Medtronic (MDT) is a preeminent leader in the medical devices industry, an industry which is set to see quite dynamic growth in the future. According to Guideline Medical Consulting, the compound annual growth rate for developed markets is expected to be a respectable 7.5% over the next five years, with the bulk of growth arising from emerging markets at a 15% CAGR. Within this industry, Medtronic has shown impressive financial performance over the past ten-year period, and its presence in 140 countries means that it is in a prime position to supply these technologies to countries that need them the most. In fact, Goldman Sachs recently upgraded MDT to a buy rating given expected increases in organic growth. However, would a value investor such as Benjamin Graham be tempted to buy Medtronic? According to his criteria, the answer is yes, he would. But not at this price. Graham would only ever buy a company if it was mispriced, i.e. trading below its fair value. Nevertheless, fair value today does not mean fair value tomorrow. While MDT may not be undervalued at this point in time, it could well be undervalued relative to its future earnings. The below metrics demonstrate that Medtronic is a financially robust company with growth prospects that are too strong to ignore.
Benjamin Graham sets out the following criteria that he would rigorously apply to appraise an investment:
1. The earnings-to-price yield must be twice the value of the current triple-A bond yield.
With an earnings per share of $3.75 for 2013, and a current market price per share of $56.89, the earnings-to-price yield of MDT is 6.59%. With a 10-year triple A US Bond Yield of 2.886%, the earnings-to-price yield is more than twice the value of the triple A US Bond Yield.
2. A P/E ratio of four-tenths or less of the highest P/E ratio reached by the stock in the last five years.
With the current P/E ratio (15.7) being just over 6/10 of the 5-Year High (24.54), the stock does not reach Benjamin Graham's 4/10 criteria.
3. A dividend yield worth two-thirds of more of the current triple-A bond yield.
A dividend yield of at least two-thirds of the triple-A bond yield. With a current dividend yield of 2% compared to a 10 Year US Bond Yield of 2.886%, MDT meets this criteria.
4. A stock price worth two-thirds or less of the tangible book value per share.
With common equity of $18,671m and common shares outstanding of 1,016m, the book value per share is $18.38, less than the current stock price of $56.89.
5. A stock price worth two-thirds or less of "net current asset value", i.e. current assets less total debt.
With current assets of $17,852m for 2013 along with total debt of $10,651m, MDT's net current asset value per share stands at $7.08. This is clearly far less than the current share price of $56.89.
6. A total debt figure less than that of total book value.
With total debt of $9,851m and total book value of $18,671m, MDT's debt accounts for 48% of its total book value.
7. Current ratio of two or higher (i.e. current assets divided by current liabilities).
With current assets of $17,852m and current liabilities of $3,950m, MDT's current ratio is 4.52.
8. Total debt equal to or less than twice the "net current asset value" as outlined under rule no. 5.
With total debt of $9,851m and a net current asset value of $7,201m for 2013, total debt is less than twice the figure of MDT's net current asset value, or $14,402m.
9. The company must have increased earnings by 7% per annum compounded over the last 10 years.
The company has succeeded in growing earnings by 10.36% per year.
10. There must have been no more than two declines of 5% or greater in year-end earnings in the past ten-year period.
With no more than two declines in EPS not exceeding 10%, Medtronic has successfully shown stable earnings growth over the past 10 years.
With a score of 7 out of 10, these financials suggest that Medtronic is a financially sound company, and if past is prologue, the company can expect to enjoy high growth in earnings over the next five years. However, with the current P/E ratio quite higher than 40% of the 5-Year High that Graham would have specified, along with an overinflated stock price relative to the company's book value, MDT is not technically undervalued. Based on a current P/E ratio of 15.7 and EPS of $3.75 per share for 2013, the fair value of Medtronic is priced at $58.88 based on a simple EPS multiple analysis (15.7*3.75 = 58.88). At MDT's current price of $56.89, the firm appears fairly valued. However, its future growth prospects indicate that the company will not stay that way and investors should be ready to initiate a buy if growth continues, as it is my view that while a company may be fairly valued today, it can still be undervalued relative to future earnings growth. To quote legendary value investor Warren Buffett, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." Analysis of the expected growth in dividends and earnings per share also reveals a potential upside from 29% to as much as 61% in the next five years as per the dividend discount model below.
In terms of an overview of the business analysis of Medtronic, there are several reasons why I believe the company has the capacity to grow earnings and dividends into the future:
1. The company is highly innovative, having shown the capacity to quickly cater to new trends in the medical technology industry. As an example, 38% of the company's total revenue has come from products introduced in the past three years.
2. The company has an excellent track record of consistently offering shareholders increasing dividend payments for the past 36 years, and most recently increased its cash dividend by 8% in 2013.
3. MDT is continuously expanding into the all-important emerging markets to increase sales, with revenue in these markets growing by 17% on a constant currency basis.
4. With a developed expertise across a wide spectrum of fields in medical technology, such as Cardiac and Vascular, Coronary, and Restorative Therapies, MDT is in a prime position to further its competitive advantage and take advantage of new trends before competitors.
Projected Share Price =
(dividend(yr1)/(1+dr)^1) + (dividend(yr2)/(1+dr)^2) + (dividend(yr3)/(1+dr)^3) + (dividend(yr4)/(1+dr)^4) + (dividend(yr5)/(1+dr)^5) + (Terminal PE*Terminal EPS)/(1+dr)^5)
where dividend = dividend per share; yr = year; dr = discount rate
Target Price Scenarios
Projected Target Price
At a 5% discount rate of MDT's future growth in dividends and terminal growth in earnings per share, the projected target price is $90.22. At a 10% discount rate, the projected target price is $71.89. Using both a 5% and 10% discount rate (as this is typically what a benchmark index such as the S&P 500 returns over a normal five-year period), investors should be looking for an eventual target price range of $72-$90 based on estimated growth in both dividends and earnings per share.