Pfizer's Value (Drip Port) June 17, 1999

<THE DRIP PORTFOLIO>
Pfizer's Value
Brand name at a store-brand price?

by Jeff Fischer (TMFJeff)

ALEXANDRIA, VA (June 17, 1999) -- Pfizer (NYSE: PFE) is trading at 38 times its trailing 12-month earnings per share, 40 times 1999 estimates, and 33.9 times the year 2000 EPS guess. The largest uncertainties facing the company are, as usual, factors mainly beyond its control. These include the government and its recent mumblings on prescription drug costs; the Federal Drug Administration (FDA) and its willingness to approve new drug applications; and the ability of Pfizer's scientists to stumble upon new medicines and skillfully mold them into something marketable.

Despite the uncertainties always surrounding biotechnology and pharmaceuticals, leading companies can become large enough that earnings growth, over the years, becomes reasonably predictable. Large pharmaceutical businesses are not as predictable as something like Coca-Cola (NYSE: KO) per se, but they are predictable enough to form an approximation of future results based on one or two decades worth of past growth rates. (By the way, who would have predicted that Coca-Cola would suffer four years of flat sales? That tells you something about the ability to predict anything.)

Pfizer's business has steadily grown at a market-beating pace for the past two decades. Averaging the decade-long periods together displays smooth double-digit growth and rounds down the few years where results disappointed or rose excessively to the upside. That's the past. Putting a fair value now on future consistent growth and increasing shareholder equity is the difficult task. No matter how we measure something like free cash flow, Pfizer -- like Coca-Cola -- will appear expensive. Our intentions are a little more humble, although they are aggressive and speculative, too. We want to estimate whether or not Pfizer is near a valuation that might grant us near our 15.5% hoped for annual return. Picking up from yesterday, we're going to run a relatively simple discounted cash flow model on the company.

Excluding discontinued operations, net income at Pfizer totaled $1,950 million last year, or $1.95 billion. Return on Equity (ROE) was 40% in 1998 and has averaged 20.26% for the past ten years. ROE was in the mid-teens for five years, then jumped above 30% beginning in 1994 after a significant decrease in shareholders' equity. It has remained at those levels since, and last year's 10.3% jump to 40% does not represent a ROE that we'll expect to continue (just to be safe). I feel comfortable hoping for ROE of 33.5% from Pfizer, however, over the next 20 years.

Why does this matter? Because one can use ROE multiplied by one minus the dividend payout ratio to approximate the growth rate of earnings. If our ROE averages 33.5% for 20 years, and the dividend payout ratio hovers around 38.5% (0.385), we have: 1 - 0.385 = 0.615 x 33.5 = 20.60%. According to this, we can hope for average EPS growth of 20.60% annually. This rate sounds reasonable for the next few years given that 20% EPS growth is indeed the published estimate, and the current five year EPS growth estimate is 18.76%. However, we won't accept 20% indefinitely. It is too aggressive. In the next eleven years, we'll project 15% average growth, and in the ten years following we'll assume 12.89% average growth -- as if I had some crystal ball! Remember, these are just estimates (that we hope are reasonable) in order to get a feel for how the stock could be valued.

Let's begin to project. Yesterday, we touched on the discount rate. We'll apply a few different rates in our examples today. Our goal or hurdle is a 15.5% return, so it makes sense to use that as the discount rate first. This is a relatively high rate. Meanwhile, we're going to use various income growth rates. Our terminal, continuing growth rate after 11 years will be the not unfeasible 12.89% that we decided upon with the necessary arbitrariness of an alchemist. 1998 ended with $1.95 billion in income. We'll adopt the 20% expected growth rate for the next two years and then we'll taper it down as the years unfold.

To find the discounted value of annual cash flow, we divide the income by the discount rate (squaring the discount rate by an additional factor for each additional year beyond one). Here we go with a 15.5% discount rate.

