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There are several methods to estimate the fair value of a company. In my last article, I introduced the discounted future earnings model as a valuation tool.

As Professor Donald F. Kuratko from Indiana University, Kelley School of Business, states:

This model attempts to establish future earning power in current dollars. Projects future earnings (five years), calculates the present value using a then discounted rate based on projected “timing” of future income.”

The model is based on a well-defined formula which is derived by discounting the future earnings such that:

V = Et0 + Et1/(1+r) + Et2/(1+r)2 + … + Et5/(1+r)5 + CV5/(1+r)5

Estimating the capital value at the last period acts as a perpetuity that creates regular earnings:

CVt5 = Et5 / r

The method is finalized as follows:

After redefining the future earnings based on earnings growth estimations, the method is formulized as follows:

V = E0 + E0 (1+g)/(1+r) + E0(1+g)2/(1+r)2 + … + E0(1+g)5/(1+r)5 + E0(1+g)5/[r(1+r)5]

This formula reduces the entire complexity of stock metrics into reduced to just 3 parameters. All we need is the current-period earnings, earnings growth estimate and the discount rate. Details of this estimation technique with an application to technology stocks can be found here.

Both the earnings growth rate and the discount factor are subjective parameters. You can set these parameters as you wish, according to your own diligence. If you require a higher return, set the discount rate higher. If you think that the growth rate is overly optimistic, set the growth rate lower. The discount rate is truly subjective, and it might vary from sector to sector. A rule-of-thumb is to take 0.11 as a benchmark and increase the discount rate for high-risk sectors.

Historically, the average return of DJI has been around 11% (including dividends). However, healthcare stocks seem safer for me; therefore, I will use a slightly lower discount factor of 0.10. That means an annual return lower than 10% is not acceptable for me. The excess return potential is calculated in the same way as Benjamin Graham’s Margin of Safety. Applying the discounted earnings growth formula to the largest 40 healthcare stocks that have a maximum P/E ratio of 30 gives us the following results:

Company

EPS Growth

Value

Price

Excess Return

Eli Lilly & Co. (NYSE:LLY)

3,01%

60,99

34,1

78,86%

Aetna (NYSE:AET)

10,96%

63,02

35,98

75,17%

CIGNA (NYSE:CI)

8,22%

72,63

42,4

71,30%

AstraZeneca PLC (NYSE:AZN)

2,00%

77,83

46,33

68,00%

WellPoint (NYSE:WLP)

10,14%

104,41

67,41

54,89%

Humana (NYSE:HUM)

8,68%

96,49

64,01

50,75%

Unitedhealth Group (NYSE:UNH)

11,23%

62,57

42,79

46,23%

Amgen Inc. (NASDAQ:AMGN)

7,59%

70,76

53

33,50%

Gilead Sciences (NASDAQ:GILD)

14,92%

52,31

39,79

31,46%

Medtronic, Inc. (NYSE:MDT)

9,41%

45,03

37,31

20,70%

Johnson & Johnson (NYSE:JNJ)

6,14%

69,73

58,48

19,24%

Teva Pharmaceutical (NYSE:TEVA)

13,81%

57,22

48,43

18,16%

Forest Laboratories (NYSE:FRX)

3,17%

36,29

30,79

17,88%

Novartis AG (NYSE:NVS)

4,73%

61,41

53,67

14,43%

Quest Diagnostics (NYSE:DGX)

11,32%

62,01

55,21

12,32%

Bristol-Myers Squibb (NYSE:BMY)

1,80%

25,20

25,57

-1,45%

Becton, Dickinson and Company (NYSE:BDX)

10,14%

75,70

76,96

-1,64%

Smith & Nephew (NYSE:SNN)

10,65%

52,52

55,31

-5,04%

Covidien (NYSE:COV)

11,46%

48,48

51,09

-5,11%

Abbott Laboratories (NYSE:ABT)

9,21%

44,50

47,65

-6,60%

Laboratory Corp. of America (NYSE:LH)

12,41%

81,93

88,41

-7,33%

Dr. Reddy's Laboratories (NYSE:RDY)

54,95%

31,43

34,58

-9,11%

St. Jude Medical (NYSE:STJ)

12,43%

42,44

48,01

-11,60%

CR Bard (NYSE:BCR)

11,59%

81,61

95,13

-14,21%

Biogen Idec (NASDAQ:BIIB)

8,71%

58,93

69,56

-15,29%

Stryker (NYSE:SYK)

11,86%

48,97

61,41

-20,26%

Fresenius Medical (NYSE:FMS)

11,41%

50,29

65,1

-22,75%

Varian Medical (NYSE:VAR)

15,68%

49,99

65,54

-23,72%

DaVita (NYSE:DVA)

11,55%

60,00

80,53

-25,49%

Zimmer Holdings (NYSE:ZMH)

10,37%

44,52

60,67

-26,63%

Pfizer (NYSE:PFE)

2,01%

14,38

19,76

-27,21%

Thermo Fisher (NYSE:TMO)

11,83%

38,67

54,08

-28,49%

Baxter International (NYSE:BAX)

10,01%

36,37

51,24

-29,02%

Express Scripts (NASDAQ:ESRX)

19,59%

36,77

52,28

-29,68%

Perrigo (NYSE:PRGO)

14,64%

46,34

75,45

-38,59%

Celgene (NASDAQ:CELG)

24,54%

32,82

53,81

-39,00%

Hospira (NYSE:HSP)

11,36%

32,24

53

-39,17%

Life Technologies (NASDAQ:LIFE)

11,24%

30,37

50,96

-40,40%

Novo Nordisk (NYSE:NVO)

15,85%

70,97

121,54

-41,61%

Shire (SHPGY)

13,38%

48,89

85,17

-42,59%

Based on the discounted future earnings model, Eli Lilly, Aetna, and Cigna have the greatest upside potential. Eli Lilly and Aetna are the lowest-priced stocks with upside excess-return potentials of 78.86% and 75.17% respectively. Eli Lilly is a terrific dividend company with a current yield of 5.6%. It is one of the 8 underpriced healthcare stocks with huge potential. Blackrock (NYSE:BLK) is extremely bullish about Eli Lilly, and the investment titan significantly increased stock holdings in the last quarter. Aetna’s current P/E ratio of 8.69 is among the lowest in the industry. Cigna has one of the best balance sheets, as well. With $45 billion in current assets, the company has a strong and stable cash-generating capacity.

When we look at the bottom of the list, one can see that growth companies are well-overpriced. Surely Life, Novo Nordisk, and Shire are great companies, but not such great stocks. Even after accounting for the double digit growth estimations, their future performance is not enough to pass my minimum 10% return threshold. The analysts have optimistic growth expectations, but these stocks are priced above their intrinsic value.

Warning: Do NOT blindly read the formula and short any of the stocks with negative potential. An excess return of “0” implies that I expect the annual return to be around the discount rate. A negative excess return potential does not necessarily imply that these stocks will have negative returns. They are expected to perform lower than the preset discount rate.


Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Top Healthcare Stocks With Highest Upside Potential