I looked at a portfolio of 11 securities in the Major Pharmaceuticals industry sector and evaluated them based on three criteria:
- Quality of Earnings
- Earnings Growth
- Theoretical Price based on the Ohlson Clean Surplus, or OCS
Novo Nordisk (NYSE:NVO) was the only security to show strong quality of earnings and to trade at a discount relative to the OCS theoretical price. It was also the only security to show growth in earnings year over year over the past five years.
Merck (NYSE:MRK) had poor quality of earnings and traded at a premium to the theoretical price. It only had one year of year-over-year growth in its earnings.
Quality of Earnings
In my opinion, using a quality of earnings framework is important because it provides a window into how trustworthy the financial statements are. I use a modified version of Lev & Thiagarajan's, utilizing eight of their 12 metrics (or 11 if you only use R&D or capital expenditures but not both). Specifically I use:
- % change in sales - % change in inventory
- % change in sales - % change in accounts receivables
- % change in firm's R&D - % change in sector R&D
- % change in gross margin - % change in sales
- % change in sales - % change is S&A expenses
- % in effective tax rate (NYSE:T) (if change in earnings>0 and Tt - Tt-1>0 or if change in earnings<0 and Tt - Tt-1<0)
- % change in sales - % in number of employees
- Unqualified audit opinion
The tests are designed such that a positive result is a signal in favour of good quality of earnings and is given a point value of one. A negative result indicates a poor quality of earnings signal and is given a value of zero.
Novo scored seven out of eight. On the other hand, Merck and four others only scored three.
This metric assigns a "1" to each occasion of year over year growth and a "0" to each occasion of year over year decay. Each year over year period is summed and because I am using five years of earnings data, the scores can range from 0 to 4.
As you can see, Novo Nordisk came out on top. Had the Q of E score been mediocre or poor, we would not have such a high degree of confidence in the result. As it is, this is very strong.
Ohlson Clean Surplus
The OCS is a relatively unknown valuation method that after about a dozen calculations comes up with a theoretical price for the security under analysis. I use it to determine whether a security is under or over valued and I like this method because it's been scientifically tested with the results peer reviewed and it performs very well, specifically over a medium time frame (two to three years). I also like it because it's created from the balance sheet rather than the income statement (more reliable) and it doesn't hinge on critical estimates. Oh, it's true, there is one estimate, but it's minor (it's the expected market premium and I used 7%, as this is the average, long-term growth rate of the S&P).
Novo's OCS theoretical price is $47.90, indicating it was trading at a discount of approximately 35% when I ran the model. It didn't have the largest discount of the group, but when combined with the other two factors it looks really good. Merck, on the other hand, was trading at a 70% premium.
If you are interested in an analysis into the company's product line and operational landscape, then I highly recommend Daniel Schonberger's excellent article "Novo Nordisk: Why the Diabetes Giant Will Continue to Grow."
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in NVO over the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.