Most analysts love Novartis AG, which has an average rating of buy. But there's reason to believe the stock may be overvalued at today's price of $105.3 per share. Let's look at the fundamentals ourselves and see if we reach a different conclusion than the analyst community.
The first step in determining whether a stock is overvalued is to check its price to book (P/B) ratio. This is perhaps the most basic measure of a company's valuation, which is its market value divided by its book value. Book value refers to the sum of all of the company's assets minus its liabilities -- you can also think of it as the company's equity value.
Traditionally, value investors would look for companies with a ratio of less than 1 (meaning that the market value was smaller than the company's book value), but such opportunities are very rare these days. So we tend to look for company's whose valuations are less than their sector and market average. The P/B ratio for Novartis AG is 5.67, compared to its sector average of 4.08 and the S&P 500's average P/B of 2.95.
Modernly, the most common metric for valuing a company is its Price to Earnings (P/E) ratio. It's simply today's stock price of 105.3 divided by either its trailing or forward earnings, which for Novartis AG are $3.86 and $7.25 respectively. Based on these values, the company's trailing P/E ratio is 27.3 and its forward P/E ratio is 14.5. By way of comparison, the average P/E ratio of the Health Care sector is 30.21 and the average P/E ratio of the S&P 500 is 15.97.
The problem with P/E ratios is that they don't take into account the growth of earnings. This means that a company with a higher than average P/E ratio may still be undervalued if it has extremely high projected earnings growth. Conversely, a company with a low P/E ratio may not present a good value proposition if its projected earnings are stagnant.
When we divide Novartis AG's P/E ratio by its projected 5 year earnings growth rate, we obtain its Price to Earnings Growth (PEG) ratio of 2.1. Since a PEG ratio between 0 and 1 may indicate that the company's valuation is proportionate to its growth potential, we see here that NVS is overvalued when we factor growth into the price to earnings calculus. One important caveat here is that PEG ratios are calculated on the basis of future earnings growth estimates, which may turn out to be wrong.
Indebted or mismanaged companies can't sustain shareholder value for long, even if they have strong earnings. For this reason, considering Novartis AG's ability to meet its debt obligations is also an important aspect of pinning down its valuation. By adding up its current assets, then subtracting its inventory and prepaid expenses, and then dividing the whole by its current liabilities, we obtain the company's Quick Ratio of 0.412. Since NVS's is lower than 1, it does not have the liquidity necessary to meet its current liabilities.
One last metric to check out is Novartis AG's free cash flow of $3.58 Billion. This represents the total sum of all the company's inflows and outflows of capital, including the costs of servicing its debt. It's the final bottom line of the company, which it can use to re-invest or to pay its investors a dividend. With such healthy cash flows, investors can expect Novartis AG to keep paying its 3.3% dividend.
Analysts are bullish on Novartis AG, but we are concerned they may be missing the clouded growth picture, as expressed by the stock's elevated PEG ratio. In addition, many of its valuation metrics point to a stock with an inflated value. We will keep following NVS to see whether the analyst community was right.
