Excerpt: Why Stocks Go Up and Down

Excerpt: Why Stocks Go Up and Down


Over the next several pages, we will analyze Abbott Labs’ stock (symbol: ABT). The analysis is based on one completed on January 26, 2011.

As you may know, Abbott Labs is a diversified global healthcare company with prod-ucts in five categories: Pharmaceuticals (57% of revenues), Nutritionals (16%), Diag-nostics (11%), Vascular (9%), and Diabetes Care (5%). The company generated $35.2 billion in sales in 2010. Some of the company’s well known brands include: 1) HUMIRA, the leading biologic for the treatment of Rheumatoid Arthritis, 2) nutrition-al products for infants (Similac) and adults (Ensure), and 3) the FreeStyle family of blood glucose monitoring systems for diabetics. The company is headquartered in Abbott Park, Illinois, has 91,000 employees, and is a constituent of the S&P 500 Pharmaceuticals sector.

Over the past year, Abbott’s stock has fallen -14.2%, underperforming the S&P 500 by nearly 33%. The poor performance has been driven primarily by two factors:

1) investor rotation out of the pharmaceuticals industry
2) potential competition for the Abbott’s leading product, HUMIRA, an injectable for the treatment of Rheumatoid Arthritis (RA)

—– pages 341 to 373 are not included in this excerpt —–


Price/Earnings Ratio

Given that earnings power is a key determinant of stock value, we begin our valuation analysis by looking at the price/earnings (or P/E) ratio. As noted in the last chapter, the P/E reflects the price an investor is paying per dollar of earnings generated by the company. The forward P/Es for Abbott and other, similar companies in the pharmaceu-tical industry are listed in Figure 19.11.

From the figure, we can see that Abbott Labs trades in line with the other companies in the pharmaceutical industry. Specifically, the company’s P/E of 10.3x 2011 EPS is equal to the industry average and only slightly lower than the median value of similar companies (10.8x).

Many investors would look at Figure 19.11 and conclude that the company is fairly valued and move on. That certainly could be the case. The reason we say could be is that we haven’t looked at how Abbott’s fundamentals compare to its peer group. The P/E multiple you’d be willing to pay depends importantly on the expected growth rate in earnings and your degree of confidence in those growth estimates. The last column in the figure lists the expected long-term growth rate in earnings for Abbott Labs and the other pharmaceutical companies. As you can see, Abbott is expected to grow earnings at a rate of 10.1%, while the peers are growing earnings at a much lower rate of 4.4%.

We can explicity account for the differences in growth by calculating what’s known as the price/earnings-to-growth (or PEG) ratio. To do so, we simply divide the P/E mul-tiple for each company by its expected growth rate. Using the consensus estimates from Figure 19.11, the PEG ratio for Abbot Labs and the industry are as follows:

PEG for Abbott = 10.3 / 10.1 = 1.0x
PEG for peers = 10.3 / 4.4 = 2.3x

The PEG ratio reflects the P/E ratio per unit of earning growth. In this case, Abbott Labs’ PEG ratio of 1.0x is noticeably lower/better than that of the industry (2.3x). This indicates that while Abbott has the same P/E multiple as the group, the stock may actually be undervalued after adjusting for the company’s higher expected growth rate. Remember, a company with a high price multiple may be an attractive investment opportunity provided the company is expected to generate even higher earnings growth (as we see here).

Now that we’ve looked at Abbott’s P/E vs. its peer group, let’s continue the analysis by looking at where Abbott is trading vs. it’s historical range…

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