A few weeks ago, we kicked off a series on valuation basics.
In the first two lessons, I explained why it’s important to look at a stock’s valuation before you buy… and how to do it using five popular valuation ratios. (Catch up here and here.)
Today, we’ll put it all together… and compare two pharma stocks using our five metrics.
As I mentioned last time, when looking at valuation ratios, you want to compare stocks in the same industry.
And there’s a lot of interest right now in the pharmaceutical space, or companies racing to develop treatments and vaccines for COVID. This has led to solid returns in some of these stocks… and not-so-great returns in others.
Since Johnson & Johnson (JNJ) and Pfizer (PFE) are both healthcare giants with successful vaccines, they make for a good valuation comparison.
Let’s start by checking how their P/E ratios measure up…
Price-to-Earnings
The price-to-earnings ratio, or P/E, is one of the most common valuation metrics for analyzing stocks. It measures the current market value of a stock compared to its earnings.
Johnson & Johnson has a trailing P/E ratio of 29.10. We get this number by taking Johnson & Johnson’s recent price of $160.35 and dividing it by its trailing twelve-month earnings per share (EPS) of $5.51.
Johnson & Johnson P/E = 160.35/5.51 = 29.10
Pfizer has a trailing P/E ratio of 20.68. We get this number by taking Pfizer’s recent price of $35.36 and dividing it by its trailing twelve-month earnings per share (EPS) of $1.71.
Pfizer P/E = 35.36/1.71 = 20.68
As you can see, Pfizer is cheaper than Johnson & Johnson based on their P/E ratios.
The P/E ratio is a great starting point for comparing companies. But we need to compare multiple ratios to get the whole picture.
Let’s look at another valuation metric that includes their growth rates…
PEG Ratio
The P/E ratio doesn’t take earnings growth into account. The PEG ratio helps fix this limitation.
To find the PEG ratio, you first need to calculate the P/E ratio for a stock. Next, simply divide the P/E by the company’s expected earnings growth. I prefer to use a company’s projected five-year growth rate for earnings per share (EPS). I use the consensus growth rate of Wall Street analysts.
Let’s continue with our Johnson & Johnson and Pfizer example…
To calculate Johnson & Johnson’s PEG ratio, we take its P/E of 29.10 and divide it by its projected five-year growth rate. You can find growth estimates for stocks at Yahoo Finance by punching in the ticker and clicking on the “analysis” tab. For Johnson & Johnson, it shows a five-year growth rate (in percent) of 5.6. This gives us a PEG ratio of 5.20 for the stock.
Johnson & Johnson PEG = 29.10/5.6 = 5.20
Let’s also check the PEG for Pfizer. As we calculated above, Pfizer has a trailing P/E of 20.68. If we divide this number by its five-year growth rate of 10.07 (again, scroll down on the “analysis” tab in Yahoo Finance), we get a PEG Ratio of 2.05.
Pfizer PEG = 20.68/10.07 = 2.05
Johnson & Johnson’s PEG ratio is 5.2, while Pfizer’s PEG ratio was 2.05. Similar to our P/E calculations, Pfizer looks more attractive than Johnson & Johnson.
Price-to-Book (P/B)
The price-to-book ratio is similar to the P/E ratio. Instead of focusing on earnings, this ratio looks at a stock’s “book value.”
Book value is essentially the value of a company based on its balance sheet. It’s the company’s total assets minus its outstanding liabilities.
To calculate this ratio, you simply divide the stock price by its book value per share. Let’s use Johnson & Johnson (JNJ) and Pfizer (PFE) as examples again.
Johnson & Johnson has a P/B ratio of 6.66. We get this number by taking Johnson & Johnson’s current price of $160.35 and dividing it by its book value per share of $24.04.
Johnson & Johnson P/B = 160.35/24.04 = 6.66
Pfizer has a P/B ratio of 3.11. Again, we calculate this by dividing its market price of $35.36 by its book value per share of $11.36.
