Earlier this week, I looked at the valuations of 5 large pharmaceutical companies: Johnson & Johnson, Pfizer, Merck, Amgen, and Eli Lilly. I was trying to get an idea of which one was the most “over-valued”.
Long story short, Johnson & Johnson and Amgen are the most expensive, relative to their asset base. That doesn’t necessarily mean their stocks are bad investments. There could be good explanations for their current valuation. Still, the expectations for Johnson & Johnson and Amgen seem to be much higher than for the other 3 companies.
Zooming in, one particular comparison was interesting: Johnson & Johnson versus Pfizer. The chart below shows the market capitalization and total asset value, as of 2016 Q3, for both companies. (Market capitalization is stock price multiplied by the number of outstanding shares of stock.)
The market values Johnson & Johnson at $310.4 billion and Pfizer at $197.3 billion. But Pfizer has a larger asset base! In fact, Pfizer has nearly $40 billion more assets than Johnson & Johnson, but it’s worth over $110 billion less.
The balance sheet is supposed to tell us the market value for a company’s assets. Given these numbers, we could spend less money replicating Johnson & Johnson’s asset base, yet still have a company worth more than Pfizer. What gives?
A quick note on intangible assets
Not all assets are created equal. We can have tangible assets and intangible assets. Tangible assets are easier to value. We know what we paid for a piece of land, or for a building, or for a piece of manufacturing equipment. On our balance sheet, we assign a value equal to the purchase price for these assets.
(We can then depreciate that value over time, assuming it’s something that wears down. Buildings and equipment get depreciated. Land doesn’t, because we don’t “consume” it as we use it.)
But what about intangible assets? It’s a lot harder to assign a fair value, since we can’t reach out and touch them. We’re talking about the value of things like patents, or a brand, or customer relationships, or an ongoing research and development program. We have to make some guesses when we’re valuing these assets.
Here’s what Pfizer says about its in-process research and development (IPR&D) efforts:
For IPR&D assets, the risk of failure is significant and there can be no certainty that these assets ultimately will yield successful products. The nature of the biopharmaceutical business is high-risk and, as such, we expect that many of these IPR&D assets will become impaired and be written off at some time in the future.
Think about it this way. Pfizer knows what it spends on its research scientists. It knows what it spends on lab equipment. It knows what it spends to license outside technology. It can assign a value to its R&D program equal to its costs. In this way, it’s just like buying a piece of equipment.
The problem, though, is not all the R&D activity will bear fruit. Until we know that for sure, we’ll assume we’re using the cost dollars to build up an asset. Once we know a particular path is a dead end, we’ll write down the R&D asset, basically flushing those cost dollars down the tube.
Another important intangible asset is goodwill. Even though it’s intangible, it’s reported separately from the other intangible assets. This line item shows up when one company acquires another company. In most cases, the buyer will pay more than the balance sheet says the target company is worth. (The balance sheet value is called the book value, which equals total assets minus total liabilities.)
The balance sheet of the buyer still has to balance after the transaction. The amount by which the purchase price exceeds the book value of the purchased company shows up as a goodwill asset. Because large companies tend to make a lot of acquisitions, their goodwill lines can have large dollar amounts.
These two line items, intangible assets and goodwill, explain some important differences between Johnson & Johnson and Pfizer.
Comparing the asset base of these two pharmaceutical companies
Let’s take a look at the asset base of these two companies. We know Pfizer has a larger asset base than Johnson & Johnson, even though it’s worth less. But what kinds of assets do these companies have?
We can quickly see two big differences:
- Johnson & Johnson has a lot more current assets than Pfizer. In other words, Johnson & Johnson has more assets that it expects to turn into cash over the next 12 months.
- Pfizer has a lot more intangible assets and goodwill than Johnson & Johnson. And we know these assets are notoriously difficult to value.
With intangible assets, you have to perform impairment checks to determine when they need to be written down. It’s possible that Johnson & Johnson is more aggressive about writing off failed R&D efforts than Pfizer is. It’s possible that Pfizer has substantially overpaid for its acquisitions, and thus has an inflated goodwill line. It’s tough to know either of these things with confidence, though.
