Which Dominant Drugmaker Is a Better Buy Today?

Looking for a great investment? One way to make sure you've picked the right stock is to compare it to a strong peer on a series of cold, objective financial results and other key statistics. In that spirit, we'll be taking a closer look today at two of the world's largest drug manufacturers, Pfizer (NYSE: PFE  ) and Johnson & Johnson (NYSE: JNJ  ) .

The companies will go head to head in several battles. The winner will be the one with the most cumulative victories through contests of valuation, earnings quality, and dividend sustainability. We'll also examine analyst optimism toward each stock to see what sort of growth the market's top minds envision in the years ahead.

In this corner…
Pfizer and J&J are competitors and collaborators. Each company has wide-ranging pharmaceutical operations, but J&J takes the lead in diversification by offering consumer products from contact lens solution to mouthwash. J&J also produces various health care devices that include diabetic blood-glucose monitors and artificial replacement joints. Pfizer calls itself "the world's largest research-based pharmaceutical company," and its long, long list of drugs in development attests to that claim.

Pfizer and J&J teamed up with Elan (NYSE: ELN  ) to produce bapineuzumab, a once-promising Alzheimer's drug that appears destined for the reject pile after our two competitors discontinued phase 3 trials. Pfizer and J&J have a strong enough working relationship that the former sold its consumer health division to the latter years ago.

On the flip side, J&J faces stiff competition from Pfizer -- as well as from Teva Pharmaceuticals (Nasdaq: TEVA  ) and Procter & Gamble (NYSE: PG  ) , among others -- as it gradually recovers from an appallingly long list of product recalls initiated over the past couple of years, including over-the-counter medication, contact lenses, and replacement hips. J&J also faces potential Pfizer competition in rheumatoid arthritis drugs. J&J's Remicade may soon battle Pfizer's tofacitinib for doctor recommendations, as the latter drug is progressing nicely through its phase 3 trials.

Pfizer faces its own problems as it approaches a prescription-drug patent cliff, which promises generic versions of drugs making up 23% of the company's total 2011 sales within the next few years. That may be a greater long-term risk than anything J&J faces today, so it's worth keeping in mind as our two competitors face off.

Now, let's get down to ringside and get this contest started.

Valuation battle
We use many different numbers and ratios when talking about the value of a stock. We'll check each company's current P/E and its average P/E over the last five years. We'll also check current and five-year average price-to-free-cash-flow ratios. Earnings can be gamed with a number of different accounting tricks, but free cash flow is harder to manipulate, making it a favored metric here at the Fool.

The difference between a stock's ratio today and its five-year average will be more important than the numbers themselves. Ratios much lower than their averages may have more room to grow back to that middle ground. Ratios much higher than average may be at risk of declines.

For the tiebreaker, we'll check one lesser-used ratio: enterprise value to EBITDA, which my Foolish colleague Matt Koppenheffer fully explains here. A smaller number is better when it comes to well-established companies, as it may point toward stronger future growth.

Metric

Pfizer

Johnson & Johnson

P/E 17.7 21.1
5-Year Average P/E 15.7 14.9
P/FCF 30.4 12.0
5-Year Average P/FCF 16.5 13.0
EV/EBITDA 8.6 12.2

Sources: Wolfram Alpha and YCharts. Winners in bold.

It looks like Pfizer takes this round despite an inflated current price-to-free-cash-flow level. Its lower EV/EBITDA tips this contest in the end, but that's not the only alternative valuation metric in which Pfizer excels. Fool columnist Morgan Housel pointed out last year that Pfizer's enterprise value to unlevered free cash flow is also attractively positioned in the single digits.

Earnings quality battle
A company can be cheaply valued without being a good value. To balance out our valuation fight, let's look at a few key earnings statistics for each company. We'll look at each company's net margins, returns on equity, and annualized rates of earnings growth for the last five years.

To gauge consistency, let's also dig into each company's streak of both profitable years and improving profitability. A company with no momentum today is less likely to become a superstar later -- it has happened before, but not often.

