Merck Stock: Still Cheaper Than Graham Price-Earnings Ratio (NYSE: MRK)

MRK Stock: Still a Buy

Last time we looked at Merck (New York Stock Exchange:MRK) in July 2022 Bullish theory (As you can see in the chart below.) At the time, the stock was priced at $75 per share and trading at roughly 12.5x FWD. P/E. And the bullish arguments were pretty clear to us (key points quoted below).

Merck is currently valued at approximately 12.5x FW P/E, but remains significantly undervalued. Growth in its pipeline drugs, particularly molnupiravir, is not appropriately priced, with a PEG ratio of just 0.78. We expect continued strong performance from the company’s core oncology franchise, Keytruda. The combination of a valuation discount and mispricing of growth potential should drive double-digit annual earnings over the next few years. The company’s A+ financial strength and long-term support make it even more attractive to conservative investors.

All of the above points have come true for MRK. Overall, MRK has delivered a total return of over 45% since then, far outperforming the S&P 500’s return of around 30%. Typically, effective bull theories tend to reverse course: as prices rise, valuations expand and risks grow. This is certainly true for MRK in some respects. At current price levels, the P/E is around 14.6x based on FY1 EPS, roughly 17% higher than when I last wrote.

However, in the remainder of this article, we argue that despite this bold expansion, our bullish thesis remains valid. Specifically, we argue that valuation remains reasonable (or even discounted) when taking into account projected growth. Specifically, the Graham P/E (more on this in the next section) is approximately 23.7x by our estimate, leaving a generous margin of safety at the current price. Other previous considerations remain valid (e.g., the success of the Keytruda franchise) or have further strengthened (e.g., financial strength).

MRK: Growth outlook and Graham P/E

As a mature, leading company in a stable sector (and one that has paid consistent dividends for many years), I think it’s very reasonable to view MRK as a classic “defensive stock” as Ben Graham describes it in his book. The wise investorSo I will assess its value according to the so-called Graham method described in the book (now named after him). More specifically,

The Graham P/E is calculated as 8.5 plus 2x the expected annual growth rate. In other words, in Graham’s view, a business that is stagnant and has 0% growth potential should be worth a P/E of 8.5.

This approach requires that you first make growth projections. The graph below shows: Consensus EPS Estimates MRK stock growth rate over the next 5 years. As you can see from the chart below, the EPS consensus forecast for MRK stock indicates significant growth over the next few years. That is, EPS is expected to grow from $8.64 at the end of fiscal 2024 to almost $12.5 at the end of fiscal 2028. The growth rate is somewhat uneven, exceeding 14% in fiscal 2025, followed by high single-digit growth rates for the following few years. Incidentally, the 472% growth rate this year should be ignored. This is due to the previously announced and widely expected costs associated with Merck’s cancer drug collaboration agreement with Daiichi Sankyo.

According to analysts’ forecasts, EPS is expected to grow at a compound annual growth rate (CAGR) of 7.6% between FY2024 and FY2028. Incidentally, the forward P/E is expected to fall to around 10x by the end of FY2028. Here, I will estimate MRK’s Graham P/E using the growth rate implied by the forecasts, and I will explain shortly why I agree with such forecasts. At a CAGR of 7.6%, MRK’s Graham P/E is around 23.7x (8.5+2×7.6). Compared to the FWD P/E of 14.6x mentioned earlier, this leaves a wide margin of safety, even though it is close to the all-time high price.

Now, let’s discuss the key sources of profits that we believe could support the above growth. The biggest differentiator, in our opinion, is its balanced business model and revenue streams. MRK is focused on a diversified portfolio across established and emerging markets. Unlike many of its peers that rely heavily on blockbuster drugs in developed markets, MRK generates the majority of its revenues from vaccines and established therapies in developing markets. This strategy mitigates risk by reducing dependency on a single product or geographic region. MRK also continues to invest heavily in research and development in areas of high unmet medical need, such as oncology and immuno-oncology (as can be easily seen in the chart below). This focus on future growth areas positions MRK well to capitalize on upcoming advancements in these fields.

Thanks to such a strong portfolio and pipeline, MRK has been performing well recently (often above consensus expectations). For example, the company’s top-selling product, Keytruda, posted a 21% YoY increase (to $6.61 billion) in Q4 2023, while Gardasil sales increased 27% (to $1.87 billion). The Keytruda franchise is owned by Pfizer Comirnaty The COVID-19 franchise will be the top-selling drug globally in 2023. Going forward, we expect Keytruda’s momentum to continue given its favorable market position and the fact that it has patent protection until 2028. We also believe that immunotherapy will remain a key growth engine in the coming years, owing to increasing global adoption in early-stage indications and continued strong demand from the metastatic segment.

Other risks and final considerations

In terms of downside risks, MRK shares the two most significant risks with its peers: clinical trial failures and pricing pressures. Clinical trial failures could significantly delay or derail the development of promising drugs, leading to revenue shortfalls and share price declines. Increased government and payer scrutiny of drug prices (which has become a sensitive political issue in recent years in our view) could put pressure on margins. In addition to these general risks, MRK also faces some unique challenges. A large portfolio in developing markets is subject to currency fluctuations and potential political instability. With respect to valuation, other metrics could send a contraction signal to the above valuation. For example, with respect to dividend yield, the stock’s current yield is near its lowest level in at least five years, as can be seen in the top panel of the chart below, indicating overvaluation. However, given the relatively low dividend payout ratio (~35% on Q1 EPS), we believe it would be unwise to place too much reliance on yield as a valuation metric here. The company has also allocated a significant portion of its capital to strengthening its balance sheet (see panel below) and increasing its book value in recent years, which we believe to be a positive move. As a result, it is not surprising that dividend growth has lagged EPS growth and the dividend yield is below its historical average.

In conclusion, we believe MRK remains an attractive buying opportunity despite the significant price appreciation since our last coverage. In short, we still see a great combination of growth and value. Admittedly, the valuation has expanded slightly since our last coverage, from about 12.5x FWD P/E at the time to about 14.6x now. However, the valuation remains reasonable when factoring in growth potential such as the Graham P/E. Other considerations we covered in our previous paper, such as momentum in the Keytruda franchise and financial strength, remain valid or have further strengthened since our previous coverage.