Pfizer Trading Well Below Its Intrinsic Value

Earlier this week, I detailed why I think Pfizer (PFE) has a wide moat. Today, I’m going to discuss what I believe Pfizer’s stock is actual worth. Determining a stock’s intrinsic value is critical in determining whether there is a significant margin of safety in investing in that stock.

The intrinsic value of a stock is simply the present value of future owner’s earnings. I use free cash flow often to estimate the earnings available to owners. Free cash flow is just net cash from operating activities (found on the statement of cash flows) minus capital expenditures. Ideally, I like to look at the past 10 years worth of free cash flows. The past 10 years of free cash flows for Pfizer are indicated by the green dots plotted on the graph to the left. Over the past trailing twelve months, free cash flows were $15,647 million.

I took the past 10 years worth of annual free cash flows for PFE and the trailing twelve months of free cast flows (FCF) and I drew a line through them. Actually, I did this by running a linear regression of the free cash flows over time. The trend is characterized by the equation: FCF(i) = 1604.9(year) + $14,926. This means that free cash flows start at $14.9 billion and grow by $1.6 billion each year.

Many would argue that a percent growth rate would be more appropriate to model FCF growth, but I find that linear trends are more conservative and often fit the data better for wide moat companies with consistent earnings. However, if you are still interested in the growth rate for my forecast, it is about 9%. You might notice the R2 = 0.93 in the graph above. That number indicates that 93 percent of the variation in free cash flows over the past 10 years can be explained by the linear trend line. That is a good sign that the linear trend is good at describing past free cash flow growth. However, this analysis still suffers from looking in the rear view mirror while trying to see what is coming ahead. This is definitely not a safe way to drive, and in investing this is one of the reasons why I insist on maintaining a wide margin of safety.

I am currently using a 10 percent discount rate and a perpetual growth rate of 3 percent for growth after 10 years. The 3 percent steady state growth rate is loosely based on GDP growth rates. My discount rate minimum is 10 percent. Since the 10 year Treasury Note rates are so low (4.58%), I am currently falling back on my default of 10 percent. This is similar to the way I believe Warren Buffett does this.

Using these inputs, I calculated an enterprise value of $283.5 billion. To get the intrinsic value of equity, I then added back $1.177 billion in cash and subtracted $5.561 billion in long term debt. That gave me an equity value of $279.158 billion, which then divided by 7.251 billion shares gives a per share intrinsic value of $38.50. With PFE trading at around $25, the margin of safety is greater than 50%.

In addition to running this 10 year growth model, I also looked at a 5 year growth period as well. The five year growth model looks back five years to estimate the linear trend in FCF growth and then it projects out five years of future free cash flows. This model had a lower R-squared of 89%. The resulting intrinsic value estimate was somewhat lower at $36.66 per share, but that price still provides a significant margin of safety.

I also decided at this point to take a peek at what analysts where forecasting growth would be over the next five years. According to the numbers at Yahoo! Finance, the average forecast in growth in earnings over the next five years is 5%. It’s interesting to note that at the end of 2004, analysts were predicting 11% growth per year over the next five years. I believe the 5% growth rate is an overreaction by analysts to the recent bad news to hit Pfizer. Nevertheless, I used this 5% growth rate for earnings and the average projected earnings per share of 2.18 to determine the intrinsic value of Pfizer shares using Graham’s Formula. This quick and dirty formula gives me an intrinsic value of $33.80 ($2.18*(8.5+2*5)*4.4/5.25). Even this lower intrinsic value still provides an acceptable 26% margin of safety.

A few things to look out for when calculating intrinsic values include: share dilution, stock option expenses, and pension liabilities. Share dilution seems under control with the number of share outstand dropping to 7.2 billion recently from a high of 7.5 billion two years ago. Stock options had an estimated cost of $457 million out of $8 billion in net income, which is 5.7% of earnings. This is higher than I would have liked, but not unexpected for this type of company. Finally, there are significant pension liabilities and other post retirement benefit liabilities on the balance sheet. At the end of 2005, it looks like projected U.S. pension benefit obligations exceeded the fair value of plan assets by about $1.1 billion and international pension benefit obligations exceeded the fair value of plan assets by $2.4 billion. The future expenses of stock options and pension liabilities could likely reduce owner’s earnings, but I haven’t made any adjustments at this time since the significant margin of safety I believe could cover these costs.

I’ve looked at the intrinsic value of Pfizer using a few methods detailed above. My conclusion is that the intrinsic value per share of Pfizer falls between $34 and $38.50. This estimate indicates that there is a significant margin of safety. This will be particularly important if Pfizer is not able to maintain a steady stream of new patent protected drugs or in the unlikely scenario that Congress passes legislation curtailing drug costs (this concern is over-hyped right now). If all goes well, I will collect a 3.8% dividend while I wait for Pfizer’s stock price to rise back up to its intrinsic value. I wouldn’t be surprised to find Pfizer overvalued in a few years if manic Mr. Market changes his negative attitude on drug stocks, and Pfizer in particular, and decides that drug stocks are once again the darlings of Wall Street.

Given the comments I’ve already received on my Pfizer moat check, I expect you will have lots of thought to share on my analysis in the comments section below. I look forward to the discussion.

PFE 1-yr chart:

Disclosure: author is long Pfizer.

Comments

[Paul J:]

Your models ignore an extraordinarily large white elephant. Pfizer's research group is one of the worst performing of all of the big pharmaceuticals. No financial model or projection can change that fact.

Pfizer has not developed a blockbuster inhouse since Viagra in 1996. Their fat revenue stream is primarily the result of buying Warner-Lambert to get Lipitor. They didn't discover Lipitor, the Parke-Davis unit of Warner-Lambert did.

One could have bought Ford for the dividend some time ago, but ouch that wasting away of the principal would have hurt.

2006 Dec 14 02:57 PM

[jbs:]

To build on Paul J's point: It is absolutely fundamental that the reason behind past growth is determined before one can determine what the future growth rates will be.

The previous growth trend takes into account the acquisitions as Paul mentioned. In order to believe that the trend over the past ten years will continue for another ten, one would have to believe that there would be equally beneficial acquisitions, or that some other change in the company would produce those growth rates.

The fact that PFE has an economic moat is of importance when making these projections, but I think the author is going too far to use this as the only justification for future growth assumptions (if I've interpreted his assumptions correctly).

Finally, I took a look at PFE last week after the discontinuation of torcetrapib trials... R&D was the issue for me. I agree PFE has a wide moat, that's not the issue for me. Intuitively, I think it's undervalued. But after looking at it I just couldn't feel comfortable with putting a value on it.

2006 Dec 15 04:55 AM

[maz:]

Interesting valuation but what makes you confident that Pfizer can sustain past growth when several of their largest blockbusters have lost patent protection recently or are coming off patent in the next 4 years? Patent protection is a two edged sword (20 years is usefully 9 to 12 years because of long development lead times) because the more success (eg Lipitor) the greater the urgency to find replacements once the patent expires. I'm not necessarily disagreeing with your valuation (although I am more conservative) but I don't see how a regression analysis is a substitute for future business analysis to support the growth assumptions. That method might be more suitable to Coke or Bud's business model.

Small nitpick: "intrinsic value of $38.50. With PFE trading at around $25, the margin of safety is greater than 50%" - this is a 35% margin of safety as % is based on valuation - or 50% + upside

2007 Jan 22 02:07 PM