Morningstar Advisor - April/May 2009 - (Page 63) make sure we are not missing anything. Sum-of-the-parts analysis is helpful for the large, diverse firms that have many divisions. This analysis not only helps us confirm our discounted-cash-flow analysis, but also sheds light on the primary value drivers within complex companies like Abbott Laboratories. Additionally, we perform relative valuation analysis across the pharmaceutical industry with several metrics, including price/earnings, enterprise value/EBITDA, and others. The comparable analysis yields a gut check to determine how each company in the pharmaceutical industry stacks up to one another. Beyond using different valuation techniques, we also stress test our sales assumptions for new drugs. We run bear and bull cases for any critical new drug, which helps segment a range of valuation outcomes based on different scenarios for an important drug. For most major pharmaceutical firms, the range in valuation based on one drug usually can change the valuation by up to 5% to 8%. The range helps determine the degree of uncertainty surrounding the fair value estimate. HK: Would you recommend buying a basket of Big Pharma stocks—through an ETF, for example—or cherry-picking a few names? DC: Picking a couple select drug companies should offer investors better rewards than an ETF. For the most part, a Big Pharma stock will likely perform in line with a pharmaceutical ETF, especially stocks like Johnson & Johnson and Pfizer. Because Big Pharma offers such a wide portfolio of drugs, stock prices tend to move in tandem with each other. However, the extra reward offered by picking a few select names should offset the risk of less diversification than provided by an ETF. The current valuations of certain pharmaceutical firms like Novartis make this particularly true. They offer strong risk-adjusted return potential. K Haywood Kelly, CFA, is vice president of equity research at Morningstar. Chris Davis Bill Gross Bob Rodriguez John Bogle Don Phillips Strong Voices. Smart Conversations. Morningstar Investment Conference May 27–29, 2009 McCormick Place, Chicago Register Today! Gain the investing insight you need in this economy. Conference registration includes access to all conference sessions and the exhibit hall; 2 continental breakfasts, 2 lunches, and 2 cocktail receptions; and an opportunity to earn CE credits. Online: MorningstarAdvisor.com/2009conference Phone: 866 839-9729 MorningstarAdvisor.com 63 http://www.MorningstarAdvisor.com/2009conference http://www.MorningstarAdvisor.com/2009conference http://www.MorningstarAdvisor.com
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