The Business Of

Healthcare | CVS Health | Valuation Special

Morning All!

TGIF! The weekend is so close! But before we get there, we’ve got one final newsletter to round off The Business Of CVS Health. Let’s have a quick recap of some of the fun, surprising things we’ve learnt about CVS Health this week…

• Boots - the largest pharmacy chain in the UK - Boots - is actually owned by CVS Health’s biggest pharmacy competitor - Walgreens!

• Lower Than Tesco - of all the companies we’ve covered on TBO that make a profit, CVS Health has the lowest EBIT margin. Even lower than Tesco’s 4%!

• Huge Scale - through the company’s acquisitions of Caremark and Aetna, CVS have become a large, vertically integrated player. Some would say too large!

But anyway, we’re going to shift gears today. And we’re going to be discussing valuations! We hear of certain companies making billions in revenue. We hear about companies like Apple being worth trillions of dollars. Well today, we’re going to spend a bit of time unpacking how valuations actually work. So, without further ado, let’s get stuck in! But first…

Career Talk

That’s right! It’s the next edition of our Career Talk newsletters. We’ve kept it a little under wraps this week. But it’s an absolute cracker - like honestly, a cracker!

This week we’re exploring Currency Trading with Ahmed Mahar. After graduating from the University of Hull in 2011, Ahmed worked his way up the currency trading team @ JPMorgan Asset Management. Eventually becoming the Executive Director of the team! However, after 11 years at the firm, Ahmed decided it was time for a move. And he’s now the Head of Finance and Ops @ The Diary of a CEO!

I’ll be chatting to Ahmed about;

• how he got into his role at JPMorgan Asset Management,

• what currency traders actually do (?!),

• what advice he’d give students wanting to get into asset management/trading,

• why he made the exit from finance to startup!

It really isn’t one to miss! Especially for anyone who’s interested in asset management and The Diary of a CEO! That email’s going out in a few hours. But for now, let’s get back to CVS and valuations!

Revenues Don’t Tell Us Anywhere Near Enough!

So, to start off, let’s remind ourselves why we’re doing this. Well, this week we’ve seen that CVS Health make a ton of money. A ginormous $322bn worth of revenues in 2022. And to put into context just how big that is, I used the comparison with Microsoft who made $198bn in revenues in 2022. So, CVS Health made ~1.6x more revenue than Bill Gates’s creation.

But as we alluded to yesterday, there’s something odd here. Because despite CVS Health making ~1.6x more revenue than Microsoft. Microsoft is valued ~28x more! The tech company is worth $2.55 trillion vs CVS Health’s $89bn. Which makes Microsoft the 2nd largest company in the world! Whilst CVS Health are only 160th in the world when it comes to market value. So, why is this?

Well, keen TBO readers will know that we can’t just be looking at revenues! Revenues don’t tell us anywhere near enough of a company’s story. We need to look at EBIT (operating profit). And maybe Microsoft’s EBIT is ~28x higher than CVS Health’s? That would explain the 28x value!

But as we can see below… that isn’t the case! Microsoft’s huge EBIT margin of 42% gives them a massive EBIT of $83bn. But it’s still only ~11x higher than CVS Health’s EBIT figure of $7.7bn!

So, there’s STILL something odd here. Microsoft’s EBIT is ~11x higher than CVS’s. But their market value is ~28x higher. Surely if a company has 11x higher profits than another, then that company should be worth 11x more? Right? Well, not quite! And let’s find out why!

Missing: A Profit Multiple!

Okay, so let’s clear up the confusion. What we’re missing here is a multiple. Let’s compare Microsoft and CVS Health’s market values (market caps) to their EBIT figures. Which will create a Market Cap/EBIT multiple or ratio - which I’ve kind of made up! The ‘correct’ ratios to use are either EV/EBIT or Market Cap/Net Income (P/E). But’s let’s have a look at what my made up multiple is for both companies!

And what we can see is that Microsoft is being valued by the stock market at ~31x their EBIT. $2.55 trillion (Microsoft’s market cap) divided by $83bn (Microsoft’s EBIT) = ~31. Whilst CVS is only being valued at ~12x their EBIT! $89bn (CVS’s market cap) divided by $7.7bn (CVS’s EBIT) = ~12.

But why is there this difference? Why don’t investors just value them on the same EBIT multiple? Well, to understand this, we need to briefly touch on what the multiple actually represents!

It’s All About FUTURE Cash Flows… And The Growth Of Those Cash Flows!

Okay, so very last thing for the week! And I’m going to keep it short and simple. Because the topic of valuation could take up a whole 3-week series on TBO! And the first question to ask ourselves is - what is the value of a company?

Well, as the image above kind of indicates, it’s the sum of a company’s future cash flows. The crucial word here is future. And the reason that’s crucial is because it means we can’t just look at Microsoft’s EBIT ($83bn) and CVS Health’s ($7.7bn). When trying to measure how valuable they are. Because those figures are in the past!

And this is where the earnings multiple comes into play. The earnings multiples (my own above, P/E, EV/EBITDA) give us an idea of what investors are expecting for future cash flows. When that multiple is high, it means investors are expecting a lot of growth in that company’s profits. Let’s look at an extreme example to help our understanding. And it’s a hot company at the moment - Nvidia!

So, Nvidia’s market cap is $1.03 trillion. The company’s 2022 EBIT was ~$10bn. So, what’s the Market Cap/EBIT multiple here? A whopping ~100x! And why’s this so high? Because investors believe that Nvidia’s profits and cash flows are going to grow massively in the future!

Let’s look at it this way. If you had a supermarket company that had $10bn EBIT and is expected to grow profits at 3% a year. And you had Nvidia that has $10bn EBIT and is expected to grow profits at 40% a year. Which company would be more valuable? Nvidia surely - they’d have higher future cash flows! And that would mean valuing their $10bn EBIT on a higher multiple!

So let’s wrap up by going back to Microsoft and CVS Health. The main reason Microsoft’s multiple (~31x) is 2.6x higher than CVS Health’s (~12x). Is because investors believe Microsoft will be able to grow their profits and cash flow at a faster rate than CVS in the future. Now, these multiples change often over time. And vary a lot across industries. And unfortunately we don’t have time to go into all of that now - maybe another newsletter soon!

But I hope we’re all aware now why Microsoft is CURRENTLY valued ~28x more than CVS despite having less revenues! It makes ~11x more profit and is valued on a ~2.6x higher multiple. What’s 11 x 2.6? ~28! Magic!

7th Jul 2023

Nigel Jacob CFA