Abbott Laboratories (ABT) is engaged in discovery, development, manufacture, and sale of diversified line of healthcare products. It has four segments: Pharmaceutical Products, which include a line of adult and pediatric pharmaceuticals manufactured, marketed, and sold directly to wholesalers and healthcare facilities; Diagnostic Products, which include a line of diagnostic systems and tests manufactured, marketed, and sold to hospitals and commercial laboratories; Nutritional Products, which include a line of pediatric and adult nutritional products, and Vascular Products, which include a line of coronary, endovascular, and vessel closure devices for the treatment of vascular disease. Abbott Laboratories is a dividend aristocrat that has raised its dividend for 39 consecutive years.
A 10-year summary of Sales, Earnings Before Interest and Tax (EBIT), Earnings per share (EPS), yearly high and low stock price, corresponding high and low P/E (calculated by dividing the high and low price by the EPS for the year), and average P/E (average of high and low P/E) is shown below.
Key 10-year data for Abbott Laboratories
|Year||Sales (in Millions)||EBIT (in Millions)||EPS||High Price||Low Price||High P/E||Low P/E||Average P/E|
From these data, we can plot Sales, EBIT, and EPS versus Year, as shown in the chart below.
Sales (in Millions), EBIT (in Millions), and EPS versus Year for Abbott Laboratories, 2001-2010
As evident from the above chart, ABT has demonstrated reasonably predictable sales and earnings over the past 10 years, allowing us to predict EPS in the near future, say in five years (i.e. Year 2016), using the linear regression equation for EPS = 0.2384 (2016) - 476.01 = 4.6044.
A conservative average P/E estimate for the stock can be obtained as follows:
Signature P/E: A well-established stock has a signature P/E, an average P/E it commands in the market based on its business. We calculate this by averaging the Average P/E over the past 10 years, excluding any outliers (data points that fall significantly beyond the other data points). The high P/Es in Year 2001 and 2006 are outliers, so we average the Average P/Es from the other 8 years to arrive at a signature P/E of 20.9.
High P/E estimate: a conservative high P/E estimate can be calculated by averaging the five lowest High P/Es of the 10 High P/Es from the past 10 years. The 5 lowest High P/Es from the past 10 years are 15.5, 18.7, 19.7, 23.1, and 23.3, which average 20.1.
Low P/E estimate: a conservative low P/E estimate can be calculated by averaging the five lowest Low P/Es of the 10 High P/Es from the past 10 years. The 5 lowest Low P/Es from the past 10 years are 11.2, 15.8, 16.3, 17.9, and 19.1, which average 16.1.
Average P/E estimate: this takes the average of the High P/E estimate and the Low P/E estimate, as calculated above, to give a conservative estimate of an average P/E for the stock we can expect. Averaging 20.1 and 16.1 gives us 18.05.
Multiplying our EPS projection for 5 years hence by the average P/E estimate gives us a projected average price for the stock: $4.6044 * 18.05 = $83.13. Compared with the current price of $55.43, this represents an annual stock price return = 10.66%. When we add in the 3.46% dividend yield, the total return expected is an annualized 14.1%, which means an investment in ABT today is expected to double in a little over 5 years.
Given a beta = 0.32 for ABT, a risk-free rate = 3% (using the yield on 30-year Treasury bond as a benchmark), and estimated risk premium of about 5% for the general stock market, we have a discount rate = 3% + 0.32*(5%) = 4.6%. Applying this discount rate of 4.6%, our projected price of $83.13 in 5 years translates to a target price of $66 in today's dollars, which is 20% below the current price of $55.43 for the stock. For a good margin of safety, investors are well advised to buy only if the current price is at least 20% below the target price, which means a price of $53.
What is the market's expectation of ABT's growth rate given its current market price of $55.43? Since stock price = dividend * (1 + growth rate) / (discount rate - growth rate), we have growth rate = ((stock price) * (discount rate) - dividend) / (stock price + dividend). Plugging in stock price of $55.43, dividend rate of $1.92, and discount rate of 4.6%, we get a growth rate of 1.1%. This seems low, given that ABT has grown its revenue by 9.5%, its earnings by 6.5%, and its dividend by 9.9% annually over the past 5 years. While the growth rate is supposed to slow down a bit as a company matures, a market expected growth rate of 1.1% suggests that the stock is currently undervalued. This may be due to the low discount rate used. As interest rates go up, the discount rate would increase accordingly.
Current P/E Compared With Signature P/E
As an additional consideration, we should also determine how the stock's current P/E compares with its signature P/E, since established stocks tend to revert back to their respective signature P/Es over the long term. Current EPS = 2.9, giving us a current P/E = 19. This is 91% of the stock's signature P/E of 21, which suggests the stock is currently slightly undervalued. In general, we should look to buy when the current P/E is 80% or less of the stock's signature P/E, which means a price of $48.47.
Lastly, we calculate the Risk Index, calculated as (Current Price - Forecast Low Price)/ (Potential High Price - Forecast Low Price) to give an estimate of the risk: reward ratio. Risk index less than 20% is desired, which gives us +200% potential returns for every risk of 50% loss we assume.
The Forecast Low Price is calculated by multiplying the Low P/E estimate by the Forecast Low EPS, to give a conservative estimate of low price for the stock in 5 years, assuming zero EPS growth and low valuation. Forecast Low EPS is estimated by averaging the EPS over the past 5 years. For growth stocks with predictable earnings growth, EPS in 5 years should not be any lower than this conservative estimate. For ABT, the forecast low EPS is equal to 2.624, so the Forecast Low Price = 16.1 * 2.624 = $42.13.
The Potential High Price is calculated by multiplying the High P/E estimate by the projected EPS in 5 years, giving us a price target in 5 years should the stock command a high P/E. For ABT, this equals 20.1 * 4.6044 = $92.33.
Thus, the Risk Index = ($55.43 - $42.13) / ($92.33 - $42.13) = 26%. Since this is greater than 20%, the stock has an unfavorable reward to risk ratio at the current price. A pullback to $52 would give a risk index below 20%.
Abbott Laboratories, currently selling at $55.43, has a target price of $66. While the stock currently offers good expected returns and is selling at a discount to its historic valuation, there is not enough margin of safety to buy at the current price, which is near the stock's 52-week high. I therefore rate the stock a Hold at the current price, but recommend buying on a pullback to $48-52 as a long-term investment.
Disclaimer: Use this information as a starting point for your own due diligence, before buying any stock. If you do buy, be sure to read any annual reports (10-K) and quarterly reports (10-Q) to ensure that the fundamentals remain good and the stock is on target to reach its projected price. After holding for five years, repeat the analysis detailed in the article to decide whether to continue to hold, add, or reduce your position.