Where Will Merck Stock Be In 4 Years?

Summary:

• Merck & Co., Inc. stock has performed very well for me during the past two years.
• It often takes several years for the prices of overvalued or undervalued stocks to reflect today’s earnings-based valuations.
• In this article, I use a simple earnings valuation technique to estimate approximately where Merck & Co., Inc.’s stock price will be 4 years from now if those trends hold.
• I will compare those estimated returns to the S&P 500 index and cash’s expected returns to determine whether to rate Merck a buy, sell, or hold.

Introduction

I always like to start my articles by reviewing any past coverage I’ve had of a stock. So let’s take a moment to review my past Merck & Co., Inc. (NYSE:MRK) coverage before we get started on the current valuation. I last wrote about Merck nearly two years ago on 5/22/21 with a “Buy” article titled, “Merck Is A Great Relative Value And A Good Absolute Value.” Here is how the stock has performed relative to the SPDR S&P 500 Trust ETF (SPY) since the article was published:

Since that article, SPY is essentially flat, while MRK is up +53%. So far, this idea has worked out well, and I am still long MRK myself. In fact, I’ve barely looked at this stock since buying it two years ago (my favorite kind of investment).

This article will be part of a new series I’m writing about the ability to roughly predict stock prices of steady-earning businesses over the medium term of 4 years. I often receive feedback on my articles that stock valuations of the sort I share on Seeking Alpha are not useful for predicting or improving one’s returns. These critiques come in a couple of variations. One of them states that investors should just buy the stocks of quality businesses whenever they find them regardless of price. Another, the flip-side of this thought process, is that stocks shouldn’t be sold based on valuation because that is “market timing.” I strongly disagree with both critiques, so I will be systematically tracking the results of my 4-year return estimates for stocks like Merck in an effort to hopefully demonstrate the usefulness of earnings-based valuations. (More on this experiment later.)

Even though my Merck position has performed well, sometimes after a pretty fast price rise, a stock can get overpriced, so I think now is a reasonable time to reevaluate Merck stock to see where it stands today. One note of caution I do want to point out is that using historical earnings metrics for pharma stocks can be dangerous due to the timing of expiration of current drug patents and the development of newer replacements. So, as a general rule, I only use this type of analysis on the bigger drug makers, and I prefer that they have at least 3 solid drugs contributing to earnings and a long history of producing successful drugs in the past. Because of pharma’s unique situation, the application of the valuation technique I use here has its limitations, but it can still be useful to investors as an additional tool to supplement any deeper research they have performed on the business.

Valuation

The first thing I check with almost every stock before I start the valuation process is the business’s historical earnings cyclicality. I generally require at least one recession as part of the data so I can see how earnings performed during that recession. Because 2020’s recession was so unusual, I place most of the weight on the 2008/9 recession when examining the historical earnings cyclicality. This can also help me assess the long-term earnings trend, which I require to generally be growing over time. (I don’t have any interest in buying the stock of shrinking businesses or turnaround stocks.)

The green shaded area in the FAST Graph above represents Merck’s annual earnings per share. The main thing I’m checking for here is whether or not there are any EPS growth declines that are -50% or deeper. If there are, then an earnings-based analysis will likely not be very useful. During this history, Merck has had periods of stagnation and one year with a -19% EPS decline, but nothing close to a -50% decline. So, given the normal pharma-business caveats I noted earlier in the article, it’s reasonable to use Merck’s earnings history to roughly value the stock.

Next, I need to select the historical time frame I want to use in order to estimate the earnings growth rate going forward. In my previous article, I used a time from 2015 to 2021. This time I will extend that time frame from 2015 to 2023’s expected earnings. Since, as we will see in a moment, earnings are expected to decline in 2023, using 2023’s earnings expectations will make the valuation a little more conservative. Because I’m going to use EPS in order to estimate earnings, I also check for any share buybacks that occurred over this period, because those will inflate the EPS growth rate by lowering the share count. (A rising share count, however, will already be incorporated in the EPS figure, so I won’t make adjustments if the share count has risen.)

Merck has reduced its share count by about 11% during this time period. I will make adjustments for those buybacks when estimating the earnings growth rate.

