Savvy investors know the difference between price and value. Price is what a stock can be bought for, while value is what the company is actually worth on the basis of a future free cash flow stream. Everybody knows what the price is, but not everybody cares to calculate the true intrinsic worth of a company. It's no wonder why we have such volatility in the markets - many investors don't have an estimate of what the company is worth. So, how can they make buy or sell decisions rationally? As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. We calculate what we think the company is worth for all companies in our coverage. Let's calculate Amgen's (AMGN) intrinsic value.
Our Report on Amgen
• Amgen earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 54.8% during the past three years.
• 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.
• Amgen's cash flow generation is robust, but its financial leverage could potentially be concerning down the road. If cash flows begin to weaken, we'd become more cautious on the firm's overall financial health.
• The firm's share price performance has trailed that of the market during the past quarter. However, it is trading within our fair value estimate range, so we don't view such activity as alarming.
• Amgen is one of the world's largest biotechnology firms. The company's pipeline continues to advance, and commercial execution of its portfolio remains strong, particularly with its Neulasta/NEUPOGEN franchise.
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 (GM:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Amgen's 3-year historical return on invested capital (without goodwill) is 54.8%, 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 gray 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. Amgen's free cash flow margin has averaged about 34.5% during the past 3 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. At Amgen, cash flow from operations decreased about 19% from levels registered two years ago, while capital expenditures expanded about 7% over the same time period.
We think Amgen is worth $98 per share, offering upside to the $84 price tag it is currently trading. Our model reflects a compound annual revenue growth rate of 2.2% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 1.3%. Our model reflects a 5-year projected average operating margin of 48.7%, which is above Amgen's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.1% for the next 15 years and 3% in perpetuity. For Amgen, 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 $98 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 Amgen. We think the firm is attractive below $69 per share (the green line), but quite expensive above $127 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 Amgen's fair value at this point in time to be about $98 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 Amgen's 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 3 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 $125 per share in Year 3 represents our existing fair value per share of $98 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