Abbott Labs Has More Than 30% Upside

Sep.16.11 | About: Abbott Laboratories (ABT)

As part of our stock-research process, we use a rigorous discounted cash-flow process that uncovers the true intrinsic worth of companies. After updating our valuation assumptions for Abbott, we think the firm is worth just under $70 per share, up from about $63 previously.

We think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.

If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. We think our methodology and broad coverage universe is largely responsible for the meaningful outperformance of the portfolio in our Best Ideas Newsletter.

Our Report on Abbott (click to enlarge images):

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Investment Considerations

With every company in our coverage universe, we rate them on 13 unique measures. To get started, we show Abbott's below:

Investment Highlights

Abbott Laboratories earns a ValueCreation™ rating of "excellent," the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 27.4% during the past three years.

We're big fans of Abbott's expanding reach in emerging markets. We think revenue from these fast-growing regions will increase at a 15%-20% annual pace for the next several years and account for as much as $14 to $15 billion in revenue by 2014/2015. Abbott's pharma market-share lead in India is particularly impressive, at nearly 7% -- better than any domestic and global peer.

Abbott Laboratories has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 22.5% in coming years. Total debt-to-EBITDA was 2.1 last year, while debt-to-book capitalization stood at 45.8%.

The company's stock price has outperformed the benchmark during the last quarter, and its valuation still looks interesting at these levels. Investors could be accumulating shares, as the stock continues to trade at bargain-basement levels.

The firm sports a very nice dividend yield of 3.8%. We expect the firm to pay out about 40% of next year's earnings to shareholders as dividends.

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Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (NASDAQ:ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Abbott's 3-year historical return on invested capital (without goodwill) is 27.4%, which is above the estimate of its cost of capital of 9.8%. As such, we assign the firm a ValueCreation rating of "excellent." In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

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Cash Flow Analysis

Valuation Analysis

We think Abbott is worth $68 per share, which represents a price-to-earnings (P/E) ratio of about 22.9 times last year's earnings and an implied EV/EBITDA multiple of about 13.1 times last year's EBITDA. We've raised our fair value estimate from $63 per share previously due to higher emerging-market growth assumptions. Our model reflects a compound annual revenue growth rate of 5.4% during the next five years, a pace that is still lower than the firm's 3-year historical compound annual growth rate of 10.7%.

Our model reflects a 5-year projected average operating margin of 24.1%, which is above Abbott's trailing 3-year average. Beyond year 5, our valuation model assumes free cash flow will grow at a modest annual rate (1%) for the next 15 years and 3% in perpetuity. We employ a 9.8% weighted average cost of capital to discount future free cash flows.

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Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $68 per share, every company has a range of probable fair values that's created bythe uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our rating sets the margin of safety or the fair value range we assign to each stock.

In the graph below, we show this probable range of fair values for Abbott Laboratories. We think the firm is attractive below $51 per share (the green line), but quite expensive above $85 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Abbott's fair value at this point in time to be about $68 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Abbott Laboratories's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence.

This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $84 per share in Year 3 represents our existing fair value per share of $68 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

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