Above, I have another FAST Graph from the time period 2015 through 2023. I have annotated it with the data I will use for my 10-year collected earnings projections. Note that I am pulling forward 2023’s expected EPS rate of $6.88 per share, which, at the current price translates to a P/E ratio of about 15.94, an earnings yield of +6.28%. The earnings growth rate from 2015 through 2023, has been about +7.45% if we take into account the negative growth year expected this year and the buybacks they’ve made. (This is more conservative than FAST Graph’s calculation of +10.42% EPS growth which does not account for those things.)

The way I think about this is if I bought Merck’s whole business for $100, it would earn $6.74 the first year ($6.28 plus 7.45% growth), and that $6.74 would grow at a rate of +7.45% each year, for 10 years total.

Below is a table that shows the expected cumulative collected earnings on $100 over 10 years.

Year	Earnings for Year	Cumulative Earnings
1	$6.74	$6.74
2	$7.24	$13.99
3	$7.78	$21.77
4	$8.36	$30.14
5	$8.99	$39.12
6	$9.66	$48.78
7	$10.38	$59.16
8	$11.15	$70.31
9	$11.98	$82.29
10	$12.87	$95.16
Total	$95.16	$100 + $95.16 = $195.16

Click to enlarge

So, if you bought Merck at the current valuation for $100 and collected all the earnings for yourself you would have started with $100 and ended 10 years later with $195.16. This is a compound annual growth rate of about +6.92%.

Next, what I will do is take that long-term average earnings CAGR of +6.92% and figure out what that works out to after four years’ time, since our goal is to estimate the returns over that time period. When I do that, it works out to a basic total return of +30.66%. So, over the next four years, if we disregard market sentiment and assume it stays the same, treating MRK more like a private business, we could expect our total return in collected earnings after four years to be valued at about +30.66% if we assume the earnings trend will continue for 10-years total.

This return is the absolute return expectation if we assume that market sentiment for the stock is similar to what it is right now. But I think it’s also worth comparing this expected 4-year total return to alternative investments. The two alternatives I will compare it to are the SPDR S&P 500 Trust ETF and the iShares Treasury Floating Rate Bond ETF (TFLO), which is what I’m currently using as my cash equivalent for investment money. The reason we compare to alternatives is to see if there are better simple alternatives that don’t require a lot of skill to analyze, which basically anyone could own instead of the individual stock.

Using a similar method that I used with MRK’s earnings, I also track about half of the S&P 500 (SP500) stocks using this method, which represents about 2/3rds of the S&P 500 weighting. If I use that group of stocks to estimate their 4-year expected returns, I get an absolute expected total return for the index of +27.48%. And, I generally expect TFLO, or short-term treasuries, to yield about 4% per year over this time, or to produce a 17.00% total return in four years. Let’s see what sort of return MRK is likely to produce compared to these alternatives given these estimates.

4-Year No Mean Reversion	4-year total return expectation	4-year return expectation minus SPY’s +27.48%	4-year return expectation minus TFLO +17.00%
MRK	+30.66%	+3.18%	+13.66%

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Overall, if sentiment remains the same for MRK and the wider market, MRK should be expected to return similar returns as the wider market (30.66% vs. +27.48%).

It’s always good to start with steady sentiment as a base for a valuation, but I’ve found that over the longer-term (and four years is starting to get into the “longer term”) stock earnings valuations tend to revert toward a mean of about a +7.00% 10-year earnings CAGR. (For a stock with the same earnings growth expectations as MRK of +7.45%, we would expect an average P/E ratio of about 15.69 to be the “normal” P/E the market would be likely to pay.)

In order for MRK’s expected +6.92% 10-year CAGR expectation to get up to a 7.00% 10-year CAGR and a P/E of 15.69, the stock price needs to come down a little because the price one pays for a stock has an inverse relationship to future returns. For this reason, my preferred way to estimate future total returns once we get out to four years is one that includes this generic 7.00% CAGR mean reversion expectation. So, next, I will examine what would happen to the stock price if the P/E reverted from its current 15.94 level, to a slightly lower 15.69 level over the course of four years.

With a Generic 7% 10-year Mean Reversion Assumption	4-year total return expectation	4-year return expectation minus SPY’s +13.62%	4-year return expectation minus TFLO’s +17.00%
MRK	+28.45%	+14.84%	+11.45%

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For comparison, if the S&P 500 index were to revert to a 7.00% CAGR expectation over four years it would produce a +13.62% total return based on my estimates. TFLO’s returns would be expected to remain about the same as before with a +17% return. If MRK’s business earnings produce an average return valuation by the market, it is likely to return about +28.45% over the next four years on a total return basis. This is +14.84% (or +1,484 basis points) of difference between the S&P 500’s +13.62% expected 4-year return. That’s not much of a difference over 4 years, but there also isn’t much of a difference compared to TFLO with a +11.45% (or +1,145 basis point) spread.

