Fair Prices for J&J and ImClone?

It's easier to value the future cash flows of a business like Johnson & Johnson with decades of strong, predictable growth. It's less easy to do so for a biopharmaceutical hopeful like ImClone Systems -- and that was before the SEC and Congress began investigating company management. Not surprisingly, under certain assumptions the healthcare giant is still undervalued, while even with optimistic assumptions ImClone Systems looks overvalued.

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By Tom Jacobs (TMF Tom9)
January 28, 2002

A short three weeks ago, I agreed with the economist John Maynard Keynes that it is a wild-eyed guess what any business will be worth any time in the future. Yet by making certain assumptions, we can at least determine whether a potential investment's current valued bears any reasonable relation to its future potential. 

One helpful tool is discounted cash flow (DCF) analysis. We estimate a business's future free cash flows and discount them to present value per share. Then we compare that number to the current stock price to determine whether the stock is under, over, or fairly valued (if at today's prices it offers the opportunity for returns above, below, or at the discount rate you choose). For a step-by-step explanation of DCF analysis, check out George Runkle's column and Jeff Fischer's DCF analysis of Paychex (Nasdaq: PAYX). For help in reading financial statements and finding the numbers you need to perform a DCF, consider taking our fun and simple online seminar, Cracking the Code: Read Financial Statements Like a Pro.

DCF analysis is more helpful when a company has a history of dependable numbers, but it's more speculative -- some would say impossible -- for a developing business that may be hemorrhaging cash. A super example of the former is healthcare giant Johnson & Johnson (NYSE: JNJ), owned by both our DRIP (dividend reinvestment plan) portfolio and Rule Maker portfolios. For the latter type, I promised to examine up-and-coming biotech drug maker, ImClone Systems (Nasdaq: IMCL), an outfit more in the risky universe of our Rule Breaker portfolio. After that promise, the company came under SEC and Congressional investigations. It's an even better example now of how speculative it is to apply DCF analysis to development-stage, unprofitable entities. 

Stable companies with a history of free cash flow
Diversified healthcare giant Johnson & Johnson's extraordinary management has operated three main business segments to produce an unparalleled history of increasing profits, free cash flow, and dividends -- and returns to shareholders. I recommend Jeff Fischer's recent column "J&J's CEO Takes a Bow" to grow wide-eyed at the company's accomplishments.

For our DCF analyses of both Johnson & Johnson and ImClone, we want to use a long period, say, 20 years, of future free cash flows. Few businesses survive and prosper at all, and rarely for 10, 20, or more years, but Johnson & Johnson is one that has done it for decades.

Discount rate?
Remember: The discount rate you choose reflects your evaluation of business risk and the kind of return you must have to compensate for taking that risk. A higher discount rate reflects higher risk and desired return, and produces a lower present value of future free cash flows. A lower discount rate implies less business risk and return needed to compensate for that risk, and results in a higher present value of future free cash flows. If we choose 11%, we're saying that a particular company represents the risk-return trade off of the S&P 500, which has produced an 11% return over rolling 20-year periods since the 1920s.

I looked at the last five years of Johnson & Johnson's share dilution, dividends, and free cash flow (23% compound annual growth rate -- oh baby!), to estimate rates for each, and decided on an annual dilution of 1%, an annual 12% increase in the dividend, and free cash flow growth rates as follows:

         Free Cash Flow
Years     Growth Rate 
1-5           20%  
6-10          15%
11-15         10%
16-20         7.5%

Changing any of these assumptions about dilution, dividends, and growth changes the result considerably. Using these assumptions, here are the present values of future free cash flows for different discount rates:

Discount --Present Value--     Vs. 1/25/02 
Rate    Total No Div'd Div'ds  close $57.65
8% $85.20 $66.30 $18.90 undervalued 9% $75.47 $58.76 $16.71 undervalued 10% $67.00 $52.20 $14.80 undervalued 11% $59.63 $46.49 $13.15 3% overvalued 12% $53.22 $41.50 $11.72 overvalued 15% $38.48 $29.99 $ 8.44 overvalued

But to reiterate my point about not making DCF a religion, what if there is a rough year? Say in year six? The nearer the year, the more these numbers are all thrown off. Play with it in a spreadsheet and see what happens. 

Riskier companies with no history of free cash flow  
It's less helpful to estimate future cash flows from an unproven, speculative business, with no track record of producing any free cash flows. Take ImClone Systems, a biopharmaceutical company whose value rests upon the prospects of its main cancer drug candidate, Erbitux, that I promised to evaluate because its stock had tanked and I wondered if it was a bargain or stay-away.