Pfizer P/B = 35.36/11.36 = 3.11
The third time’s the charm, as Pfizer is once again cheaper than Johnson & Johnson based on price-to-book. But there are two more ratios we should look at to make sure.
Price-to-Sales (P/S)
Price-to-sales measures a company’s market value relative to its annual revenue. You can calculate it by dividing the stock price by the company’s sales per share.
Here are example calculations using the same stocks. Johnson & Johnson has a P/S ratio of 5.11. We get this number by taking Johnson & Johnson’s current price of $160.35 and dividing it by its sales per share of $31.37.
Johnson & Johnson P/S = 160.35/31.37 = 5.11
Pfizer has a P/S ratio of 4.69. Again, we calculate this by dividing its market price of $35.36 by its sales per share of $7.54.
Pfizer P/S = 35.36/7.54 = 4.69
Based on price-to-sales, Pfizer is once again more attractive.
Price-to-Cash-Flow (P/CF)
The final valuation metric we’ll look at is price-to-cash flow. This is an excellent metric for checking how much cash a company is generating relative to its market value.
To calculate the price-to-cash-flow ratio, take the stock price and divide it by cash flow per share. While book value per share and sales (revenue) per share are easily found on Yahoo Finance, you need to go an extra step to find cash flow per share.
For example, to find Johnson & Johnson’s cash flow per share, we divide the company’s operating cash flow ($23.54B) by its shares outstanding (2.63B). Both figures are on Yahoo Finance.
Johnson & Johnson cash flow per share= 23.54B/2.63B = 8.95
Now, we take Johnson & Johnson’s current stock price of $160.35 and divide it by its cash flow per share of $8.95.
Johnson & Johnson P/CF = 160.35/8.95 = 17.92
To find Pfizer’s cash flow per share, we divide the company’s operating cash flow ($14.4B) by its shares outstanding (5.56B). Both figures are on Yahoo Finance.
Pfizer cash flow per share= 14.4/5.56 = 2.58
Now, we take Pfizer’s current stock price of $35.36 and divide it by its cash flow per share of $2.58.
Pfizer P/CF = 35.36/2.58 = 13.71
Pfizer is cheaper compared to Johnson & Johnson in all five valuation ratios. Now, we must find out why. As we discussed last time, cheap doesn’t necessarily mean a good buy. It could be cheap for a reason…
One thing we can do is compare balance sheets. One of my favorite metrics to look at is a company’s current ratio. The current ratio is a liquidity ratio that measures a company’s ability to cover its short-term obligations with its current assets. (See Yahoo Finance under the Statistic tab.)
It can also be calculated by dividing a company’s current assets by its current liabilities. (These figures can be found on Yahoo Finance in the Balance Sheet section under the Financial tab.) A ratio over 1 indicates that a company has more current assets than liabilities.
Johnson & Johnson has a current ratio of 1.21, while Pfizer has a current ratio of 1.35. This means Pfizer has more liquidity based on its current ratio.
Another metric I like to check is profit margin. The profit margin is a ratio of a company’s profit (sales minus all expenses) divided by its revenue. (This is also on Yahoo Finance under the Statistic tab.)
Johnson & Johnson has a profit margin of 17.82%, while Pfizer has a profit margin of 22.95%. So, Pfizer also looks like it is more profitable.
Finally, we can compare growth outlooks. We already found the five-year projected growth rates for these companies when we looked at their PEG ratios. Johnson & Johnson had a five-year growth estimate of 5.6% per year, while Pfizer has a five-year growth estimate of 10.07% per year. So, Pfizer also has a better growth outlook.
Taking action
If we take everything into account, PFE looks like the more attractive stock at the moment than JNJ.
Keep this template handy whenever you’re comparing two stocks in the same industry. While we couldn’t cover every factor that makes a stock over or undervalued, this template should give you a solid place to start.
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