Alternative Valuation Models

Residual Operating Income (ROPI) Model

Key Assumptions:

The valuation of Merck & Co. via the Residual Operating Income (ROPI) model involves several critical assumptions reflected in the company's financial data. For the fiscal year 2022, the ROPI analysis begins with Net Operating Assets (NOA) of $67,087.00 million after adjustments for operating leases and excess cash. The Weighted Average Cost of Capital (WACC) is held constant at 5.91%, used to determine the breakeven NOPAT required for Merck & Co. to cover its cost of capital, which stands at $3,967.08 million for the same fiscal year. The actual NOPAT far exceeds this figure at $18,166.33 million, indicating a healthy residual operating income of $14,199.26 million.

The ROPI model uses the average of the previous three years to forecast future performance and valuation, with the extraordinarily high figure of 2022 treated as an exception. This conservative approach to averaging ensures that transitory increases do not have an undue impact on valuation. The growth rate is expected to begin at 0.52% in 2023, demonstrating cautious optimism about the company's capacity to grow in a mature market. This rate is predicted to steadily decline over time, reaching 2.80% by 2033, indicating that Merck & Co.'s growth trajectory is reasonable.

In estimating the equity value of Merck & Co. using the ROPI model, a fundamental assumption is made regarding the sustainability and predictability of its operating income. By selecting a baseline ROPI of $8,435.81 million, the analysis assumes this figure realistically reflects the company's ability to generate profit above its operational costs and capital charges. This figure is not merely historical but is seen as indicative of Merck & Co.'s ongoing operational efficiency and effectiveness. This valuation process, while anchored in historical data, is forward-looking. It implies a belief in Merck & Co.'s potential to maintain profitability and shareholder value, considering the competitive dynamics of the pharmaceutical industry and the company's strategic positioning.

Secondly, the WACC is assumed to be a stable and accurate reflection of Merck & Co.'s risk profile and the cost of capital over time. This rate is applied to the NOA to calculate the breakeven NOPAT, which serves as a benchmark for evaluating the company's operational efficiency and its ability to generate income over and above the capital costs.

Analyzing the Final Stock Price: 

The Residual Operating Income (ROPI) model aims to predict the annual surplus profits a company will have after fulfilling its obligations to investors and other stakeholders. This model enables investors to gauge the stock price by considering the yearly surplus income generated by the company. To derive this value, four fundamental assumptions were taken into consideration.

In constructing a valuation for Merck & Co using the Residual Operating Income (ROI) model, a number of foundational assumptions are made to guide the process. These assumptions are essential for interpreting past financial data and projecting the future financial health of the company. The initial assumption is related to the adjustments for operating leases. Given recent changes in accounting standards that now require operating leases to be recorded on the balance sheet, the analysis retroactively applies these standards to previous years for which data is available. This allows for a consistent comparison of Merck & Co.'s NOA across all fiscal years, reflecting a methodical approach that seeks to normalize the data for analytical accuracy. 

The final stock price per share reflects the intrinsic value based on the company's ability to generate future earnings above its cost of capital. It suggests that the market expects Merck & Co. to continue creating value for its shareholders at a rate that justifies this stock price. This valuation provides investors with a benchmark for the company's worth as per the ROPI model's assessment, considering the present value of its future excess earnings potential. The stock price $145.41 per share. This valuation is derived from a series of calculations, which are grounded in the company's financial data bellow.

Table 1 presents the initial portion of the process used to estimate Merck & Co.'s stock price through the Residual Operating Income (ROPI) model.

Dividend Discount Model (DDM)

Key Assumptions:

The Dividend Discount Model (DDM) is based on the simple assumption that a company's surplus earnings are allocated to its shareholders as dividends. This approach determines Merck & Co's stock price by discounting future dividend payments to their present value. The underlying assumptions are clear, given the model's simplicity, and are listed below.

1. The Dividend Discount Model for Merck & Co calculates the stock price by looking at the dividends issued over the past fiscal year, as reported in the company's latest Value Line summary, which aggregates dividends from the four quarters.

2. The model assumes that the dividend growth rate will match the projected sales growth for each fiscal year. These projections align with the forecasts utilized in both the Free Cash Flow and Residual Operating Income models.

3.  Lastly, the discount rate applied to future dividends, to determine their present value, corresponds to Merck & Co's cost of capital. This rate is derived from the Capital Asset Pricing Model (CAPM), detailed previously in Post 7, ensuring consistency across valuation methodologies.

Analyzing the Final Stock Price:

The Dividend Discount Model (DDM) applied to Merck & Co. estimates a stock price of $113.95, which is calculated by discounting the forecasted dividends back to the present value using the company's cost of equity, which stands at 5.91%. The model starts with an anticipated dividend of $2.92 in the year 2023, with subsequent years showing an increasing trend in dividends in line with the projected growth rates, starting from 0.52% in 2023 and incrementally rising to 5.94% in 2026, before gradually declining to 2.80% by the final year considered.