After the company announced that the FDA refused to accept its application to approve Erbitux, ImClone shares collapsed 70% over the next month from $55.25 the day before the announcement to last Friday's $16.49. Drug giant Bristol-Myers Squibb (NYSE: BMY) thought so well of the drug and the company that it bought $1 billion in ImClone shares at $70.00, and promised up to $1 billion in milestone payments as the drug worked its way through the FDA.

I no longer think ImClone is a bargain. The SEC and Congress are investigating the company to find out whether top management -- including the CEO, who The New York Times reports may have a severe personal debt problem -- may have sold shares in the company with full non-public knowledge that  FDA problems were likely. Sadly, the personal debt pressure casts a pall over the Erbitux data and application process.  

How to account for this kind of risk?
Steer clear of this company unless you like parachuting without a second parachute. But for educational purposes, let's make some assumptions and see what, if anything, ImClone shares are worth today under a DCF analysis.

First, a caveat: Understand that as ImClone's market cap declines -- $1.2 billion on Friday, with $242 million in long-term debt, it's getting to the point where Bristol-Myers Squibb could buy the company to keep any future Erbitux sales entirely to itself instead of paying ImClone the rest of its $1 billion in milestone payments and sharing revenues. 

Apart from the sale, I imagine five scenarios for this company:

A. Erbitux is a fraud that no one wants, and management fudged the numbers under financial and other business pressure. Bristol-Myers Squibb won't bail them out by buying the company on the cheap. [Not unlikely: Let's assign a 30% chance to this.]

The four remaining scenarios assume that Bristol-Myers keeps to its commitment to pay $1 billion in milestone payments when the FDA accepts the application, the FDA approves it, and it hits the marketplace.

B. Erbitux does not require new trials, the FDA will accept a revised application, and the drug will be approved for colorectal cancer pursuant to its fast rack designation this year. Bristol-Myers will pay two of three $333 million milestone payments in 2002, and the third in 2003. From 2003 to 2006, the drug will ramp to $1 billion in revenues, with ImClone and Bristol-Myers splitting them 50-50. ImClone will have a truly whopping cash king margin 20% -- 20% of the revenues will be free cash flow. [Unlikely: 5% chance.]

C. No new trials, but Erbitux eventually is approved for head and neck and prostate cancer, too. Revenues ramp to $3 billion a year over 2003-2007. [Unlikely: 5% chance.]

D. New trials are required, so all the dates in B are pushed, and the drug has $1 billion potential. The trials take two to three years, and the application and approval come in 2004. Revenues ramp to $1 billion from 2005 to 2008. [More likely: 30% chance.]

E. New trials, but revenues ramp to $3 billion from 2005 to 2008. [More likely: 30% chance.]

I use a 15% discount rate, not the 50% this company probably deserves, to show that even then the company is overvalued today under most assumptions. I also assume 3% share dilution per year, no dividends, and -- call me crazy -- that when Erbitux's patent protection runs out, it will be followed by other income streams.  Even with all these rosy assumptions, it's hard to find any scenario under which ImClone is undervalued.

The results?  

         %       Present  Vs. 1/25/02
Scenario Chance  Value    Close $16.49 
A        30%     $0.00   way overvalued
B         5%     $15.13  a little overvalued 
C         5%     $34.77  undervalued
D        30%     $9.16   overvalued
E        30%     $18.08  a little undervalued 

If you multiply the values by their percentage likelihoods and divide by 100, you get $10.67. Currently way overvalued at a 15% discount rate. And if you raise the discount rate to reflect the risk, these numbers decline even more, so that the valuation conclusion is even more grim.

For a more detailed table of assumptions, check out my post on the Fool on the Hill discussion board.

Where to from here?
DCF analysis is one essential part of a stock investor's toolkit, but it is only one of those that help us as  we study and learn, as Philip Fisher wrote, through the "painful method of [our] own mistakes." If you have resources you'd like to point out to other Foolish investors and carry this discussion further, please join the conversation on our Fool on the Hill discussion board.

Have a most Foolish day.

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Tom Jacobs (TMF Tom9) wishes he had known all this number stuff before he lost a ton of money in the market, but he's learning. He welcomes your comments at, but can't give individual investment advice (who in their right mind would want it?). He owns no stocks mentioned here. The Motley Fool is investors writing for investors.