The share price of Merck (MRK) has appreciated by 24% over the past 12 months and just reached its 52-week high at $48.69. Although the stock continues to offer an attractive 3.8% dividend yield and the company fundamentals remain in a healthy state, the solid price run-up has lifted the stock valuation to a frothy level, and I believe investors should take a pause for now. My opinion is based on the following 4 reasons:
1. Merck stock seems somewhat pricey relative Pfizer (PFE), the company's closest peer (see chart below). Merck's consensus revenue and EBITDA growth estimates are better than Pfizer's projections. However, its earnings growth potential underperforms the peer benchmark on both short and long term basis. On the profit side, Merck's various margins and capital return metrics are markedly below Pfizer's figures. In terms of leverage and liquidity, Merck carries a slightly lower debt load, but its free cash flow margin is below Pfizer's level. Due to the lower leverage, Merck is able to maintain a higher interest coverage ratio, but both the firm's current and quick ratios are below those of Pfizer.
Merck's current price multiple at 13.2x next 12-month EPS is 3% below that of Pfizer. After accounting for the 5-year EPS growth estimate, the stock's PEG ratio is 6% above Pfizer's. Given Merck's notably lower profitability, I believe the stock is modestly overvalued relative to Pfizer in terms of financial performance (see chart above).
2. Over the past 12 months, Merck's forward P/E and PEG multiples have expanded by 31% and 62%, respectively (see charts below).
However, market's consensus EPS estimates for 2013 and 2014 have experienced multiple downward revisions over the period, and analysts' average estimated 5-year EPS growth rate has also been lowered from 4.7% to 3.8% since 12 months ago, suggesting the significant multiple expansions are likely exaggerated and hard to be justified (see charts below).
3. Despite the fact that sell-side analysts are still generally bullish on the stock as reflected by the 13 strong buy/buy ratings out of the total 20 ratings compiled by Thomson One, their 1-year average price target at $50.43 is only 3.8% above the current share price. Based on the capital asset pricing model, Merck's cost of equity is likely between 6% and 8% (see chart below). If theory holds, sell-side's average price target would imply that the shares are fully priced or even slightly overpriced.
4. Merck's dividend yield is currently near its 5-year low, and it appears that there has been a solid technical yield support at between 3.5% and 4.0%. If history is a good guide, the dividend yield downside would be limited at this level and the chance for a rebound is higher down the road (see chart below).
For existing shareholders, there are still reasons to continue holding the stock such as:
- The 3.8% dividend yield supported by the healthy double-digit free cash flow margin remains tempting under the current low-interest market environment;
- The stock's forward P/E multiple is still trading at a 10% discount to the same multiple of S&P 500 Index, which stands at 14.6x now; and
- The stock price also gets somewhat support from a share repurchase program.
However, for margin of safety reason, I would encourage buyers to wait for a pullback or selling out-of-money put options.
All charts are created by the author except for consensus estimate tables, which are sourced from S&P Capital IQ, and all financial data used in the article and the charts is sourced from S&P Capital IQ.