Estimating The Intrinsic Value Of Merck & Co., Inc. (NYSE:MRK)

Today we’ll do a simple run through of a valuation method used to estimate the attractiveness of Merck & Co., Inc. (NYSE:MRK) as an investment opportunity by taking the foreast future cash flows of the company and discounting them back to today’s value. I will be using the Discounted Cash Flow (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward.

We generally believe that a company’s value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

See our latest analysis for Merck

The model

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second ‘steady growth’ period. In the first stage we need to estimate the cash flows to the business over the next ten years. Where possible we use analyst estimates, but when these aren’t available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.

Generally we assume that a dollar today is more valuable than a dollar in the future, and so the sum of these future cash flows is then discounted to today’s value:

10-year free cash flow (FCF) forecast

2020 2021 2022 2023 2024 2025 2026 2027 2028 2029
Levered FCF ($, Millions) US$10.2b US$13.7b US$14.6b US$11.0b US$11.8b US$11.3b US$11.0b US$10.8b US$10.8b US$10.8b
Growth Rate Estimate Source Analyst x3 Analyst x5 Analyst x4 Analyst x2 Analyst x2 Est @ -4.58% Est @ -2.68% Est @ -1.35% Est @ -0.43% Est @ 0.22%
Present Value ($, Millions) Discounted @ 6.2% US$9.6k US$12.2k US$12.2k US$8.6k US$8.8k US$7.9k US$7.2k US$6.7k US$6.3k US$5.9k

(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$85b

The second stage is also known as Terminal Value, this is the business’s cash flow after the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 10-year government bond rate of 1.7%. We discount the terminal cash flows to today’s value at a cost of equity of 6.2%.

Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = US$11b× (1 + 1.7%) ÷ 6.2%– 1.7%) = US$247b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$247b÷ ( 1 + 6.2%)10= US$135b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is US$221b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of US$79.3, the company appears about fair value at a 9.2% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope – move a few degrees and end up in a different galaxy. Do keep this in mind.

NYSE:MRK Intrinsic value May 1st 2020
NYSE:MRK Intrinsic value May 1st 2020

Important assumptions

We would point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. If you don’t agree with these result, have a go at the calculation yourself and play with the assumptions. The DCF also does not consider the possible cyclicality of an industry, or a company’s future capital requirements, so it does not give a full picture of a company’s potential performance. Given that we are looking at Merck as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which accounts for debt. In this calculation we’ve used 6.2%, which is based on a levered beta of 0.820. Beta is a measure of a stock’s volatility, compared to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

Next Steps:

Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to “what assumptions need to be true for this stock to be under/overvalued?” If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. For Merck, There are three additional factors you should look at:

  1. Risks: Case in point, we’ve spotted 2 warning signs for Merck you should be aware of.
  2. Future Earnings: How does MRK’s growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
  3. Other Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!

PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NYSE every day. If you want to find the calculation for other stocks just search here.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.