Valuing Abbott Labs
Plus, Touchstone Fourth

by Brian Graney (TMFPanic)

ALEXANDRIA, VA (July 2, 1999) -- Continuing from where we left off yesterday, today we'll take a look at Abbott Laboratories' (NYSE: ABT) current price in the market and some of the growth assumptions that are built into it.

Being not particularly creative with a long Fourth of July weekend just ahead of us, we'll just rip-off the methodology Jeff used to check out Pfizer two weeks ago. (Click here for that analysis). These companies are very different in terms of their product lines and revenue drivers, so we'll set aside the question of who has the better business quality for the moment. Instead, we'll focus on price.

Abbott's current P/E represents a 15% discount to the average P/E of the S&P 500 and the company has a 1.45% dividend yield and an estimated 12% long-term growth rate. Pfizer, for its part, currently trades at a 29% premium to the S&P 500, sports a 0.82% dividend yield, and is expected to grow earnings 18% annually over the long-term. Given the market's willingness to grant higher relative valuations to faster growers, this situation is not particularly surprising. But does Abbott's lower valuation compared to Pfizer, despite its lower growth rate, make it a more likely candidate to hit our magical 15.5% annual return rate in the coming years? Let's find out.

We'll plug our assumptions for Abbott's future growth into a simple discounted cash flow model (using earnings as a proxy for cash flows -- it's Friday after all) to get a sense of what kind of expectations might be priced into Abbott's current share price. We use the word "might" here because this is just one model of the company using our own expectations, regardless of how half-baked they may turn out to be in the end. Others will assume different growth rates and come up with a wholly different set of numbers. That's okay -- the idea is to make a reasonable estimate using assumptions you believe are realistic, rather than boil everything down to an exact prediction (which is impossible to do anyhow.)

For our model, we'll start out with Abbott's 1998 net income of $2.33 billion and merger-mate Alza's $112.3 million in 1998 income. Since the merger won't be completed until later this year, we'll assume that both companies will grow their 1999 earnings at two different growth rates. Abbott has grown its earnings an average of 11% annually over the past five years, so assuming the same growth this year gives us $2.59 billion in projected 1999 earnings. Alza's growth rate has been a much faster 16% annually, showing the benefits of its concentration in the high-margin drug business. Extrapolating that rate gives projected 1999 earnings of $130.3 million. Adding the two estimates together, we get a starting figure of $2.72 billion for the estimated 1999 earnings of the combined companies.

From here on out, things get messy. Abbott has said that the merger is going to dilute its fiscal 2000 earnings by about $0.03 per share but should start to add to earnings thereafter. We're going to be conservative and assume that the stresses and strains that can often crop up in mergers will result in only 10% earnings growth for the merged company in the next two years. This may be over-conservative, but we'd rather underestimate what the company can do post-merger than be too aggressive in assuming that everything will turn out hunky-dory.

After the two years of 10% growth, we'll assume Alza's strong pipeline and Abbott's better overall competitive position after the merger will boost its growth rate to 12% annually for the following eight years. Again, we may be undershooting. A 13% or even 14% post-merger earnings growth rate is a stretch in my opinion, but it's still not completely out of the realm of possibilities. Yet, we'll make the financial GOPers in Fooldom proud and stay on the conservative side of things.

Discounted at our 15.5% annual hurdle rate, here is what Abbott's next eleven years of earnings (including 1999) look like with our growth assumptions in place. (Note: To find the discounted value of annual earnings, divide the income by 1 plus the discount rate, squaring the discount rate by an additional factor for each additional year beyond one.)

Year     Income           Discounted Value (15.5%)

1999     $2.72                     $2.35       
2000     $2.99 (10%)                2.24
2001     $3.29 (10%)                2.13
2002     $3.68 (12%)                2.08
2003     $4.12                      2.01
2004     $4.61                      1.95
2005     $5.16                      1.89 
2006     $5.78                      1.83
2007     $6.47                      1.78 
2008     $7.25                      1.72
2009     $8.12                      1.67
Sum     $54.19                    $21.65
To obtain a terminal value for earnings after year 11, we divide our year 12 earnings by the difference between our discount rate (15.5%) and the company's long-term growth rate from year 11 onward (we're going to stay conservative and assume 10%). Year 12 earnings would then be $8.93 billion. Dividing by 0.055 (or 0.155 minus 0.10) gives us $162.4 million in terminal earnings. Discounted at our 15.5% rate, we get $28.8 billion in discounted earnings, which we can then add to our $21.65 billion in discounted earnings for years 1 through 11 for a grand total of $50.45 billion in discounted earnings.

With 1.54 billion shares outstanding pre-merger, buying Abbott's shares at $32.76 per share would secure our coveted 15.5% annual return given our assumptions. That's 28% lower than Abbott's closing share price of $45 7/16 per share yesterday. Coincidentally, that's exactly the same percentage premium Jeff arrived at for Pfizer using his first set of growth assumptions. Ain't life funny sometimes?

So should we block out Abbott from our radar screen because its current share price doesn't fit the result spit out by our model? That would be foolish, not Foolish.

These are just assumptions, and conservative assumptions at that. The changes underway at the business might result in higher growth rates down the road than we currently expect, making the current price more attractive. For instance, hiking up the annual growth rate from year 11 onward in our model to 12% from 10% will give a much higher figure for discounted terminal earnings and will ultimately produce a share price for Abbott that is very close to today's price. That's an example of how a few percentage points here or there in your own investing models can mean the difference between a market-beating return and long-term underperformance.

Like peanut butter without the jelly, it is unappetizing for an investor to think solely about the quality of a particular business without also looking at its going price. Spending a mere few days thinking about these two issues in relation to Abbott is not the end all, be all of our research on the company. We'll learn much more about Abbott and where it is heading in the months to come as it continues to grow and repositions itself as a tougher competitor in the healthcare world.

Touchstone Friday: It may be hard to believe, but we're already halfway through 1999. Hopefully, we'll have the opportunity to add one or more companies to our portfolio before the year is out. Nothing makes us happier than picking up quality businesses at reasonable prices. (Although Jeff also gets unusually excited whenever a new Beanie Baby comes out, but that's just him.) We'll keep digging.

Jeff started off the week with a look at Intel and the Y2K issue on Monday, then peered inside Campbell's recent fiscal Q4 earnings warning on Tuesday. On Wednesday, Jeff ran portfolio holding J&J through the discounted cash flow ringer and Thursday was dedicated to an update at recent changes at Abbott Labs.

Have a great holiday weekend and Fool on!

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