McKinsey Free Cash Flow Model

By utilizing the Weighted Average Cost of Capital (WACC) determined in Post 7, along with several other factors to be elaborated on, we applied the McKinsey Free Cash Flow (FCF) Model to forecast the stock price of Merck & Co. At the time of this analysis, Merck & Co's stock was trading at $104.37. The forecasted price, derived from the McKinsey model, is $104.48, indicating a minor overvaluation of the stock. The upcoming discussion will delve into the foundational assumptions of this valuation. These assumptions are considered robust, informed by a deep understanding of both the company and its industry, much of which has been detailed in previous posts. 

Table 1 displays the conclusive calculations of the McKinsey Free Cash Flow Model, with the final row boldly emphasizing the "Value per Share" or the calculated stock price of NFG, based on the outlined assumptions.

Key Rate Calculations

The four key yearly rates that serve as the baseline for Free Cash Flow valuation for Merck & Co include the revenue growth rate, the proportion of revenues absorbed by the cost of goods sold (COGS), the percentage of revenues allocated to selling, general, and administrative (SG&A) expenses, and the percentage change in net operating assets (NOA). These metrics are each underpinned by distinct assumptions, yet they draw from a unified perspective on the pharmaceutical industry and Merck & Co’s position within it. 

Merck & Co is expected to maintain a steady growth trajectory, capitalizing on its robust pipeline of pharmaceuticals and its strategic initiatives in emerging markets. The assumption for COGS reflects efficient cost control and the benefit of economies of scale, while SG&A expenses are projected to remain stable as a percentage of revenue, indicating disciplined operational management. Investment in research and innovation is anticipated to drive future growth, despite the competitive and regulatory challenges inherent in the pharmaceutical industry. The consistent NOA suggests an effective allocation of capital and resources, aligning with Merck's focus on core areas of expertise and potential divestiture of non-essential assets. This outlook is underpinned by the essential nature of healthcare and the continued demand for medical innovation.

"Table 2: This table presents the four essential percentages employed in calculating free cash flows for the upcoming ten fiscal years. These important rates encompass the revenue growth rate (Growth %), the proportion of revenues attributed to cost of goods sold (COGS %), the percentage of revenues allocated to selling, general, and administrative expenses (SG&A %), and the percentage alteration in Net Operating Assets (delta NOA %)."

Growth Rate of Revenues

For Merck & Co., the growth rate of revenues for stock price calculation is based on two principal assumptions, drawing on industry-specific factors and historical trends. The first assumption involves the short-term revenue growth rate for the initial three years. Here, we utilize the average of the forecasts provided by Value Line and FactSet. These projections reflect growth rates of 0.52%, 5.46%, and 6.39% for each respective year. This assumption is predicated on the belief that these expert forecasts accurately capture the immediate industry trends, Merck’s current product pipeline, and market dynamics, including its recent R&D initiatives and expansion strategies. The second assumption pertains to the long-term growth rate, extending beyond Fiscal 2025. This is influenced by the broader trends and challenges in the pharmaceutical industry, including factors such as evolving healthcare regulations, competitive market pressures, and the pace of innovation in drug development. In this context, we conservatively estimate Merck's long-term annual growth rate at 2.8%. This rate takes into account Merck’s stable market position, but also incorporates potential industry disruptions and the typical growth trajectory for a mature pharmaceutical company. It reflects an expectation that while Merck may experience robust growth in the near term, its growth rate will likely stabilize as the market matures and new challenges arise.

Table 3 presents the sales/revenue forecasts for Merck & Co. This information was sourced from Value Line and FactSet for the future years. These forecasts are utilized to compute both the average revenue forecast and the growth rate compared to the previous year's revenues. This information is essential for the free cash flow model.

Cost of Goods Sold- Percentage of Revenue

The approach to estimating the cost of goods sold (COGS) as a percentage of revenues for Merck & Co is informed by both historical data and projected industry trends. Initially, to establish a reliable baseline, we consider the average COGS percentage over the past five years. This average, at 29.09%, is indicative of stable operational and production costs relative to revenue during this period.