                    Discounted
Year      Income      Value
1999      $2.34b       $2.02b
2000      $2.80         2.09
2001      $3.31         2.14
2002      $3.87         2.17
2003      $4.49         2.18
2004      $5.21         2.19
2005      $5.99         2.18
2006      $6.89         2.17
2007      $7.93         2.16
2008      $9.04         2.13 
2009     $10.30         2.11    
Sum      $62.17       $21.49

$21.49 billion is the current value of the first 11 years (we did eleven because 1999 is half over). To find the continuing value after year eleven, we divide year twelve's earnings by the difference between our discount rate (15.5%) and the company's long-term growth rate from year eleven on (we're going with 12.89%). Year twelve earnings would be $11.62 billion. We divide that by 0.0261 (which is 0.155 minus 0.1289) and we derive another $445.2 billion in continuing (and terminal) value before discounting it, at which point it becomes worth $78.98 billion now. So, we have a total value of $21.49 plus $78.98, or $100.47 billion. With 1.29 billion shares outstanding, to hope for a 15.5% annualized return on Pfizer over a few decades, we'd want to buy shares at $77.88 according to the parameters of this model. Pfizer trades 28% above that price.

Let's make a few tweaks. In the model that we just created, we assumed growth for the first 11 years of 20%, 20%, 18%, 17%, 16%, 16%, 15%, 15%, 15%, 14%, 14%, and then we dropped down to 12.89% terminally. Our first five years assumed 18.2% average growth, or 0.50% below the published estimate. Let's go with the exact published estimate this time and then let's afford Pfizer higher earnings growth in subsequent years, too. The strength of the pharmaceutical industry holds that 15% annual growth is not unreasonable for a well-financed and well-managed giant that has hundreds of trials taking place at all times. Some of the trials are bound to hit big and every new winning product represents entirely new earnings growth.

Prizer is the premier research & development pharmaceutical company in the world, with arguably the strongest pipeline. We can afford it slightly higher growth in years one through ten (or eleven) and we can afford it slightly higher ROE, too, thereby giving it a higher continuing value. We will also drop our discount rate one point, to 14.5%, in order to demonstrate the significant difference this can make. Besides, we wouldn't be unhappy with that market-beating return (at all) over 20 years. No way. If the stock could return that annually it'd surely trade at a growing premium to its rate of growth, too -- perhaps surpassing our goal in the end.

Let's assume ROE is 36% the next 20 years, or 2.5% higher. Let's assume the dividend payout is 39%. Doing the math (1 - 0.39 x 36 = 21.96) gives us a 21.96% expected growth rate. This figure is a great indicator of current growth, but it is too high to assume for future results, especially when looking ahead five years and much longer. We'll move the continuing growth rate down to a much more realistic 13% -- just a point above ancient Johnson & Johnson's (NYSE: JNJ) 12% ongoing growth rate.

Time to refigure. This time we're going with the published growth estimate for years one through five, we're adding 1% more earnings growth to three of the years during the first eleven years, and we're assuming 13% continued growth rather than 12.89%. Also, our discount rate is one point lower, which is by far the most significant change. Let's see at what price the company could, in this model, provide us with 14.5% returns given the above parameters.

                     Discounted
Year      Income      Value
1999      $2.34b       $2.04b
2000      $2.80         2.13
2001      $3.31         2.20
2002      $3.90         2.26
2003      $4.53         2.30
2004      $5.26         2.33
2005      $6.10         2.36
2006      $7.07         2.39
2007      $8.14         2.40
2008      $9.30         2.40
2009     $10.76         2.42
Sum      $63.51       $25.23

Year twelve earnings, growing at 13%, would be $12.15b. We divide that by the difference between our discount rate (14.5%) and the long-term growth rate that we're assuming (13%), and that equals 1.5%, or 0.015. Divide $12.15 by 0.015 to derive $810 billion in continuing (and terminal, in theory) additional value. After discounting, this is worth $159.5 billion. Add this to the $25.23 billion from the eleven year value and we have $184.73 billion in total value. With 1.29 billion shares outstanding, we'd be willing to pay -- according to this model -- up to $143.20 per share and still hope to meet our discount rate's goal over a lifetime.

Given that these models are based on future estimates that stretch not just two decades, but terminally, they must be taken with a grain of salt. But if you feel comfortable assuming that Pfizer can grow earnings some 15% annually the next decade and 13% after that, the shares are more attractive now than they have been for some time. If you hope for at least a market-matching 11% return in the decade or two ahead, Pfizer could be an investment that can deliver it from the going price while carrying upside potential beyond that thanks to a tremendous business, strong pipeline, and superior management. The stock also carries some downside risk, of course, given the premium price that it is still fetching and the uncertainties always surrounding the industry.

Weighing risk to reward, the shares are worth a long-term investor's second look, not to mention a direct investor.

I expect that there will be questions, discussion, or even alarms raised on the math involved. Please post anything on the Drip Companies message board. Fool on!

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