DDM is especially suited for companies that are perceived to be mature and have fewer growth opportunities, as it is built on the premise that such firms will return most of their excess earnings to shareholders in the form of dividends. This model, therefore, may not fully capture the value of a company that is still in a growth phase and likely to reinvest a significant portion of its earnings back into the business rather than distribute it as dividends.

For Merck & Co., the DDM valuation might seem conservative, especially if the company has substantial growth opportunities and chooses to reinvest its profits to capitalize on these prospects, which could lead to a lower dividend payout in the short to medium term. The terminal value of $148.13, reflecting the present value of all future dividends beyond the forecast period, plays a significant role in this valuation, indicating the long-term expectation of the company's profitability.

The stock price of $113.95 provided by the DDM suggests a conservative estimate of Merck & Co.’s value, potentially positioning it as a lower bound of the company's intrinsic stock value. It accounts for the immediate return to investors through dividends but may not fully encapsulate the company’s potential for future growth and reinvestment strategies that could enhance shareholder value over time. Therefore, while the DDM provides a useful perspective on the company’s value, it should ideally be considered in conjunction with other valuation models that account for growth and reinvestment potential to obtain a more comprehensive view of Merck & Co.'s intrinsic value.

Table 2 presents the calculation of Merck & Co stock price using the Dividend Discount Model. Notably, the estimated stock price for Merck & Co, highlighted in yellow, is considerably higer than its current stock price as per the DDM analysis.

Market Multiples Approach

Assumptions:

Using companies such as Johnson & Johnson, Thermo Fisher Scientific, Abbott Laboratories, and Novartis as comparables in a market multiple valuation of Merck & Co. is a strategic choice informed by several key factors:

Industry Similarity: These companies operate within the same pharmaceutical and healthcare sectors, mirroring Merck & Co.'s industry. This alignment ensures that selected comparable share commonalities in terms of regulatory environments, market dynamics, and growth opportunities, which is crucial for an accurate assessment when applying market multiples.

Similarity in Industry: These firms work in the same pharmaceutical and healthcare areas as Merck & Co. This alignment guarantees that selected companies have a similar regulatory regimes, market dynamics, and growth potential, which is critical for an appropriate assessment when applying market multiples.

Global Presence: The foreign operations of Johnson & Johnson, Thermo Fisher Scientific, Abbott Laboratories, and Novartis provide a broad and diverse framework for comparison. Merck & Co., with its global activities, can draw substantial comparisons with these corporations, who operate in diverse regional marketplaces. This variety increases the significance of Merck & Co.'s market multiple analysis, which accounts for the challenges and opportunities of a global marketplace.

Choosing a Price:

In assessing Merck & Co. with the market multiples approach, the selection of companies such as Johnson & Johnson, Thermo Fisher Scientific, Abbott Laboratories, and Novartis is strategic. These companies operate in similar sectors, making them suitable for a comparative analysis. Their established market presence and financial performance provide a benchmark against which Merck & Co.'s market valuation can be measured.

In the pursuit of arriving at a suitable valuation using this model, it becomes highly crucial to evaluate and take into account various financial metrics. Each of these metrics offers a distinct viewpoint on a company's position in the market. Four essential multiple ratios - price to revenue, price to cash flow, price to earnings, and the price to book ratio - play pivotal roles in creating a comprehensive understanding of the pharmaceutical industry's market dynamics. This methodology gains significance when forecasting the future valuation of Merck & Co within the broader market context. Merck & Co.'s price to sales multiple is noted at $4.35, while its market to cash flow stands at $23.13. These multiples, alongside a price earnings (trailing) multiple of $33.92 and a price book ratio of $5.61, are instrumental in calculating the implied stock price.

Each of the four ratios plays a vital role in providing a comprehensive understanding of how the pharmaceutical industry assesses the worth of its companies. These ratios offer a nuanced perspective on aspects such as financial health, profitability, and growth potential. By incorporating a variety of financial metrics, this model strives to encompass the multifaceted nature of Merck & Co's position within the market,  and also taking in to account the sales per share which is noted as $23.40.

Then taking the implied stock prices for Merck & Co. across all these multiples provide a range of valuations. When these figures are averaged—excluding the outlier-influenced extremes—an implied stock price of $75.66 emerges from the model. This price is reflective of the company's financial stability and market position when benchmarked against the selected price. The initial ROPI value for Merck & Co. is set with a clear understanding of the company's operational effectiveness and its capacity to generate excess returns over its cost of capital, a crucial aspect of this financial metric. This ROPI value, alongside the other multiples, underpins a stock price that is informed by both Merck & Co.'s financial performance and its standing within the competitive landscape of the pharmaceutical industry.