Valuation – Expected Return

Merck has traded at an average price-to-earnings ratio of 12.6 over the last decade. However, this period includes many years of stagnation and hence we believe that the stock deserves a higher earnings multiple. Given the exciting growth potential of Keytruda, we assume a fair price-to-earnings ratio of 15.0 for the stock. Merck is currently trading at a price-to-earnings ratio of 14.1. If the stock trades at our assumed fair valuation level in five years from now, it will enjoy a 1.2% annualized boost in its returns thanks to the expansion of its price-to-earnings ratio.

Given also its 3.1% dividend yield and its 5.0% average annual earnings-per-share growth, Merck can offer a 9.0% average annual return over the next five years. This an attractive expected return, particularly given the fact that the broad market is trading at an all-time high, with most stocks appearing fully valued right now.

Final thoughts

Merck has returned to growth mode in the last four years. It also has exciting growth prospects ahead, primarily thanks to the expanding use of Keytruda. Given also the reasonable valuation of Merck and its 3% dividend yield, the stock could offer a 9.0% average annual total return over the next five years. This is an attractive expected return, particularly given the fully valued status of the broad market.