As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Abbott Laboratories' (NYSE:ABT) case, we think the firm is fairly valued at $65 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. Abbott Laboratories posts a VBI score of 6 on our scale, reflecting our 'fairly valued' DCF assessment, its neutral relative valuation versus peers, and bullish techinicals. Abbott Laboratories is competitive with Merck (NYSE:MRK) (based on our VBI score), and both outperform Bristol-Myers Squibb (NYSE:BMY), and Eli Lilly (NYSE:LLY). However, Pfizer (NYSE:PFE) has the best VBI score within the peer group, coming in at 9 (10 is best).
Our Report on Abbott Laboratories
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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.
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 $49, we'd take a closer look.
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 20.5% in coming years. Total
debt-to-EBITDA was 2.1 last year, while debt-to-book capitalization stood at 45.8%.
The firm's share price performance has trailed that of the market during the past quarter. However, it is trading within our fair value estimate range, so we don't view such activity as alarming.
The firm sports a very nice dividend yield of 3.6%. We expect the firm to pay out about 44% of next year's earnings to shareholders as dividends. We are considering the firm for addition to the portfolio in 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. Abbott Laboratories' 3-year historical return on invested capital (without goodwill) is 27.4%, which is above the estimate of its cost of capital of 9.9%. 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 (for the combined entity) 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.
Abbott To Split Into Two
Abbott announced plans to split its existing business into two distinct publicly-traded entities. According to its recent press release: "The diversified medical products company will consist of Abbott's existing diversified medical products portfolio, including its branded generic pharmaceutical, devices, diagnostic and nutritional businesses, and will retain the Abbott name...The research-based pharmaceutical company will include Abbott's current portfolio of proprietary pharmaceuticals and biologics and will be named later…The research-based pharmaceutical company has nearly $18 billion in annual revenue today and will have a sustainable portfolio of market-leading brands, including Humira, Lupron, Synagis, Kaletra, Creon and Synthroid…The diversified medical products company has approximately $22 billion in annual revenue today and a durable mix of products balanced across four major businesses."
In all, we think such a split will allow two separate management teams to improve operations, implement cost savings, and allocate capital better than they could do as one entity. Further, we like the research-based pharma company's attractive pipeline, and the diversified medical products company's emerging market potential. CEO Miles White will head the diversified medical products company, while Richard A. Gonzalez, executive vice president (Global Pharma) will become chairman and CEO of the research-based pharma company. The transaction is intended to be a tax-free stock distribution to Abbott shareholders, and management expects that both companies' dividends, when combined, will equal the current Abbott dividend at the time of separation, which is expected to be completed by the end of 2012. We are anxiously awaiting the split to better analyze the economic characteristics of each entity.
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. Abbott Laboratories' free cash flow margin has averaged about 21.3% 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 Abbott Laboratories, cash flow from operations increased about 24% from levels registered two years ago, while capital expenditures fell about 21% over the same time period.
Our discounted cash flow model indicates that Abbott Laboratories' shares (for the combined entity and at this time) are worth between $49 and $81 each. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $65 per share represents a price-to-earnings (P/E) ratio of about 20.5 times last year's earnings and an implied EV/EBITDA multiple of about 12.6 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 4.5% during the next five years, a pace that is 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 25.5%, which is above Abbott Laboratories' trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.1% for the next 15 years and 3% in perpetuity. For Abbott Laboratories, we use a 9.9% 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 $65 per share at this time (for the combined entity), 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 Abbott Laboratories. We think the firm is attractive below $49 per share (the green line), but quite expensive above $81 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 Laboratories' fair value at this point in time to be about $65 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' 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 $80 per share in Year 3 represents our existing fair value per share of $65 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.