Looking for a cheap stock with name-brand power and a strong, diversified portfolio of products? At first glance, you couldn't do much better than Abbott Labs (NYSE:ABT). The company's stock has jumped more than 5.4% year-to-date since its spinoff of former pharmaceutical business AbbVie (NYSE:ABBV), yet it's still trading at a price-to-earnings ratio of just over 9.8.
Impressed? Buyer beware: This is a textbook example of why the P/E ratio, one of the fundamental numbers for valuing stocks, isn't always an investor's best friend. For all its strengths and potential, Abbott's not as cheap as it looks.
As cheap as it looks?
Comparing Abbott's P/E to other major diversified health care firms would make many investors think it an extraordinarily cheap stock. Johnson & Johnson (NYSE:JNJ) by comparison sports a much higher P/E of 21.3, while Merck's (NYSE:MRK) is even higher, at 22.7. Abbott's stock has outperformed Merck over the past year, and its 23% growth compares well with J&J's. But is Abbott so cheap after all?
This is a case where it's important to read the fine print. Price-to-earnings ratios involve earnings over the trailing 12 months. Guess what Abbott still had over its last reported 12 months? If you guessed AbbVie -- its pharmaceuticals division and now-independent company that made up the biggest single division by sales and a huge chunk of earnings last year -- you're right.
AbbVie reported net earnings for the past year of $5.2 billion – earnings actually earned by Abbott, which saw full-year 2012 earnings of around $6 billion in all. Take away that $5.2 billion and Abbott's P/E grows substantially. To get a better idea of the new Abbott's real valuation, take a look at its forward P/E, based upon analyst projections of future earnings over the next fiscal year. Abbott's forward P/E of 15 makes it a good deal more expensive than Johnson & Johnson's forward P/E of 13.8 or Merck's considerably smaller ratio of 11.5.
Cheap? Perhaps not after you consider Abbott's downsizing. But that doesn't mean this is a stock you should avoid; on the contrary, Abbott has plenty of growth opportunities ahead despite shedding its blockbuster-fueled branded pharmaceuticals business.
Reasons for faith
The branded pharmaceuticals business is notable for its high margins and boom-or-bust risks. Losing that business doesn't lend itself to cheap P/E valuations for Abbott's future, with divisions such as nutritionals and generic drugs fueling tomorrow's revenue. Still, this company didn't make a shortsighted move by spinning off AbbVie.
On the contrary, Abbott refocused into a leaner, more stable firm that will keep on rewarding investors for some time to come. Shedding its pharmaceutical business freed Abbott from the patent-cliff-related headaches affecting rivals such as Merck, which has struggled to recapture revenue lost from blockbuster drug Singulair's patent expiration. While spinoff AbbVie will have to deal with the loss of massive blockbuster drug Humira's patent protection in the near future, Abbott can look forward to a stable, if slower-growing, future.
Nonetheless, if Abbott interests you, don't judge the stock by its P/E valuation. There are plenty of reasons to have faith in this company's future, from its emerging market growth in areas such as nutritionals to its dominant position in the drug-eluting stent market. Buying it just because it looks cheap at first glance, however, is a move that will leave investors disappointed.
Fool contributor Dan Carroll has no position in any stocks mentioned. The Motley Fool recommends Johnson & Johnson. The Motley Fool owns shares of Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.