Value Battle: Pfizer Inc. (PFE) vs. Merck & Co., Inc. (MRK)

James Montier is one of the premier value investors of our times. His 2009 book, Value Investing: Tools and Techniques for Intelligent Investment, is a must for anyone serious about this style of investing.

Value Battle: Pfizer Inc. (PFE) vs. Merck & Co., Inc. (MRK)

Montier’s first of seven immutable laws of investing is the margin of safety, the discount between the intrinsic value of a stock and its current market price.

“The objective of investment (in general) is not to buy at fair value, but to purchase with a margin of safety,” James Montier wrote in 2011. “This reflects that any estimate of fair value is just that: an estimate, not a precise figure, so the margin of safety provides a much-needed cushion against errors and misfortunes.”

Montier applies this thinking when assessing a stock and he’s not buying unless there’s a significant margin of safety.

In the value battle between Pfizer Inc. (NYSE:PFE) and Merck & Co., Inc. (NYSE:MRK), we’ll look at four components of the valuation process — normalized price-earnings ratio, profit margins, sales growth and dividend yield — to come up with a winner.

Valuation: Pfizer (PFE) vs. Merck (MRK)

Metric PFE MRK
Normalized P/E (TTM) 14.6 22

Op. Profit Margins

(5-year Average)

25.8% 16.2%

Sales Growth

(5-year Average)

-6.0% -3.0%
Dividend Yield (Current) 3.8% 3.1%

Source: Morningstar, ADVFN

How you rank the four components in terms of importance will have a lot to do with which stock wins the value battle.

Clearly, you want the normalized P/E ratio to be as low as possible with the other three as high as possible. Although, in the case of the dividend yield, the growth of the dividend is just as important, or more so, than the yield itself. All things being equal, the stock with higher dividend growth would be the value winner in my opinion. However, we likely won’t get to that.

Normalized P/E

Pfizer continues to get a conglomerate discount from investors who are frustrated with its lack of revenue growth. While the company has said it won’t split into two businesses — patent-protected drugs and generics — it hasn’t ruled out the possibility of selling or spinning off the consumer healthcare business, which includes brands such as Chapstick and Advil.

With patent expirations on both Viagra in 2017 and Lyrica in 2019 and the consumer healthcare business valued as high as $14 billion, this divestiture would get Pfizer focused on its specialty drug business where the real profits are.

It’s got work to do, but at a normalized P/E ratio one-third Merck’s, Pfizer’s definitely the value play based on this particular metric.

Operating Profit Margins

Pfizer expects its fiscal 2016 adjusted cost of sales to be between 21.5% to 22%, which puts its gross margin around 78%, 14 percentage points higher than Merck’s through the first nine months of fiscal 2016. Although Merck’s have been improving lately, Pfizer’s are still much healthier. Ultimately, higher gross margins often lead to higher operating profits.

Advantage, Pfizer.

Sales Growth

InvestorPlace contributor Dana Blankenhorn did a good job in early November dissecting what’s wrong with Pfizer after it missed analyst earnings expectations for the third quarter.

He believes the healthcare sector as a whole is weak due to increased competition, less pricing power for branded drugs and more shelf space for generics benefiting from a bevy of patent expirations over the next few years.

Bottom line: Investors ought to look somewhere other than Pfizer for real revenue growth.

The Dividend

Pfizer might have issues of revenue growth, but there’s no question it still generates significant operating profits and free cash flow, a key ingredient for covering dividends.

Pfizer’s current free cash flow is $2.22 per share, providing a free cash flow yield of 7% (Dec. 9 closing price of $31.70) compared to 6.4% (FCF of $3.92 per share) for Merck.

While Pfizer has a 118% payout ratio compared to 94% for Merck, they both dedicate about 50% of free cash flow to paying dividends. Long term, don’t worry about either company’s ability to pay their dividends.

Only you can determine if the margin of safety for both Pfizer stock and Merck stock is big enough to justify buying either of them. If you’re going to buy based on relative value, however, Pfizer’s definitely it.

As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.

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Article printed from InvestorPlace Media, https://investorplace.com/2016/12/pfe-mrk-pfizer-merck-stock/.

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