Using Ratios To Identify Stocks Set To Outperform Their Peers: Pharmaceutical Rankings Update

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Includes: ABBV, GILD, JNJ, MRK, PFE
by: Stock Scrutiny

Summary

Updated rankings for major pharmaceutical companies used in my analysis are given.

Using a comparison between this year's and last year's scores, I'll introduce some interesting trends.

Year to Date performance is presented along with how this is related to each stock's final score.

Introduction

Moving on to the third article in this series, the focus will be on major pharmaceutical companies. The stocks included are Johnson & Johnson (JNJ), Abbvie (ABBV), Merck (MRK), Gilead Sciences (GILD), and Pfizer (PFE). For the readers who haven't seen my previous research, my goal with these analyses is to use ratios to identify stocks within a certain industry that will outperform their competition due to high-quality financials. In short, my theory predicts that companies that display above average rankings relative to its peers (according to my model) will experience greater price appreciation in the long run than some of the lower ranking companies. For full detail of my process, feel free to visit my first article that introduces all of my research.

Ratio Research

Debt

JNJ

ABBV

MRK

GILD

PFE

Current Ratio

1.58 (2)

1.20 (5)

1.42 (3)

2.84 (1)

1.27 (4)

Quick Ratio

1.25 (2)

1.10 (3)

1.10 (3)

2.75 (1)

.98 (5)

Defense Interval

40 (5)

462 (2)

171 (3)

627 (1)

43 (4)

Interest Coverage Ratio

19.07 (1)

8.50 (4)

8.43 (5)

10.91 (3)

14.85 (2)

Current Liquidity Ratio

212.19 (2)

251.10 (4)

572.72 (5)

-425 (1)

231.26 (3)

Debt/Equity Ratio

.51 (1)

10.49 (5)

.70 (3)

1.41 (4)

.58 (2)

Current Debt Scores

1. Gilead- (1 + 1 + 1 + 3 + 1 + 4) / 6 = 1.83

2. Johnson & Johnson- (2 + 2 + 5 + 1 + 2 + 1) / 6 = 2.17

3. Pfizer- (4 + 5 + 4 + 2 + 3 + 2) / 6 = 3.33

4. Merck- (3 + 3 + 3 + 5 + 5 + 3) / 6 = 3.67

5. Abbvie- (5 + 3 + 2 + 4 + 4 + 5) / 6 = 3.83

It's obvious that Gilead holds a large advantage over some of its competition in regards to debt. On average, they place the best out of the five stocks. Following shortly behind is Johnson & Johnson, who is renowned for its solid financial standing year after year. After a steep drop off, Pfizer comes in at 3rd place, followed by Merck and Abbvie. It can also be interesting to look at the previous year's scores to see any developing trends:

Gilead 2017 Debt Score- 2

Johnson & Johnson 2017 Debt Score- 1.5

Pfizer 2017 Debt Score- 4.33

Merck 2017 Debt Score- 3.5

Abbvie 2017 Debt Score- 3.67

Gilead's slight improvement in its score was enough to overtake 1st place as Johnson & Johnson lost some of its ground. Pfizer jumped up an entire point, yet still places below average among the five companies. Merck dropped from 3rd to 4th place, but only lost .17 points from the year before. Abbvie also only dropped slightly, but Pfizer's big jump up in the rankings caused it to rank last in the debt analysis.