This implies that over the medium term on a relative basis, MRK is probably fairly valued compared to the S&P 500 and also fairly valued compared to the likely returns from a cash equivalent.

Ratings & Explanations

Assuming my estimates are reasonably close, there are several ways to interpret these results. The things we don’t know, even if the earnings return estimates end up being fairly accurate, are what sort of mood the market will be in and how the wider economic conditions might influence the returns in four years. If we are in a deep recession at that particular time, then we would naturally expect the earnings to be lower, while if we are in some sort of economic boom, we would expect them to be higher. So, using relative returns is a way to somewhat control for macroeconomics. If we are in a recession, then it’s likely SPY will perform poorly as well, so the difference between those returns is what we care about if we want to control for macro conditions.

Using mean reversion, on the other hand, helps to account for how people feel about certain stocks at certain times and what sort of returns investors are willing to accept. In this case, MRK and SPY have similar valuations, so there isn’t a lot of difference between the two.

Different investors might have different assumptions and expectations about sentiment and macro conditions will be, so that’s why I also provided the expectation without assuming mean reversion. That said, I do generally assume that after a period of four years, the chances are good that mean reversion will take place for most stocks, so, personally, I care about the mean reversion estimates the most. Additionally, I aim for a 4-year mean reversion expected return that is about 75% before I buy a stock based on earnings valuations. If I write about a stock (and earnings are not expected to drop because of a near-term recession) and it has a 75% 4-year return expectation, I will buy it, and those stocks will earn a “Strong Buy” rating from me.

Because I know I’m aiming for higher returns than many other market participants, I will rate stocks a “Buy” if the 4-year mean reversion total returns are 25% (2,500 basis points) higher than both SPY and TFLO, because these will likely be above market average returns and above cash average returns.

If the 4-year mean reversion returns are within 25% (+/- 2,500 basis points) of SPY, then I would consider that stock a “Hold.” I don’t consider any of my estimates superbly precise. They are meant to work as a rough guide, where we can take action if they reach extremes. So, within this range, I don’t have a strong opinion about the stock one way or the other.

If the 4-year mean reversion returns are likely to underperform SPY or TFLO, i.e., cash, by -25% (-2,500 basis points) or more, then that stock would get a “Sell” rating from me.

And, finally, if a stock is likely to underperform both SPY and TFLO by more than -25% or (-2,500 basis points) over the course of 4 years then the stock would be a “Strong Sell.”

I use -25% as the threshold because it’s enough of a difference that a person could sell a stock, pay a full 20% long-term capital gains tax on the sale, and still come out ahead. If a person is dealing with a bigger tax bill than 20%, then they should do the math and figure out what that level is and use that as a guide for their selling threshold.

At today’s price, Merck is expected to perform slightly better than SPY or TFLO over the next four years. But it’s entirely possible that this year’s earnings, post-COVID, come in a little worse than expected. One small disappointment there would probably put Merck’s valuation right in line with the S&P 500. Ultimately, Merck stock does not cross my +25% threshold to become a “Buy,” and I rate Merck a “Hold” at today’s price with the expectation it will perform similarly to both cash and the S&P 500 over the next 4 years.

Please read the next section if you want to like learn more about my valuation experiment and how I will measure the results of my predictions over the next four years. If you aren’t interested in that information, skip to the conclusion where I summarize my expectations and share the price at which MRK would become a “Buy,” “Strong Buy,” or “Sell” for me.

Measuring The Results of This Valuation Experiment

Writing about investing and the stock market can be useful to readers in several different ways. Articles can share strategies, discuss investing philosophy, analyze businesses and their prospects. Articles can also make predictions about future stock prices, conduct experiments, and share valuation techniques. With such a wide scope of possibilities there is a lot that could be covered within any given investing universe. Typically, my preferred approach is to focus on a given individual stock rather than the macro with my articles because I am committed to primarily sharing articles and ideas that are clearly actionable for readers. One reason I do this is so the outcomes can be measured. I tend to avoid telling stories in my articles, which can sometimes make them less compelling for readers unless I offer something more valuable than a story (like the prospect of above average returns). My goal is to offer actionable stock analysis that produces market-beating returns in the aggregate.

