Two weeks ago, I wrote a column about what to do when your favorite stock gets clobbered by the market. I got a lot of feedback from readers of that column (unfortunately, it seems that a lot of people have had this particular experience), and many of those readers wanted to know how they should go about determining the answer to the question of how to evaluate whether to sell, hold, or buy more. In reflecting further on this, it is clear to me that in order to answer that question, the investor needs to have some opinion on the fair value of the company in question. Today's topic, then, will be about calculating a fair value range for a company.
Fair value is imprecise but important
What's a company worth? Well, the classic answer you'll get to that question is "the sum of all of the future cash flows discounted back to today." While that is no doubt true, the construction of even the most rigorous discounted cash flow analysis requires that assumptions be made, and even miniscule changes in those assumptions can lead to wild changes in the calculated value.
I tend to be more comfortable in using back-of-the-envelope valuations, and then I augment that analysis with discounted cash flows in those cases where it is helpful. The answers I get are therefore much less precise, and I often end up with kind of a "high-end" value for the company if things go right, and a "low-end" value if some stuff doesn't go right. While precision is nice, it's not necessary. If the current stock price is below the "low end" fair value that I calculate for it, it becomes interesting to me as a potential buy. If it's above the "high end," it is potentially interesting as a sell candidate.
A case study
OK, enough theory -- let's get back to the real world. Today's case study is Noven Pharmaceuticals (Nasdaq: NOVN), which will be familiar to readers of this column. Brian Graney profiled the company back in May, and I updated the story after a disappointment back in August. Since then, Noven has gotten clobbered again -- meaning that it would be time for Noven shareholders to gather information, form a fair value opinion, and then determine whether they should sell, hold, or buy more.
Here's a quick recap of the latest developments. On November 1, Noven's stock closed at over $22 a share in anticipation of the company's earnings release that evening. The market obviously didn't like the information provided by the company that night, as the stock ended the next day at $15.20, a quick loss of 30%.
The news that prompted the sell-off certainly wasn't good -- Noven management reported that international sales of the company's hormone replacement patches to its partner Novartis (NYSE: NVS) next year would be well below expectations, as Novartis works off some excess inventory and awaits regulatory approval in some European countries. Since these international sales comprise the bulk of Noven's top-line revenues, a sell-off in the stock was clearly to be expected.
However, a lot of Noven's value isn't reflected on the top line. Novogyne Pharmaceuticals, Noven's 49%-owned joint venture in the U.S. (Novartis owns the other 51%) is the real gem of this business -- and Novogyne is performing very well. In addition to Novogyne, Noven has another part of the business that is not reflected in its revenues -- it's pipeline of potential new products in development. The most advanced project is a patch version of Ritalin called Methypatch, for which Noven hopes to file for marketing approval in early 2002.
Since the joint venture performance is not included in Noven's sales (it shows up only in the profit line) and Noven's pipeline isn't generating any revenue yet, my theory is that the market may have overlooked these elements of the business.
Pinning a value on Noven
Here's how I calculate Noven's fair value. First, I split the business into three parts -- there's Novogyne, the joint venture with Novartis. Then there's Noven's business outside of Novogyne, and finally, there's the research and development pipeline.
Noven's top-line sales for the most recent nine months (ending Sept. 30) were $35.7 million, on which the company earned $2.4 million. While 2002 sales are now expected to be less than 2001, I fully expect that by 2003 sales will have recovered, as Novartis gets approvals in all European countries and fully launches the products. My best estimate is that Noven will achieve $50 million in sales in 2003. Since there is some uncertainty about this part of the operation, I will assign it a multiple of three times sales. This is a big discount to most specialized drug manufacturers, which typically carry a multiple of 5 times sales and up. Multiplying $50 million times 3 gives me $150 million for this part of Noven's business.
Novogyne is hitting on all cylinders, and should turn in another strong year in 2002. Noven's deal with Novartis calls for Novartis to get the first $6.1 million in profits each year, after which Noven earns a higher split as sales rise. In the most recent quarter, Noven's cut came to $5.3 million, and should be about $15 million for the full year. With Novogyne's recent addition of a third product to its lineup, I think that $20 million in pre-tax profits to Noven in 2002 and $25 million in 2003 is a conservative estimate. Assigning a P/E of 13 to those earnings (which equates to a fully-taxed P/E of about 20) gets me a value of $325 million for Noven's piece of the Novogyne joint venture.
The final piece of the puzzle, and the hardest to value, is Noven's pipeline. The company is in Phase 3 trials with its Methypatch version of Ritalin, which if successful should become the company's best-seller, with annual sales of $50-100 million quite possible. Of course, there's a chance it won't be approved, which would mean no sales at all. I would give it about a 50% chance right now based on what I know about the product. In addition to the Ritalin patch, we have to assign a value for all the other projects that Noven has in development or might have in years to come. Since this is very tough to do with any precision, I'll just assign $100 million to the entire pipeline as a conservative estimate of what it might be worth; if Methypatch makes it to the market, that will be way low; if not, it might be a little high.
Adding up the three gives me a guestimate of Noven's fair value of $575 million by 2003. At today's price of $15.50 per share, Noven's market cap is about $350 million, which implies that Noven is trading at a 40% discount to my best estimate of the company's value. Of course, if good news comes on the Methypatch front, that could easily add $200 million to the value; if Methypatch doesn't make it, then I could easily drop it by $100 million, which would eliminate any value for the R&D pipeline whatsoever. My "high-end" fair value, then, would be as high as $775 million. The "low-end" would be about $475 million.
Of course, my analysis could be flawed, and even if accurate, bad things can always happen. All things considered, I'd certainly not be a seller at the current price. I don't want to sell when a stock is trading below what I consider to be the low range of fair value.
Zeke Ashton does not currently own shares of any company discussed in this column. The Motley Fool is investors writing for investors.