Profitability

JNJ

ABBV

MRK

GILD

PFE

Gross Margin

66.13% (5)

75.78% (3)

68.86% (4)

82.12% (1)

79.24% (2)

Operating Margin

22.34% (4)

34.03% (2)

13.57% (5)

50.67% (1)

24.79% (3)

Net Margin

18.86% (4)

33.71% (2)

10.32% (5)

36.35% (1)

21.06% (3)

Profit Per Employee

$131,888 (4)

$330,750 (2)

$96,130 (5)

$1.6 million (1)

$134,601 (3)

Return on Assets

9.85% (3)

14.79% (1)

4.6% (5)

14.59% (2)

6.66% (4)

Effective Tax Rate

15.55% (2)

24.4% (3)

28.31% (5)

24.86% (4)

11.10% (1)

Current Profitability Scores

1. Gilead- (1 + 1 + 1 + 1 + 2 + 4) / 6 = 1.67

2. Abbvie- (3 + 2 + 2 + 2 + 1 + 3) / 6 = 2.17

3. Pfizer- (2 + 3 + 3 + 3 + 4 + 1) / 6 = 2.67

4. Johnson & Johnson- (5 + 4 + 4 + 4 + 3 + 2) / 6 = 3.67

5. Merck- (4 + 5 + 5 + 5 + 5 + 5) / 6 = 4.83

There was a lot of variance in this category, as the range between the highest and lowest score was over 3 points. Gilead again performed well and earned the top spot, followed by Abbvie and Pfizer. On the lower half of the five companies is Johnson & Johnson in 4th place and Merck- who got last in almost every single ratio- in 5th. Here are last year's scores:

Gilead 2017 Profitability Score- 1.5

Abbvie 2017 Profitability Score- 2.83

Pfizer 2017 Profitability Score- 3.5

Johnson & Johnson 2017 Profitability Score- 3.17

Merck 2017 Profitability Score- 4

Gilead stayed atop the rankings and only fell moderately. Both Abbvie and Pfizer saw significant improvement in their profitability ratios relative to their competition which allowed Pfizer to transition into 3rd place. Johnson & Johnson slipped half a point and its rank followed- moving from 3rd to 4th place. Remaining in last place, Merck sported another dismal score after an already poor showing in the prior year.

Efficiency

JNJ

ABBV

MRK

GILD

PFE

Revenue Per Employee

$570,522 (4)

$972,966 (2)

$581,478 (3)

$2.37 million (1)

$544,518 (5)

Employee Cost Per Unit of Revenue

.280 (4)

.222 (2)

.242 (3)

.147 (1)

.281 (5)

Capital Expenditure Ratio

23.32 (4)

53.33 (1)

21.25 (5)

44.25 (2)

23.7 (3)

Return on Equity

22.22% (3)

233% (1)

11.37% (5)

43.65% (2)

17.18% (4)

Return on Invested Capital

11.91% (3)

18.3% (1)

5.78% (5)

17..33% (2)

7.91% (4)

Asset Turnover

.52 (1)

.44 (3)

.45 (2)

.4 (4)

.32 (5)

Current Efficiency Scores

1. Abbvie- (2 + 2 + 1 + 1 + 1 + 3) / 6 = 1.67

2. Gilead- (1 + 1 + 2 + 2 + 2 + 4) / 6 = 2

3. Johnson & Johnson- (4 + 4 + 4 + 3 + 3 + 1) / 6 = 3.17

4. Merck- (3 + 3 + 5 + 5 + 5 + 2) / 6 = 3.83

5. Pfizer- (5 + 5 + 3 + 4 + 4 + 5) / 6 = 4

In 1st place was Abbvie at 1.67, trailed by Gilead at a score of 2- another very low score for Gilead. Johnson & Johnson, Merck, and Pfizer each sport below average rankings for this selection of stocks. Here are the efficiency scores from 2017 which can be utilized to spot small developments:

Abbvie 2017 Efficiency Score- 2

Gilead 2017 Efficiency Score- 1.33

Johnson & Johnson 2017 Efficiency Score- 3.33

Merck 2017 Efficiency Score- 3.83

Pfizer 2017 Efficiency Score- 4.5

Abbvie swapped places with Gilead with the help of a solid move up in their score and a major decrease by Gilead's. Johnson & Johnson improved a touch to remain at a generally average score, while Merck didn't budge and stayed at the below average score of 3.83. At first glance, Pfizer's current efficiency score may seem discouraging, but seeing that it improved half a point could suggest that its operations in terms of efficiency is finding some footing.