Metric

Pfizer

Johnson & Johnson

Net Margin 15.8% 13.5%
Return on Equity 10.7% 14.3%
5-Year Annualized Earnings Growth 1.8% 4.3%
Consecutive Profitable Years (since 1992) 20 20
Consecutive Years of Earnings Growth 1 0

Sources: Yahoo! Finance and Wolfram Alpha. Winners in bold.

Both of these companies have proven highly resilient over time. Their twin 20-year streaks of profitability leave us tied after five head-to-head matchups, but we must have a winner. Let's take a look at each company's gross margin.

Pfizer's gross margin is 75.1% for the trailing-12-month period. J&J's clocks in at 68.5%. Close! But Pfizer takes this battle in overtime.

Dividend battle                                       
Let's see how strong and stable each company's dividend payments are. We'll examine yield and two payout ratios, both the standard net-income payout ratio and the free-cash-flow payout ratio. We'll also examine each company's five-year annualized dividend growth rate and its streak of uninterrupted payments.

Those payout ratios are important, particularly the free-cash-flow payout ratio. Companies that pay out more than they take in can rarely sustain such practices for long.

Metric

Pfizer

Johnson & Johnson

Dividend Yield 3.6% 3.5%
Payout Ratio 62.2% 72.7%
Free-Cash-Flow Payout Ratio 42.7% 50.2%
5-Year Annualized Dividend Growth (5%) 8.1%
Years of Uninterrupted Dividends 29 35

Sources: Morningstar and Dividata. Winners in bold.

Pfizer's higher yield and lower payout ratios give it the victory in our dividend battle. Nobody likes to see a dividend cut, and Pfizer came out of the recession with weaker payouts than it began with. However, it now has slightly more room to support further increases in the years ahead.

With three wins for Pfizer to zero for J&J, the next round is little more than a formality. Let's take a quick look at how the market feels about each of these stocks, just in case we find ourselves re-evaluating Pfizer over weaker investor sentiment.

Battle for the future
How do the world's most engaged market participants view these companies? Let's see what Wall Street's analysts expect and what our Motley Fool CAPS community thinks.

Metric

Pfizer

Johnson & Johnson

"Buy" Recs (% of Total Ratings) 85% 60%
Forward Growth Rate (2013) 4.5% 7.7%
CAPS Sentiment (% Outperform) 90.3% 96.5%

Sources: Yahoo! Finance, Motley Fool CAPS.

Although Pfizer has more overall bullish recommendations from the analysts, it doesn't earn J&J's respectable forward growth rate and near-unanimous CAPS approval. Will those thousands of CAPS players be proven correct in the end? Only time will tell. However, today the numbers have given us an undisputed winner. Pfizer is the better drugmaker for your money today.

There's no time like the present to diversify your dividends if you're concerned that Pfizer's hefty yield might fall off that patent cliff with its revenue. The Fool's got you covered, with nine impressively stable dividend stocks to choose from in our most popular free report. J&J's one -- you can find out the rest if you claim your copy of this important (and free) report while it's still available.

Fool contributor Alex Planes holds no financial position in any company mentioned here. Add him on Google+ or follow him on Twitter @TMFBiggles for more news and insights.

The Motley Fool owns shares of Johnson & Johnson. Motley Fool newsletter services have recommended buying shares of Procter & Gamble and Johnson & Johnson; and creating a diagonal call position in Johnson & Johnson. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 07, 2012, at 5:31 PM, dynamo112666 wrote:

    Let me get this straight... Wall street pays for future earnings yet you put the buy recommendation on the company with the lower EV/EBITDA ratio (a historical measure), lower revenue growth rates, lower debt rating, decaying dividend growth, the most revenue at risk due to patent expiration (Celebrex, Viagra), enbrel north america sales reverting back to Amgen in 2013, and an oral RA product (tofacitinib) with cancer and CV issues ??? MF you need to up your game in terms of quality contributors.

    I am however, looking to add to my short list and will do a search on Alex Plane's other buy recommendations.

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