Sigma-Aldrich: Upside Potential Outweighs Downside Risk At The Current Price

Company Description (from recent 10-k)

Sigma Aldrich Corporation (NASDAQ:SIAL) develops, manufactures, purchases and distributes a range of chemicals, biochemicals and equipment. These chemical products and kits are used in scientific research, including genomic and proteomic research, biotechnology, pharmaceutical development and as components in pharmaceutical, diagnostic and other technology manufacturing.

Sigma Aldrich is a dividend aristocrat, having raised its dividend for 35 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. Prices are adjusted for stock splits.

Key 10-year data for Sigma Aldrich

Year

Sales (in Millions)

EBIT (in Millions)

EPS

High Price

Low Price

High P/E

Low P/E

Average P/E

2010

2,270

544.00

3.12

67

47.4

21.5

15.2

18.3

2009

2,150

489.60

2.8

55.2

32.6

19.7

11.6

15.7

2008

2,200

489.50

2.65

62.6

37.4

23.6

14.1

18.9

2007

2,040

437.60

2.34

55.6

37.9

23.8

16.2

20.0

2006

1,800

378.70

2.05

39.7

31.5

19.4

15.4

17.4

2005

1,670

343.30

1.88

33.2

27.8

17.7

14.8

16.2

2004

1,410

311.80

1.67

30.4

26.9

18.2

16.1

17.2

2003

1,300

272.82

1.34

28.9

21.3

21.6

15.9

18.7

2002

1,210

272.14

1.27

25.5

20.1

20.1

15.8

18.0

2001

1,110

219.12

1.05

24.7

18.6

23.5

17.7

20.6

Click to enlarge

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 Sigma Aldrich, 2002-2011

As evident from the chart above, SIAL has demonstrated very predictable sales and earnings over the past 10 years (with R squared greater than 0.95), the mark of a great company. This allows us to predict EPS in the near future, say in five years (i.e. Year 2016), using the logarithmic regression equation for EPS = 3.414E-105 * exp(0.12*Year) = 7.2306.

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). There are no significant outliers, so we average the Average P/Es from the past 10 years to arrive at a signature P/E of 18.1.

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. Averaging the 5 lowest High P/Es from the past 10 years gives 19.

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. Averaging the 5 lowest Low P/Es from the past 10 years gives 14.2.

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 19 and 14.2 gives us 16.6.

Target Price

Multiplying our EPS projection for 5 years hence by the average P/E estimate gives us a projected average price for the stock: $7.2306 * 16.6 = $120.12, which represents an annual stock price return of 14 percent from the current price = $71. When we add in the 1% dividend yield, the total return expected is 15 percent a year, which means an investment in SIAL today is expected to double in 5 years.

Given a beta = 0.87 for SIAL, a risk-free rate = 2% (using the yield on 10-year Treasury bond as a benchmark), and estimated risk premium of about 6% for the general stock market, we have a discount rate = 0.02 + 0.87*(0.06) = 0.0722. Applying this discount rate of 0.0722, our projected price of $120 in 5 years translates to a target price = $85 in today's dollars, which is about 19 percent upside from the current price of $71, suggesting the stock is undervalued right now. 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 buy price of $68.

Market Expectation

What is the market's expectation of SIAL's growth rate given its current market price = $71? 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 = $71, dividend rate = $0.72, and discount rate = 7.22%, we get growth rate = 6%. This seems reasonable, given that SIAL has grown its revenue by 6 percent and its earnings by 8 percent a year over the past 5 years. This suggests the stock is currently fairly priced.

Current P/E Compared with Signature P/E

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. The current EPS = 3.59, giving us a current P/E = 19.8. This is about 109% of the stock's signature P/E of 18.1, suggesting the stock is slightly overvalued right now. To provide some margin for error, we should look to buy when the current P/E is 80% or less of the stock's signature P/E, which means a buy price around $52.

Sigma Aldrich's P/E Compared with Competitors' P/Es

It is helpful also to compare Sigma Aldrich's valuations with those of its competitors and peers in the chemicals industry. Current P/E and Forward P/E are tabulated below for the company and its competitors/peers.

Stock

Current P/E

Forward P/E

Sigma Aldrich (SIAL)

19.66

17.47

Thermo Fisher Scientific (NYSE:TMO)

13.53

10.7

Life Technologies (NASDAQ:LIFE)

29.95

12.27

PerkinElmer (NYSE:PKI)

14.33

12.14

Qiagen (NASDAQ:QGEN)

16.23

14.46

Mean

18.74

13.408

Median

16.23

12.27

Click to enlarge

Compared to its peers, Sigma Aldrich appears overvalued based on both current and forward P/Es. In contrast, Thermo Fisher Scientific and PerkinElmer appear undervalued on both measures.

Risk Index

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 SIAL, the forecast low EPS is equal to 2.774, so the Forecast Low Price = 14.2 * 2.592 = $36.86.

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 SIAL, this equals 19 * 7.2606 = $137.41.

Thus, the Risk Index = ($71 - $36.86) / ($137.41 - $36.86) = 34%. Since this is below 15%, the stock has a favorable reward to risk ratio at the current price.

Conclusion

Sigma Aldrich Corporation, currently selling around $71, has a target price = $85, suggesting the stock is undervalued. Upside potential appears to outweigh downside risk. However, the stock is selling at a valuation above its historic P/E, and it is relatively overvalued compared to its peers. Overall, I rate the stock a BUY at the current price, with the caveat that it might be a little pricey right now, so a long holding period, at least 5-10 years, is required to allow the stock to grow into its current valuations.

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

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.