Growth

JNJ

ABBV

MRK

GILD

PFE

EPS Growth

29.7% (3)

77% (1)

8.56% (4)

-36.1% (5)

33.8% (2)

Revenue Growth

9.1% (2)

23.7% (1)

1.6% (4)

-20% (5)

7.56% (3)

Debt Growth

74.1% (5)

17.99% (3)

-7.6% (1)

52.1% (4)

11.8% (2)

Free Cash Flow Growth

10.38% (2)

34.7% (1)

-50% (4)

-52.3% (5)

7.54% (3)

Working Capital Growth

590% (1)

-98% (4)

-630% (5)

247% (2)

176% (3)

Current Growth Scores

1. Abbvie- (1 + 1 + 3 + 1 + 4) / 5 = 2

T2. Johnson & Johnson- (3 + 2 + 5 + 2 + 1) / 5 = 2.6

T2. Pfizer- (2 + 3 + 2 + 3 + 3) / 5 = 2.6

4. Merck- (4 + 4 + 1 + 4 + 5) / 5 = 3.6

5. Gilead- (5 + 5 + 4 + 5 + 2) / 5 = 4.2

Abbvie pulled off another impressive score and secured itself the 1st place spot. Johnson & Johnson tied with Pfizer with an admirable score of 2.6, rounding out the companies who earned above average scores. Both Merck and Gilead's growth records leave much to be desired and is represented in their subpar scores and overall rankings. For further perspective, here are last year's scores:

Abbvie 2017 Growth Score- 3

Johnson & Johnson 2017 Growth Score- 3.2

Pfizer 2017 Growth Score- 3

Merck 2017 Growth Score- 2.8

Gilead 2017 Growth Score- 3

Abbvie, Johnson & Johnson, and Pfizer each improved their score quite drastically, with the most notable movement being from Abbvie, who improved a whole point to take 1st. Merck experienced a pretty big drop in its score, giving up a lot of ground it had to the rest of the field. Gilead had a surprising tumble in its growth score as well, dropping from 2nd all the way down to last place.

Final Scores

After implementing performance based weighting to each category, I have determined that the Profitability ratios are most correlated to price performance, followed by Debt, Efficiency, and then Growth. Therefore, instead of the equation for finding the cumulative score of a stock looking like this:

(Debt Score x .25) + (Profitability Score x .25) + (Efficiency Score x .25) + (Growth Score x .25) = Final Score

It now looks like this:

(Debt Score x .27) + (Profitability Score x .3) + (Efficiency Score x .25) + (Growth Score x .18) = Final Score

With this weighting, more value is given to categories with the greatest correlation to price performance, which in turn should lead to more accurate final scores. To answer any lingering questions about how I determine weighting, please see my article that introduces the concept. Here are the most recent weight-adjusted scores for the pharmaceutical industry:

1. Gilead- 2.25

2. Abbvie- 2.47

3. Johnson & Johnson- 2.95

4. Pfizer- 3.17

5. Merck- 4.05

Gilead's outstanding performance in Debt, Profitability, and Efficiency allowed it to earn 1st place overall despite its lagging performance in the Growth category. The stock's score had a further advantage due to the fact that its worst performing category (Growth) has the least amount of weight in the score determining process. Not very far behind is Abbvie, whose top categories were Profitability, Efficiency, and Growth. In 3rd place and just under the 3 threshold is Johnson & Johnson at 2.95- where a strong debt score helped bring its overall score down. In 4th place is Pfizer, who had a chance of placing above average overall if it wasn't for its poor scores in Debt and Efficiency. Coming in last was Merck, who saw an especially terrible score in Profitability, decreasing the score even more than if there was no weighting added to the system. To see a few interesting trends, here are last year's weight adjusted scores:

