In this article, I argue that Mylan Incorporated (NASDAQ:MYL) is a stock that is trading at a significant discount, and based on past performance, has the potential to generate significant alpha returns relative to its peers. I use the capital asset pricing model and P/E ratio trends as screening methods for both Mylan and its competitors in the pharmaceutical space, along with a regression analysis of operating cash flow and earnings to forecast the company's potential future performance. As a caveat, this article relies heavily on trend analysis relating to past performance, and should be regarded as a starting point for investors wishing to delve deeper in conducting a more detailed business analysis of the company.
Capital Asset Pricing Model
Using a risk-free rate of 0.04% (the current rate on the 3-month US Treasury Bill), I regress the 1-Year returns of the below pharmaceutical companies (for the period June 2013-14) against the returns of the S&P 500 to determine each company's Average Daily Return, Beta Value, R-Squared Value, Expected Return, and Jensen's Alpha, where company returns minus the risk-free rate are the dependent variable (Y), and market returns minus the risk-free rate are the independent variable (X).
|LLY||Lilly (Eli) & Co.|
|MRK||Merck & Co.|
- Average Daily Return vs. Expected Return: The average daily return shows the actual percentage daily return of each company over the given time period; this is the benchmark that we use against the expected return (the return that the CAPM says we should receive for holding the stock) to determine if a stock is undervalued or overvalued. The expected return is defined as the risk-free rate plus the product of the company's beta and the average daily market return, i.e. Risk-free rate + ß(Average Daily Market Return) = Expected Return. If the stock lies above the Security Market Line, it is undervalued. If it lies below, it is overvalued.
- Beta: This figure tells us how volatile a company's price is relative to its market index. In this case, a company with a beta of less than 1 is less volatile than the S&P 500 Index; a company with a beta of greater than 1 is more volatile than the S&P 500 Index.
- R-Squared: The R-Squared figure indicates the degree of the company's returns that can be explained by the market return, e.g. a company with an R-Squared of 100% means that 100% of the company's returns are "explained" by the market. Conversely, a company with an R-Squared of 0% means that none of the company's returns can be explained by the market return.
- Jensen's Alpha: Jensen's alpha indicates the excess return generated by a stock over its expected return according to the CAPM. If a company has an average daily return greater than the expected return, then the excess return is defined as Jensen's alpha.
From the above analysis, we can see that Actavis (ACT), Allergan (NYSE:AGN), Forest Laboratories (NYSE:FRX) and Mylan are undervalued according to the Capital Asset Pricing Model, as the actual return on these stocks are higher than their expected return. To supplement the analysis, I gathered information on the P/E ratios for each of these companies and attempted to determine a rough valuation by examining where each company's current P/E ratio is trading relative to its 5-Year Maximum.
P/E Ratio Analysis
While we can see that Forest Laboratories generated a significantly higher Jensen's alpha (α) of 0.26%, it does not appear to be trading at a significant discount in terms of its P/E ratio. However, it was discovered at this point in the analysis that both MRK and MYL were trading at a significant discount of approximately 130% to the maximum P/E value achieved over the past five years. Note that I solve for the potential upside (growth rate) using the function:
ln(Maximum PE Ratio/Current PE Ratio)
Of these two companies, MRK is fairly valued according to the Capital Asset Pricing Model, with a Jensen's alpha value of 0.00%. However, MYL was calculated to have a Jensen's alpha value of 0.08%. At this stage in the analysis, both the CAPM and P/E Ratio comparisons screened Mylan as a company that is trading at a significant discount and has the potential to further generate Jensen's alpha based on past performance. Therefore, I used regression analysis across the variables of earnings, cash flow from operating activities, and capital expenditures to determine if the potential upside yielded by the P/E Ratio was justified.
In my analysis, I am assuming that MYL will continue to grow earnings per share (EPS) by 10% over the next five-year period. However, to support this analysis, I decided to run two simple linear regressions:
1. EPS = Intercept + ß(NASDAQ:CFO)
2. EPS = Intercept + ß(Capital Expenditures)
The rationale for running these two simple linear regressions is to analyse how EPS is affected by fluctuations in CFO (Cash Flow From Operations) and Capital Expenditures. If we see a positive correlation between the two, this means that we can expect a higher cash flow will result in higher earnings, and earnings will not be offset by higher capital expenditures. For the two regressions below, we see that we have a significant positive relationship in both cases with high R-Squared Values, meaning that the two variables are effective in explaining the fluctuations in EPS. Moreover, based on this data, we can be more confident that the firm's EPS increases are sustainable, as they are matched by increases in the firm's CFO.
Taking MRK as a contrasting example, we can see that there actually exists a negative correlation between CFO and EPS. However, we can see that as capital expenditures rise, EPS also rises. This could imply that MRK's EPS increases are not sustainable in the long term, as the higher EPS earnings are not correlating with increased cash flows - this may indicate that the firm cannot generate sufficient cash flow due to increased capital expenditures, and thus, forecasting a price target based on projected EPS increases will be very superficial. In the case of Mylan, while the majority of the upside in our model is determined by EPS (which we would expect from a company that does not pay dividends), cash flow from operations is treated as an important component in determining whether the EPS forecasts are sustainable and reasonable.
As below, I use the Forecast function as a means to regress the aforementioned variables for MYL, and then use both an EPS multiple and the firm's discounted CFO per share values to calculate a price target of $114.32 for the year 2018. Note that a 5% discount rate is assumed. Since the firm does not pay dividends, I am using discounted CFO per share in lieu of a standard dividend discount model to calculate a target price. Note that while this estimate is not as conservative as a current $60-$65 range given by analysts such as RBC and UBS recently, I am assuming a 10% year-on-year growth in earnings in my analysis, and given this model forecasts for the year 2018, the price target be seen as a more long-term "buy and hold" estimate rather than a near-term price target. In my opinion, the stock has the potential to trade significantly higher than the $60-65 range if it is able to show consistent increases in both earnings and cash flow from operations. In addition, the upside of 130% indicated by the target price is consistent with the potential upside based on the results yielded in the "P/E Ratio Analysis" section.
Sources: Business Insider
Results of Analysis
Limitations Of Study
- Owing to an absence of prior price information for various companies, a one-year beta for each firm was used in the Capital Asset Pricing Model Calculations. Such a short-term figure is subject to significant changes over a longer period.
- The regression forecasts under the "Trend Analysis" section should be considered a starting point, as a regression analysis needs a significant number of observations to have theoretical validity. Owing to lack of data in this regard, the results yielded should be looked at in terms of a general trend only.
- As previously mentioned, this article forecasts MYL's future earnings performance based on past data. This could be subject to significant change, depending on the business fundamentals of the company. While the models used in this analysis appear to show promising earnings growth for the company, more fundamental research is needed to validate this.
In conclusion, I believe that MYL has a significant capacity to continue to increase earnings and cash flow, based on its previous track record. The company has generated significant alpha returns in the past year, and given its current valuation on a P/E basis, the stock appears to have more potential upside, provided its business fundamentals stay solid.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.