Numbers can lie -- yet they're the best first step in determining whether a stock is a buy. In this series, we use some carefully chosen metrics to size up a stock's true value based on the following clues:
- The current price multiples.
- The consistency of past earnings and cash flow.
- How much growth we can expect.
Let's see what those numbers can tell us about how expensive or cheap Merck
The current price multiples
First, we'll look at most investors' favorite metric: the P/E ratio. It divides the company's share price by its earnings per share (EPS) -- the lower, the better.
Then we'll take things up a notch with a more advanced metric: enterprise value to unlevered free cash flow. This divides the company's enterprise value (basically, its market cap plus its debt, minus its cash) by its unlevered free cash flow (its free cash flow, adding back the interest payments on its debt). Like the P/E, the lower this number is, the better.
Analysts argue about which is more important -- earnings or cash flow. Who cares? A good buy ideally has low multiples on both.
Merck has a P/E ratio of 34.9 and an EV/FCF ratio of 11.2 over the trailing 12 months. If we stretch and compare current valuations with the five-year averages for earnings and free cash flow, we see that Merck has a P/E ratio of 17.1 and a five-year EV/FCF ratio of 17.5.
A positive one-year ratio of less than 10 for both metrics is ideal. For a five-year metric, less than 20 is ideal.
Merck has a mixed performance in hitting the ideal targets, but let's see how it stacks up against some of its competitors and industry mates.
Johnson & Johnson
Source: S&P Capital IQ; NM = not meaningful.
Numerically, we've seen how Merck's valuation rates on both an absolute and relative basis. Next, let's examine ...
The consistency of past earnings and cash flow
An ideal company will be consistently strong in its earnings and cash-flow generation.
In the past five years, Merck's net income margin has ranged from 6.1% to 28.2%. In that same time frame, unlevered free cash flow margin has ranged from 13.1% to 34.3%.
How do those figures compare with those of the company's peers? See for yourself:
Source: S&P Capital IQ; margin ranges are combined.
In addition, over the past five years, Merck has tallied up five years of positive earnings and five years of positive free cash flow.
Next, let's figure out ...
How much growth we can expect
Analysts tend to comically overstate their five-year growth estimates. If you accept them at face value, you will overpay for stocks. But even though you should definitely take the analysts' prognostications with a grain of salt, they can still provide a useful starting point when compared with similar numbers from a company's closest rivals.
Let's start by seeing what this company's done over the past five years. In that time period, Merck has put up past EPS growth rates of -18.2%. Meanwhile, Wall Street's analysts expect future growth rates of 5.2%.
Here's how Merck compares with its peers for trailing-five-year growth:
Source: S&P Capital IQ; EPS growth shown.
And here's how it measures up with regard to the growth analysts expect over the next five years:
Source: S&P Capital IQ; estimates for EPS growth.
The bottom line
The pile of numbers we've plowed through has shown us the price multiples that shares of Merck are trading at, the volatility of its operational performance, and what kind of growth profile it has -- both on an absolute and a relative basis.
The more consistent a company's performance has been and the more growth we can expect, the more we should be willing to pay. We've gone well beyond looking at a 34.9 P/E ratio, and we see that Merck's one-year EV/FCF ratio and its five-year price multiples are quite a bit cheaper. It's managed to stay consistently profitable throughout the past five years, but there have been growth issues. As with big pharma in general, you have to be comfortable with Merck's drug pipeline to be comfortable with the stock. That's the next step after these reasonable-looking initial numbers. If you find Merck's numbers or story compelling, don't stop here. Continue your due-diligence process until you're confident one way or the other. Start with the recent Merck/Pfizer skirmish, and then add Merck to My Watchlist to find all of our Foolish analysis.
You can also the stocks that I've researched beyond the initial numbers and bought in my public real-money portfolio.
Anand Chokkavelu owns shares of Johnson & Johnson and Pfizer. The Motley Fool owns shares of Abbott Laboratories and Johnson & Johnson. Motley Fool newsletter services have recommended buying shares of Abbott Laboratories, Pfizer, and Johnson & Johnson and creating a diagonal call position in Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.