexpensive valuation, 2) an approaching near-term new product cycle with 3) a high FCF/dividend yield, and 4) limited earnings risk, in our view. We see Pfizer launching four $1+ billion products in 2012. This core portfolio of pipeline assets should enable Pfizer to return to modest top-line growth beyond the company's 2012 patent expiration cycle."
Bottom line, in the light of Pfizer's attractive valuation, sustainable dividend yield, and solid long-term prospects, the stock remains a value buy even after the price appreciation.
The comparable analysis and DCF charts are created by the author, all other charts are sourced from Capital IQ, and all historical and consensus estimated financial data is sourced from Capital IQ unless otherwise specified.
Disclosure: I am long PFE.