Gilead 2017 Final Score- 1.86

Abbvie 2017 Final Score- 2.88

Johnson & Johnson 2017 Final Score- 2.76

Pfizer 2017 Final Score- 3.88

Merck 2017 Final Score- 3.61

The first deduction I draw from using both years of data is that Gilead and Abbvie are both companies that have earned above average scores in each of the past two years. This kind of consistency, I believe, is extremely valuable when deciding whether to own a stock. Even though it gave up some ground from the prior year, Gilead still secured 1st place. I'd only start being concerned if it kept decreasing its score in future years, because if that happens, it could signal that Gilead is losing some major competitive advantages that it's currently displaying. Abbvie, on the other hand, improved its final score by quite a bit, which helped it move into 2nd place. If Abbvie can continually receive impressive scores like it did these past two years, it also has the potential to become a long term out-performer due to powerful finances relative to competitors.

Next is Johnson & Johnson, who was another company who scored below 3 in both years, signaling above average financials. It went in the wrong direction, however, as the company's ratios weren't comparatively as good as they were a year ago. That being said, it's still an achievement to be under the 3 threshold, which I think will lead the stock to appreciate well compared to the group as a whole by year end.

The third major trend I see is Pfizer's colossal gap up in its score. Just a year ago, it was in last place handily due to the poor ratios that were widespread on their balance sheet. Fast forward a year though, and it improved just over .7 points- by far the biggest move up among all the five stocks in this analysis. This kind of improvement in just one year could be mirrored by strong price performance relative to the group (although 3.14 is still technically below average). It will be interesting to see if the stock is able to make a similar move in the future which could transform the company into an above average performer.

Finally, Merck had the most disappointing performance. In 2017, the company already only scored a 3.61, but it set the bar even lower in this year's rankings. The stock dropped from 3.61 all the way down to 4.05, achieving a final score that is very hard to accomplish (not in a good way). Most stocks rank in the 2's or 3's due to pretty tough competition in terms of ratios, so for a stock's cumulative score to be in the 4's is rare and dissatisfying. If Merck fails to improve some of its ratios and gain some ground on its peers, I think its consistently abysmal scores will be reflected through its price.

Year to Date Performance

Now that the rankings and scores for each company have been presented, I'll move on to briefly showing how each stock has performed since the beginning of the year. Next to each company will be the rank it received using my model as well as the score, followed by its YTD return.

Rank Score YTD Performance
Gilead Sciences 1 2.25 4.45%
Abbvie 2 2.47 -.45%
Johnson & Johnson 3 2.95 -10.41%
Pfizer 4 3.17 2.43%
Merck 5 4.05 10.61%

Over the first half of the year, Merck has the best performance even though it has the lowest score. Since my model is not being used to predict short term (yearly) price appreciation, this isn't necessarily surprising. Maybe the returns won't change up too much by year end, but I expect that Merck will see suppressed returns relative to this group of stocks in the long run if they maintain such poor ratios. The other positive returners so far are Gilead and Pfizer, with Abbvie only a couple percentage points away. Johnson & Johnson has performed the worst out of this group, but as I previously touched on, if it maintains its already pretty good scores, it sets itself up for success in the long run. This is because, as I've stated in previous articles, I think fundamentals are key drivers to long run price performance- and not short term noise that can cause volatile swings in prices yet has no real effect on the business.

Conclusion

Using all of these ratios, I believe a bigger picture is formed. I think more value is unlocked especially as more years of data are added, revealing trends and developments that aren't always easy to see. Ratios, although admittedly having their shortcomings, are an effective way to see the standing of a business, and most effective when comparing a stock with some of its close competition.

As always, any feedback or suggestions are welcome. One thing that I'm currently working on is how to retrieve ratios in a quicker fashion. Currently it takes me about 3 hours to one analysis, as going through five companies' financials is a time consuming process. If anyone knows of an effective way to speed up this aspect of my research (programming, Excel, etc.), it would be greatly appreciated and would allow me to publish more often!

Disclosure: I am/we are long JNJ.

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.