This creates a variety of difficulties, but I’ve noticed several of them which have been occurring with more frequency with my articles. Perhaps the most common, are investors who aren’t focused on achieving above average total returns. At the portfolio level I generally aim for 15% annual returns over the long-term. My estimate is right now the S&P 500 will likely deliver less than half that rate of return over the next 5-10 years. So, there is a big gap between my goals and where I estimate the current valuation of the market is at. One way to think about this is I aim for a 400% 10-year return while the market is likely to only produce a 100% 10-year return from today going forward. This means I either need to buy stocks when they are very cheap relative to current earnings, or I need to buy stocks that will grow faster than expected for longer (thereby being very cheap, too, just in a different way).

There is a large space between market average 10-year returns of 100% and my goal of 400% where investors could successfully buy stocks at higher prices than I am willing to pay and still outperform the market. Historically, I have only written “Buy” articles when I actually purchased a stock myself. That was a way for me to “eat my own cooking”, so to speak. But because I aim for very high returns, it meant my “buy prices” were much lower than other investors would be happy with, and when an investor aims for low prices, they get fewer opportunities to buy. I actively monitor hundreds of stocks in my marketplace service, The Cyclical Investor’s Club, so it’s rare that an easy opportunity to buy a high quality stock at a cheap price slips past me unnoticed. But there are investors who don’t have a stock monitoring system like I do, so they are going to be more likely to miss opportunities, and that means they need to be willing to pay higher prices in order to get enough opportunities for their portfolio unless they are super concentrated (which I don’t recommend for most investors).

So, with this article series, I have created a new category of stock “Buys,” that I expect to outperform the S&P 500 by 2,500 basis points at some point during the next four years. So if the S&P 500 returns 10% over a given time period, I expect the buy-rated stock will return 35% or better. Or, if compared to cash, if cash returns 15%, then I would expect the buy-rated stock will return 40%. “Buy” rated stocks should outperform SPY or Cash by 2,500 basis in order to be considered a successful rating. Importantly, that spread can happen at any time during the 4-year period. Because if that spread opens up, a person could then rotate back into the index or cash if they chose and be 25% better off than before. The investment would have met it’s medium-term goal based on the valuation.

In order for my “Strong Buys” to be considered successful we will want them to return 75% at some point over four years or to outperform the S&P 500 index and Cash over four years.

Having two categories of “Buys” will create some room in my analysis for stocks that are likely to outperform the market, but are not as likely to produce the really big returns I’m looking for myself.

My plan is to track the success or failure of my stock ratings and 4-year total return estimates each quarter. Over time, I expect I’ll have at least an 80% success rate for each category of rating using the standards I described above. This means that there will be some stocks that don’t do as I expect. But I won’t know which ones will fail ahead of time, which is why when it comes to my personal portfolio I use an equal-weighted unconcentrated approach when it comes to starting initial positions, and I usually weight each position 1%. If a person has a really concentrated portfolio of less than 30 stocks, they will need to do deeper work on each business before trying to implement a numbers-based strategy like mine. I make up for lack of deep work by working quickly and monitoring a very large number of potential positions, sometimes being overly conservative, and then playing the odds. Sometimes this means I’ll miss a big winner because I’m too cautious and don’t understand something that makes that businesses special, and sometimes I buy a big loser because I don’t understand a danger that doesn’t show up in my preferred metrics. That’s okay. I usually have four out of five positions produce positive returns over four years, and many of my winners are big winners. This is how I make up for my lack of deep, time-consuming work on an individual business. So, I will be tracking to see what percentage of stocks meet my expectations and what percentage do not over time.

The ultimate goal is to provide useful data to readers whether I achieve my goals or not.

Conclusion

To sum up, the price thresholds for my Merck & Co., Inc. stock ratings, assuming earnings are similar to what analysts expect this year, show that Merck stock is currently a “Hold.” If Merck rose above $157, it would become a “Sell.” If Merck fell below $98, it would become a “Buy” and likely outperform the market. And if Merck fell below about $79, it would become a “Strong Buy” again, and likely produce superior returns with a margin of safety.

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Disclosure: I/we have a beneficial long position in the shares of MRK, TFLO either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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