Mitigating patent expiration impact
When patents have expired in the last decade, big pharma companies have had to make various changes to their business models. Companies now work continuously on new drug development to ensure consistent cash flow and minimal effect of patent expiration.
While overall industry trends impact big pharma to an extent, there are other considerations that determine valuation for these companies:
- existing patent rights
- research pipeline and drugs in development
- mergers and acquisitions executed or in the pipeline
The above chart shows the trend in forward EV/EBIDTA multiples (enterprise value to earnings before interest, depreciation, taxes, and amortization) for big pharma stocks over five years.
How valuation works
The price-to-earnings multiple is one of the simplest multiples used for valuations. Put simply, it represents the price of a stock per unit earning per share—that is, the price an investor pays to earn unit return. Forward PE is the estimated of PE multiple for the next twelve months. The PE ratio for global big pharma increased from 14.9x in 2011 to 26x in 2014. This trend is a measure of increasing investor confidence.
Free cash flow yield
To calculate free cash flow yield, you divide free cash flow by market capitalization. Generally, the lower the ratio, the less attractive the investment. The free cash flow yield for global big pharma fell from 7.5x in 2011 to 4.6x in 2014. This was caused by increased R&D (research and development) costs and reduced profit margins due to the patent expiry of a few major drugs.
To calculate PE-to-growth, or PEG, ratio, you divide the PE multiple by the growth of an industry during a given period. For global big pharma, the PEG ratio rose from 1.5x in 2011 to 2.6x in 2014.
Johnson & Johnson (JNJ), Merck (MRK), Pfizer (PFE), and Bristol-Myers Squibb (BMY) combined form 24.81% of the VanEck Vectors Pharmaceutical ETF (PPH). Another of the ETFs in this sector is the SPDR S&P Pharmaceuticals ETF (XPH).