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It's hard to overlook Eli Lilly (NYSE: LLY ) right now. From a numbers perspective, the stock practically jumps off the page. It's got a forward price-to-earnings ratio of 7.5, a dividend approaching 6%, and a return on equity of more than 40%. And all of this is from a well-known, trusted name in pharmaceuticals that's been around for well over a century.
At the same time, though, investors are all too aware of the gathering storm clouds. Over the next few years, the company's pipeline will get clobbered -- as the company's annual report noted, this year the company lost protection on Gemzar, next year Zyprexa takes the hit, and then in 2013 both Cymbalta and Humalog face the same fate.
But surely Lilly is still worth something, right? With that in mind, I decided to take a closer look to see whether pessimism might have knocked shares down to an attractive level.
It's a beautiful day in the neighborhood
One way to get an idea of what a stock might be worth is to check out how similar companies are valued. So let's take a look at how Lilly stacks up.
Total Enterprise Value/Trailing Revenue
Total Enterprise Value/EBITDA
|Abbott Labs (NYSE: ABT )||2.6||10.3||9.1||3.4|
|Amgen (Nasdaq: AMGN )||3.1||10.5||7.0||2.1|
|Bristol-Myers Squibb (NYSE: BMY )||2.2||11.7||6.4||2.7|
|Merck (NYSE: MRK )||2.7||9.6||8.1||1.9|
|Pfizer (NYSE: PFE )||2.3||7.5||5.8||1.5|
|Teva Pharmaceutical (Nasdaq: TEVA )||3.3||9.8||9.6||2.1|
Source: Capital IQ, a division of Standard & Poor's, and Yahoo! Finance. Average excludes Eli Lilly.
Using each of those averages to back into a stock price for Lilly, and then taking the average across those results, we can come up with an estimated price per share of roughly $45. This would suggest today's price of $34 and change is significantly undervalued.
A comparable company analysis like this can sometimes raise as many questions as it answers, though. For instance, is the entire group properly valued? A supposedly fairly valued -- or even overvalued -- stock among a bunch of other undervalued stocks may actually be an undervalued stock, and vice versa.
Also, while these businesses are comparable to Lilly, none is a perfect match. Teva, for instance, focuses on generic drugs and actually stands to benefit as other companies' drugs come off patent protection. Abbott has considerable exposure to patented drugs, but it has a much more diversified business that includes products in other areas such as diagnostics and nutritional products. And while Pfizer and Merck may be very similar in many ways to Lilly, the rate and impact of their patent expirations aren't exactly the same, and neither are the pipelines that they're counting on to help them rebound.
So with all that in mind, it's best to combine comparable company analysis with another valuation technique.
Collecting the cash flow
An alternate way to value a stock is to do what's known as a discounted cash flow. Basically, this method projects free cash flow over the next 10 years and discounts the tally from each of those years back to what it would be worth today (since a dollar tomorrow is worth less to us than a dollar today).
Because a DCF is based largely on estimates (aka guesses) and it attempts to predict the future, it can be a fickle beast and so its results are best used as guideposts rather than written-in-stone answers sent down from Mount Olympus.
For Lilly's DCF, I used the following assumptions:
|2010 Unlevered Free Cash Flow||$4.6 billion|
|FCF Growth 2010-2014||(6%)|
|FCF Growth 2014-2019||0%|
|Market Equity as a Percentage of Total Capitalization||84%|
|Cost of Equity||12%|
|Cost of Debt||3.1%|
|Weighted Average Cost of Capital||10.5%|
Source: Capital IQ, Yahoo! Finance, and author's estimates.
While most of this is pretty standard fare when it comes to DCFs, the academically inclined would probably balk at the way I set the cost of equity. In a "classic" DCF, the cost of equity is set based on an equation that uses beta -- a measure of how volatile a stock is versus the rest of the market -- and a few other numbers that I tend to thumb my nose at.
But when you get right down to it, the cost of equity is the rate of return that investors demand to invest in the equity of that company. So I generally set the cost of equity equal to the rate of return that I'd like to see from that stock.
Furthermore, putting together estimates for Eli Lilly hinges on figuring out just how quickly generic competition will eat away at off-patent drugs, how successful the company will be in getting drugs from its pipeline approved, and what kind of sales those new drugs will bring in. And, frankly, I just don't believe I'm in a position to come up with a particularly insightful view on these factors.
So what I've done instead is back into what the market seems to be assuming for Lilly. By starting with current analyst estimates for 6% annual declines over the next five years and then plugging in zeros for growth during the second half of the modeled period and for terminal growth, I arrived at today's price of $34.
In other words, the market seems to be anticipating that Eli Lilly will shrink around 6% per year for the next half-decade and then never grow again. Ever.
Do we have a winner?
The valuations that we've done here are pretty simple and, particularly when it comes to the DCF, investors would be well advised to play with the numbers some more.
That said, I think there's a pretty good case for buying Eli Lilly at today's price. Yes, the future is cloudy and there are significant risks ahead, but the market has priced Lilly's stock at a significant discount to much of the rest of the pharmaceutical industry. At the same time, the market's assumptions for Lilly's future seem pretty bleak, considering this is a company that more than quadrupled its sales between 1990 and 2009.
I've got my money where my mouth is on this one, as I'm a current Lilly shareholder. I don't have plans to overload my portfolio with Lilly shares, but I am planning on hanging on to the shares I own to collect the healthy dividend payouts and potentially score some nice capital gains if it's not quite the Mad Max future that Mr. Market seems to be prescribing.
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