Both companies break their intangible assets down a bit further. Johnson & Johnson shows the following split:
- Patents and trademarks — $5.8 billion
- Customer relationships and other intangibles — $11.4 billion
- Trademarks — $7.0 billion
- Purchased in-process research and development — $3.4 billion
Here is Pfizer’s split:
- Developed technology rights — $34.8 billion
- Brands (finite lives) — $1.1 billion
- Licensing agreements and other — $0.8 billion
- Brands and other (indefinite lives) — $6.9 billion
- In-process research and development — $10.6 billion
We have a little apples-to-oranges effect going on here. I suspect that patents and trademarks would line up with developed technology rights. I suspect customers relationships and trademarks line up with brands and licensing agreements. R&D is clear.
From this view, Pfizer has the much larger war chest. It has a more valuable collection of existing rights. Its ongoing R&D program is three times larger than Johnson & Johnson’s.
So why is Pfizer worth less?
It’s one thing to have assets. It’s another thing to use those assets to generate revenue and earnings
And now we come to Pfizer’s real problem. It doesn’t generate the revenue and net income that Johnson & Johnson does.
The chart below shows the details. We know that Pfizer has a larger asset base than Johnson & Johnson. Yet, for some reason, in 2016 it generated over 25% less revenue and over 50% less net income than Johnson & Johnson.
According to its balance sheet, Pfizer has more tools than Johnson & Johnson. It has a lot of advantages in terms of intangible assets. Yet it does a much poorer job than Johnson & Johnson of using those assets to deliver value to customers.
Why? What’s the problem?
It’s tough for me to speculate, given what I know at the moment. I’ve not read the financial reports deeply for either of these companies. I’ve not listened to their earnings calls. And I’m not intimately familiar with their business models.
With all of those caveats in mind, here are some possible explanations:
- Johnson & Johnson is more conservative in valuing its intangible assets. It assigns lower values in the first place, and it’s quicker to write down the value of those assets. That means we’re not getting a fair comparison of their asset bases. Pfizer might not actually have more assets.
- Johnson & Johnson has assets with a much better market fit. Say one company spends $100 million developing a weight loss pill. Say another company spends $200 million developing a weight gain pill. Even though the second company would book a larger asset value, the market for weight loss is probably much, much larger than the market for weight gain. It would be easier to generate sales off the $100 million investment than the $200 million investment.
- Johnson & Johnson runs a more efficient business, both in eliminating wasteful costs and building effective sales channels. Maybe Johnson & Johnson gets the same bang out of a $1 R&D investment that Pfizer gets out of a $2 investment. Maybe Johnson & Johnson can get their drugs in the hands of doctors much more quickly and reliably. It might just be an edge that Johnson & Johnson has operationally.
We can see why Tobin’s Q ratio isn’t the end all, be all valuation metric
In my post earlier this week, I declared Johnson & Johnson and Amgen the most “over-valued”. I used Tobin’s Q ratio to make that determination, which is the ratio of market capitalization to total asset value. Johnson & Johnson had a Q ratio of 2.2. Pfizer, in contrast, had a Q ratio of 1.1.
But we can see that not all asset bases are created equal. Johnson & Johnson monetizes its asset base much more effectively than Pfizer. Even the quick analysis I did in this post shows how nuanced the valuation game can be.
That’s one important lesson. In the world of finance, there’s very little black or white. We see a ton of gray. It’s easy to just throw your hands up and quit. Because you can’t say anything with great certainty, why say anything at all?
But then you’re giving up your power. The frustration of finance is also its beauty. Different people can have different opinions, given the same data set. You can find two extraordinarily intelligent, talented investors, with two very different perspectives on the same company.
The point is not to find the “right” answer. The point is to have an opinion. The point is to be fluent enough in the data that you can make some statements about a company or an industry. The point is to be part of the conversation, whether you have a finance background or not.
Finance is woven deeply into the day to day functioning of our largest, most influential corporations. As you build your career, even a passing familiarity with high level concepts will serve you very, very well.
- Johnson & Johnson 2016 Q3 10-Q report
- Johnson & Johnson 2o16 Q4 earnings press release
- Pfizer 2016 Q3 10-Q report
- Pfizer 2016 Q4 earnings press release