I want to take a quick look at five large publicly-traded pharmaceutical companies:
- Johnson & Johnson
- Eli Lilly
Specifically, I want to get a rough idea of how “fair” their valuations are. And I have two important caveats:
- Johnson & Johnson isn’t a pure pharmaceuticals company. No two of these companies overlap completely. So we’ll have natural apples to oranges effects happening here.
- There’s no objective way to determine whether a valuation is fair. So, I’m going to choose a metric I think is interesting and roll with it.
Our very simple metric: Tobin’s Q ratio
What is Tobin’s Q ratio? The ratio of the market value to the total asset value. Typically, we talk about the Tobin’s Q ratio for the market as a whole. For this post, I’m going to focus on the five pharmaceutical companies I listed above.
Why Tobin’s Q ratio? Because it’s a straight forward comparison of (a) how much the market values a company, versus (b) the cost to replace the company. That’s what the total asset value means. It’s the cost you’d have to pay to collect all the assets the company owns.
Presumably, you’d pay a premium to the replacement value of the company. That means Tobin’s Q ratio would be greater than 1. Why a premium? Because, again presumably, the company’s management team can get more value out of their own assets than some hypothetical, replacement-level management team.
Say you handed all of Tesla’s assets to Elon Musk. Now say you handed an exact duplicate of those assets to me. Who would you expect to perform better? Elon Musk. He knows that business inside and out. He’d have an advantage over almost any other entrepreneur on the planet. So we’ll pay a premium to get Tesla’s assets, assuming that Elon Musk is at the helm.
Tobin’s Q ratio for our pharmaceutical companies
One quick disclaimer. These companies haven’t officially filed their 2016 annual reports with the SEC yet. So I’m relying on total asset values from their 2016 Q3 10-Q reports. And their market capitalizations were as of the end of last week.
The plot below shows the results. The blue bars show the market caps. The green bars show the total asset values. The companies are ordered by market cap, largest to smallest. Take a look. Then take a minute to ponder what it means.
One conclusion jumps right off the page to me: Johnson & Johnson is valued at a massive premium to its asset base. It’s incredible. Its market cap is $310 billion. Its total asset value is $140 billion. That’s good for a Tobin’s Q ratio of 2.2.
In fact, we can put a plot of the respective Tobin’s Q ratios. That’s what we have below. Now we can more easily make some comparisons between these companies.
We see that Johnson & Johnson and Eli Lilly have the highest valuations relative to their asset base. Both have Q ratios greater than 2. We see that Pfizer drags the bottom, at a 10% premium to their total asset value. Merck and Amgen are in the middle.
Here’s another interesting observation. Johnson & Johnson is worth $115 billion more than Pfizer, but its asset base is $37 billion smaller than Pfizer’s. Crazy, right? Investors are clearly expecting Johnson & Johnson to do much, much more with their assets than Pfizer.
What’s happening to their stock prices?
How are the stock prices for these companies faring? I’ll arbitrarily look over a period covering the past six months. The plot below shows the results.
Merck is the only one whose stock price has climbed in the past six months. As a comparison, the S&P 500 has increased 6.2%. The Dow has climbed 9.3%. The other four companies are lagging badly.
We have to be careful about creating too strong of a story around stock price movements. The market is notoriously fickle. There are a bunch of factors behind these kinds of movements. We also have to keep in mind we’re talking about a six month window. In the world of investing, six months is the blink of an eye.
Another complicating factor is politics. Pharmaceutical companies are in the crosshairs of the new administration. President Trump has been vocal about reducing drug prices. And given that price reductions come right off the bottom line, investors probably have a bit of anxiety about the future financial performance of pharmaceutical companies.
So who’s the most overvalued?
According to Tobin’s Q ratio, Eli Lilly is the most overvalued of these companies, followed very closely by Johnson & Johnson. Both companies are valued at over twice their replacement cost.
Keep in mind, I’ve focused on one specific valuation metric. There are tons of different ways to value companies. In my next post, I’ll look at these companies from a slightly different perspective. Then we can decide how confident we are in labeling Eli Lilly and Johnson & Johnson “overvalued”.