For the initial three-year projection, we maintain a slightly adjusted average COGS percentage of 28.54%, as calculated from the three-year historical data. This adjustment takes into account minor fluctuations in operational efficiency and cost management strategies implemented by Merck & Co. Moving forward, to the industry trends and Merck & Co's market stance predicts a possible shift in COGS dynamics. Regulatory reforms, market competition, and innovation-driven developments are all putting pressure on the pharmaceutical business. These factors may cause a rise in production and operational expenses, particularly in R&D-intensive fields. Considering these trends, it's prudent to anticipate a gradual increase in the COGS percentage. However, Merck & Co.'s ongoing efforts in streamlining operations, enhancing production efficiency, and strategic investments in innovative technologies may mitigate some of these rising costs. Therefore, while there is an expectation of an uptick in COGS as a percentage of revenues, this increase is projected to be gradual and controlled, reflecting Merck & Co.'s robust operational management.

Note: I refrained from relying on Value Line or FactSet estimates because they didn't reflect the cost of goods sold in the same manner as Merck & Co financial statements. Specifically, Value Line only projected the operating margin and not the gross profit margin, while FactSet's "Cost of Sales" forecast seemed excessively high, encompassing more expenses than just NFG's Cost of Goods Sold as presented in their income statements.

Table 4 shows Merck & Co's Cost of Goods Sold (COGS) as a percentage of revenue over three and five years.

Selling, General and Administrative Expenses- Percentage of Revenues

For Merck & Co selling, general, and administrative expenses (SG&A) as a percentage of revenues over the last five years have fluctuated, with a five-year average of 20.30% and a three-year average of 17.81%. Although there has been a noticeable decline in SG&A expenses relative to revenues in the most recent year, this drop to 16.31% is not necessarily indicative of a lasting trend. Therefore, when forecasting future expenses for valuation purposes, it would be prudent assumption to use the five-year average rather than the anomalously low figure from the last year. This conservative approach acknowledges the variability in SG&A expenses while providing a reasonable estimate that minimizes the risk of underestimating these costs in relation to future revenues.

Table 5 displays the percentage of Merck & Co's selling, general, and administrative expenses in relation to its revenues for the past five years. It also includes the average of these expenses over the same five-year period and the average over the last three years. The SG&A percentage of revenues for the next ten years will be based on the average of the last five years for Merck & Co.

Operating Income Calculations

The next set of assumptions pertains to the calculation of operating income, which is a prerequisite for determining free cash flows. I used historical data from Merck & Co income statements as a basis to estimate the various major expense categories. Below, you will find descriptions of the four expense categories along with the assumptions associated with them.

1. The calculation of the cost of goods sold is based on a percentage of the total revenues for the year, as explained earlier.

2. Selling, general, and administrative expenses are determined as a percentage of the annual revenues, in the manner outlined earlier.

3. Research & development expenses: Despite potential speculation that Merck & Co. would maintain its past trend of not investing in R&D, the company's actual increasing expenditure in this area over the last five years indicates a continued commitment to research and development.

4. Merck & Co. has no depreciation and amortization expense, as shown by a - figure. In contrast, depreciation and amortization are not predicted as a percentage of revenue in other companies. Instead, Merck & Co. assumes that depreciation and amortization expense will remain constant at zero because there is no historical evidence of such expenses.

5. Other operating expenses/income: Given that Merck & Co. has not reported any other operating expenses in the past five years, it was assumed that this trend of non-existence in this category will persist over the next decade, aligning with the firm's historical pattern.

Table 7 illustrates the forecasted operating income for Merck & Co over the next ten fiscal years, utilizing the estimates and assumptions described earlier in this analysis.

Free Cash Flow and Stock Price Calculations

The following chart illustrates the application of these estimates in determining the annual free cash flows and subsequently discounting these cash flows using the Weighted Average Cost of Capital (WACC) as defined in Post 7. This process results in the present value of these future cash flows, which is then incorporated into the table representing the enterprise value of the company. This enterprise value is crucial in computing the stock price of the firm, providing a comprehensive financial picture that aids in investment and valuation decisions.