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By Cagdas Ozcan

Merck & Company (NYSE:MRK) provides medicines for a number of conditions. However, the top prescription drugs include asthma medication Singulair, diabetes drug Januvia, anti-inflammatory Remicade, cholesterol combatants Vytorin and Zetia, and hypertension fighters Cozaar and Hyzaar. It is one of the better performing pharmaceutical stocks this year. The stock has gained about 9% since the start of the year, and we expect the stock to carry on its upward movement.

We used our fair value model to calculate the upside potential of the stock. According to our model, there is substantial upside potential in Merck. Results of the model are discussed below.

As of the time of writing this article, MRK stock was trading at around $44.27, with a 52-week range of $37.02 - $48.00. It has a market cap of about $133.9 billion. The trailing twelve-month P/E ratio of 21.8 is above the forward P/E ratio of 11.60. P/B, P/S, and P/CF ratios stand at 2.5, 2.8, and 13.4, respectively. The operating margin is 18.5% while the net profit margin is 13%. The company has a low debt load, with a debt/equity ratio of 0.3.

Merck has a 3-star rating from Morningstar. Out of ten analysts covering the stock, three have a buy recommendation and only one analyst is neutral. On the other hand, five analysts have market outperform rating, and one analyst has market perform rating. Average five-year annualized growth forecast estimate is 2.85%.

We can estimate Merck's fair value using discounted earnings plus equity model as follows.

Discounted Earnings plus Equity Model

This model is primarily used for estimating the returns from long-term projects. It is also frequently used to price fair-valued IPOs. The methodology is based on discounting the present value of the future earnings to the current period:

V = E0 + E1 /(1+r) + E2 /(1+r)2 + E3/(1+r)3 + E4/(1+r)4 + E5/(1+r)5+ Disposal Value

V = E0 + E0 (1+g)/(1+r) + E0(1+g)2/(1+r)2 + … + E0(1+g)5/(1+r)5 + E0(1+g)5/[r(1+r)5]

The earnings after the last period act as a perpetuity that creates regular earnings:

Disposal Value = D = E0(1+g)5/[r(1+r)5] = E5 / r

While this formula might look scary for many of us, it easily calculates the fair value of a stock. All we need is the current-period earnings, earnings growth estimate, and the discount rate. To be as objective as possible, I use Morningstar data for my estimates. You can set these parameters as you wish, according to your own diligence.

Valuation

Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate.

In order to smooth the results, I will also take the average of ttm EPS along with the mean EPS estimate for the next year. The average EPS for Merck is $3.73.

While analysts tend to impose subjective opinions on their estimates, the average analyst estimate is a good starting point. Average five-year growth forecast is 2.85%. Book value per share is $18.24.

Fair Value Estimator

V0

E0

$3.73

V1

E0 (1+g)/(1+r)

$3.46

V2

E0((1+g)/(1+r))2

$3.20

V3

E0((1+g)/(1+r))3

$2.97

V4

E0((1+g)/(1+r))4

$2.75

V5

E0((1+g)/(1+r))5

$2.55

D

E0(1+g)5/[r(1+r)5]

$23.16

BV

Equals

$18.24

Fair Value Range

Lower Boundary

$41.81

Upper Boundary

$60.05

Potential

35.59%

(You can download FED+ Fair Value Estimator, here.)

I decided to add the book value per share so that we can distinguish between a low-debt and debt-loaded company. The lower boundary does not include the book value. According to my 5-year discounted-earnings-plus-book-value model, the fair-value range for Merck is between $41.81 and $60.05 per share. At a price of about $44, Merck is trading close to the lower boundary of its fair value range. The stock still has up to 36% upside potential to reach its fair value maximum.


(Click to enlarge)

Summary

The company was facing a lot of challenges in the shape on patent losses, weak product pipeline and increased competition. However, the acquisition of Schering-Plough has helped the company steady its ship. Schering-Plough will add substantial value to Merck in the long-term. According to our fair value model, there is substantial upside potential in Merck, and it should be chosen as a long-term investment. It should be kept in mind that our models are based on long-term earnings, and value the stocks based on the long-term prospects of the business.

Source: How Much Is Merck Worth?