Determining Gilead's Fair Value

| About: Gilead Sciences, (GILD)

Summary

Gilead has been outperforming the market vastly over the last twelve months.

Gilead's shares aren't overvalued compared to its own past.

Gilead seems to offer a slight to huge discount to its fair value, depending on future growth assumptions.

Overview

Gilead Sciences (NASDAQ:GILD) has had a tremendous run. Shares are up almost 80% in the last twelve months, up 35% year to date and up 14% in the last month.

GILD Chart

GILD data by YCharts

The growing share price went along with great operational and financial improvements for the company:

GILD Revenue (Quarterly) Chart

GILD Revenue (Quarterly) data by YCharts

The reason for this growth is mainly Gilead's Sovaldi drug, used to treat hepatitis C infections.

Although the share price has been rapidly increasing over the past few months, the company doesn't look overvalued:

GILD Price to Book Value Chart

GILD Price to Book Value data by YCharts

Due to the fundamental improvements, the company's multiples are now lower than they were one year ago.

Determining Gilead's Fair Value

So the company's multiples indicate it's not a bad time to buy Gilead, but what would be an appropriate price? I will determine this by using both the Benjamin Graham formula as well as the discounted cash flow method.

Graham formula:

The Graham formula is a simple approach for determining a businesses fair (or intrinsic) value.

According to Benjamin Graham, the intrinsic value of a share is:

V= EPS*(8.5+2*G)*4.4/Y

wherein

EPS = earnings per share in the last twelve months

G = estimated EPS growth rate over the next 5 years

Y = yield on AAA corporate bonds

If we apply the company's numbers, Gilead's fair value (according to the Benjamin Graham formula) is:

$4.45*(8.5+2*24.67)*4.4/4.2 = $270

With today's price of $102 this would leave an enormous 160% upside to its intrinsic value.

Discounted cash flow method:

Another, more advanced, method of determining a businesses value is the approach of discounting all future cash flows with a desired return rate and adding these present values.

Additional to the numbers used above, we have to use some more presumptions:

For the first 5 years, we can use the expected growth rate of 24.67% from above, for the time after, I will use multiple scenarios.

Let's first target an average annual return rate of 10% (this is our discount factor):

If we assume growth after year five will be zero (this is unrealistically conservative), the current value according to the DCF method is $116.12.

If we assume that the EPS growth rate after year five will be a conservative 5% (this should be highly plausible: growing human population, more and more people getting access to health care, share buybacks), the current value is $207.66.

If we assume, that the EPS growth rate will level down to an average 8% (this is a relatively optimistic approach) after year five, we get a fair value of $482.27.

Even in the most conservative (no growth after year 5) scenario, it would still be a good time to buy Gilead now, if we aim for an average return of 10%! The other, less conservative, approaches indicate a huge discount to the fair value of the company.

If we are more ambitious and target a higher average return rate, the results are a bit different. Let's say we aim for an average annual return rate of 12%.

If we take the very conservative approach and assume that there will be no EPS growth after year five, the fair value would be $94.41.

The fair value for a long term growth rate of 5% is $145.11 and for a long term growth rate of 8% the fair value is $236.37.

If an investor aims for an annual return of 12%, it looks like Gilead's shares are still trading at a discount (under the assumption that long term EPS growth will be positive).

Since the human population is growing and an increasing number of people will get access to advanced medical care (especially in emerging nations), Gilead will be able to sell products to a growing number of customers. Thus I think it is safe to assume that EPS growth rate will be positive for a long time, although it might not be as high as 8%, and the scenario with a long term growth rate of 5% seems most likely.

Possible risks

These models both factor in a high EPS growth rate over the next five years - it is estimated at almost 25%. If the growth rates are lower than expected, the fair value approaches from above are not correct.

If we use my favorite model of a long term growth rate of 5% but change the short term growth rate to 20%, the fair value is $173. If we assume a growth rate of 15% over the next 5 years, the fair value would be $142. Although still undervalued, the discount is smaller than in the other approaches.

Should long term growth be zero and short term growth rates below the expected rate, numbers are even lower. Assuming a 20% growth rate over the next five years and no growth after that, fair value would be $98. With a growth rate of 15% over the next five years and no growth after that, fair value would be an even lower $81. In these cases, the stock would be trading above fair value right now.

Possible reasons for lower than expected EPS growth rate could be:

- A competitor's product takes away market share.

- Regulating authorities demand a lower price for Sovaldi (which is very expensive) or other drugs.

Conclusion

It is impossible to exactly determine a company's future growth rates, thus I tried several of them, and it's up to everyone to make one's own assumptions (I'd be happy if you leave a comment with your opinion!). I personally like the assumption of a long term growth rate of 5% the most, I think this is still on the more conservative side and it should be possible to attain this level of growth over a long period of time. In that case, the company's stock is trading at a discount of roughly 100% to its fair value (if aiming for 10% annual return) and about 50% discount if aiming for a 12% annual return, respectively.

I think it is better to be too defensive than to be too aggressive, and thus I wouldn't buy a stock which currently trades at the fair value, it is far better to buy stocks which are trading at a discount. This margin of safety allows a positive performance even if things don't work exactly as good as assumed. If we want an annual return of 10% and allow the long term growth to be 5%, but reduce the short term growth rate to 15% (in comparison to the expected 25%), fair value would be $142. Even in this conservative, cautious approach we get a margin of safety of almost 40%, thus I think it is safe to buy the stock at the current price if one expects a solid 10% annual increase.

Since both the DCF method as well as the Graham formula come up with a fair value which is clearly above today's price, I think it is not too late to buy Gilead (although it would have been great to be a shareholder one year ago), and I will start a position in the near future.

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.