As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Merck's (MRK) case, we think the firm is fairly valued at $45 per share, slightly higher than where it is currently trading.
For some background, 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. Merck posts a VBI score of 6 on our scale, reflecting our 'fairly valued' DCF assessment, its neutral relative valuation versus peers, and bullish techinicals.
Our Report on Merck
click to enlarge images
Merck 's average return on invested capital has trailed its cost of capital during the past few years, indicating weakness in business fundamentals and an inability to earn economic profits through the course of the economic cycle. However, we think the firm will earn economic profits on a forward-looking basis for some time to come.
The company looks fairly valued at this time. We expect the firm to trade within our fair value estimate range for the time being. If the firm's share price fell below $29, we'd take a closer look.
Merck 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 32.4% in coming years. Total debt-to-EBITDA was 3 last year, while debt-to-book capitalization stood at 24.7%.
The firm's share price performance has been roughly in line with that of the market during the past quarter. We'd expect the firm's stock price to converge to our fair value estimate within the next three years, if our forecasts prove accurate.
The firm sports a very nice dividend yield of 4.4%. We expect the firm to pay out about 45% of next year's earnings to shareholders as dividends. We are strongly considering it for addition to our Dividend Growth Newsletter.
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 (ROIC) with its weighted average cost of capital (WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Merck 's 3-year historical return on invested capital (without goodwill) is 10%, which is below the estimate of its cost of capital of 10.1%. As such, we assign the firm a ValueCreation™ rating of POOR. 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.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Merck 's free cash flow margin has averaged about 13.1% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Merck, cash flow from operations decreased about 9% from levels registered two years ago, while capital expenditures expanded about 29% over the same time period.
Our discounted cash flow model indicates that Merck 's shares are worth between $29 and $61 each. The margin of safety around our fair value estimate is driven by the firm's HIGH ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $45 per share represents a price-to-earnings (P/E) ratio of about 163.1 times last year's earnings and an implied EV/EBITDA multiple of about 24.5 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of -0.1% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 23.9%. Our model reflects a 5-year projected average operating margin of 33.1%, which is above Merck's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of -0.1% for the next 15 years and 3% in perpetuity. For Merck, we use a 10.1% weighted average cost of capital to discount future free cash flows.
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 $45 per share, every company has a range of probable fair values that's created by the 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 ValueRisk™ 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 Merck. We think the firm is attractive below $29 per share (the green line), but quite expensive above $61 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 Merck 's fair value at this point in time to be about $45 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 Merck '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 $54 per share in Year 3 represents our existing fair value per share of $45 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