Dishing Up Pfizer (Drip Port) June 16, 1999

<THE DRIP PORTFOLIO>
Dishing Up Pfizer
Why we can look again, what we'll look at

by Jeff Fischer (TMFJeff)

ALEXANDRIA, VA (June 16, 1999) --

"I'd be a bum on the street with a tin cup if the market were always efficient."

Fortunately, it isn't.

Wisdom supports the Efficient Market Theory (EMT) by arguing that information is widely and quickly spread, thereby making the stock market efficient. Efficient at what, though? Information is spread more efficiently now than ever, of course, but that doesn't create an efficient market. To achieve an efficient market where everything is priced fairly, one needs to assume that investors analyze and react to information in a certain way every time. Half the people must be right, half of them wrong, so that a fair price is set in the middle. That's an "efficient" market. That doesn't happen. Sometimes most everyone is wrong and, upon realization, suddenly a stock doubles.

So, I agree that information is spread efficiently and that the stock market reacts efficiently (meaning quickly), but the stock market is not always efficient (meaning correctly priced at all times). If it were, no hope of beating the market could exist. EMT's theory holds that nobody can outperform the market because it is always efficient. Evidence stands counter to this everywhere. Lonely widows have crushed the stock market average over their lifetimes, and rather than mention luminaries that we all know by name, many of our neighbors and friends have outperformed the averages over decade-long periods, too. This is possible in part due to market inefficiences, many of which are admittedly very temporary. For example, AOL and Microsoft were not valued "inexpensively" for long after the growing potential of each company became widely recognized.

If you believe that the Wise underperform the market for a reason, then you're admitting that the stock market (which is priced by its investors, including the Wise) is not efficient. Think about that for a moment. If the market were always efficient, every move that anyone made would be correct at each moment -- you'd always buy or sell a stock at its correct fair value based on its known potential. That would mean that AOL's intrinsic value recently lost 50% in one month -- rightly and correctly as dictated by our efficient market -- even while AOL's broadband prospects brightened. The market is efficient? That would mean that the high price was efficient and the recent low was, too. How is that?

The valuation of Pfizer (NYSE: PFE) has been shaved by over 37% in the past two months based on news that we addressed yesterday. In an efficient market, this might be beyond explanation. In an efficient market, the stock's 52-week high would have been lower. If the market were efficient, it would have recognized the early warnings about Trovan long ago (they existed, presented by Pfizer itself) and it would have factored the risk that Viagra, which was killing dozens of men last fall and winter, could -- surprise -- see lower sales than were optimistically anticipated. But investors didn't efficiently analyze these situations and instead continued to bid the stock higher. Until recently.

The Drip Port's goal is to return over 15.5% annually on incrementally invested dollars (a disadvantage that we can't avoid) to turn an eventual $24,500 into $150,000 in twenty years. A quarter of our money will be invested five years or less, making our challenge all the more formidable. The most important years are now, as we begin to invest. Money put to work now will be invested the longest and has the most chance to appreciate. We waived Pfizer 19 months ago due largely to its price. The business has since grown, but the stock is now at the same price that it was fifteen months ago, so we're looking again.

Ta da.

"Forecasts are difficult to make -- particularly about the future."

Valuation forecasts rely on an ability to reasonably predict future cash flow, or earnings. Because nobody can predict this accurately all of the time, nobody can predict it period. The word "predict" doesn't leave room for interpretation. So the best that we can do is present a reasonable future scenario to see if current valuations are in the ballpark or not.

In the past 17 years, the phenomenal stock market has increasingly made the practice of valuing companies passe among some investors and all daytraders -- "value, what of it?" -- but we're investing for 20 years and one thing that we can reasonably predict is that the market will not always be this healthy. Meanwhile, one true statement about investing is that what you pay for a company determines your eventual return (or loss). Your return is based on the value subsequently created by the company in relation to the price that you paid for that very value. Math is as true to itself as is physics.

Note, we're not saying that you can predict fair value. What we have proposed here is that you should know, within reason, the approximate value that you're getting for your investment dollar. This has been the Drip Port's belief since inception: find high-quality businesses at moderate to attractive prices (recognizing that bargains are unlikely). There are many ways to invest successfully and the Fool offers several successful means to reach the same Foolish end. Our search here, however, is for good value even when dollar-cost-averaging small amounts of money. Because why should small amounts of money be invested haphazardly? We don't even view small amounts as "small." Small amounts can grow to become large amounts if invested Foolishly.

Consider Pfizer. Eyeballing it, Pfizer might (temporarily probably, if true) represent better value now than does Johnson & Johnson (NYSE: JNJ). Interestingly, we believed the opposite to be true nineteen months ago. Nineteen months ago, hopes for J&J were excessively depressed, while expectations for Pfizer were high. Now the situation has nearly flip-flopped. Is this more of the efficient market at work or another opportunity in the making?

Onto valuation...

A discounted cash flow model aims to predict the current value of all future net earnings or cash flow at a company. The model works best on an asset that ceases to operate at the end of a given time period, but with ongoing concerns such as a business we can slap a continuing value onto the model rather than stopping at a typical ten-year terminal value. That's what we'll do with Pfizer.

Now, among the most important considerations with a discounted cash flow model is the company's projected growth rate, the gross margin assumed, and the discount rate that you apply. First, if your sales growth is off by a few percentage points in either direction, your projected valuation will be considerably different than achieved. (See why predicting fair value consistently is impossible?) Next, if your assumed gross and therefore operating margin are too wrong in either direction, the company will achieve considerably higher or lower net earnings than your model assumes. Finally, the discount rate that you apply to a model can make an ending valuation difference of several hundred percentage points either way.

The discount rate accounts for the fact that money earned 10 years from now is usually worth much less than money earned today due to inflation and due to the opportunity cost. A discount rate takes into account the risk-free return that you could achieve on your money if it were invested elsewhere, such as in a government bond (a bond also takes care of the inflation concern, since bonds include inflation in pricing yields), and the discount rate should factor in a premium for the risk that you take in any particular investment.

There are various opinions on how to apply discount rates and in what amount. You can apply a discount rate equal to the market's average return of 11% if you hope to match or beat the market, or you can apply a weighted average cost of capital (WACC) figured discount rate -- a widely used method -- or you can apply the 30-year bond yield as the discount rate. The best rate to apply, however, is your own bogey number, or hurdle. What return do you hope to achieve? (15.5% for us.) Finally, in any case, the discount rate that you apply to the model should be larger than the expected growth rate of the company that you're valuing.

Here is Pfizer's past growth, provided by the Fool's financial snapshot:

                1 Year     3 Years   5 Years
Sales %          22.51      10.56      13.59     
EPS %            -7.20       6.32      24.14     
Dividend %       11.76      13.48      12.59

The company is expected to grow earnings per share over 18% annually the next five years, as shown in the Fool's earning estimates for Pfizer.

Having gone long on space and time today, tomorrow we'll determine a reasonable discount rate to apply to Pfizer's future earnings and we'll determine a realistic (we hope) earnings growth rate for the next 10 years and beyond in order to run a discounted cash flow model on the company. If you have questions about any of this -- seeing how we haven't addressed these topics for over a year (no need to over that time) -- please post on the Drip Companies message board. For more on discounted cash flow models, the Fool U.K.'s explanation is rather exceptional.

Cheers. And Fool on!

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