Pfizer Equity Analysis and Valuation4288.

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Pfizer Equity Analysis and Valuation

Valuation Date: April 1, 2005

Rusty Klein [email protected] Justin Kime [email protected] Rene Jimenez [email protected] Todd Johnson [email protected]

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Pfizer Equity Analysis & Valuation Table of Contents

Executive Summary...2

Business and Industry Analysis...7

Industry Overview...7

Five Forces Model...8

Key Success Factors..10

Firm & Industry Conclusions11

Accounting Analysis13

Key Accounting Policies...13

Degree of Flexibility..............................16

Actual Accounting Strategy...17

Quality of Disclosure.19

Ratio Analysis & Forecast Financials25

Financial Ratio Analysis25

Financial Statement Forecasts37

Valuation Analysis...39

Cost of Capital...39

Intrinsic Valuation Methods..41

Method of Comparables46

Appendix..49

References71

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Mo MoneyRusty KleinJustin KimeRene JimenezTodd Johnson

Pfizer, Inc.

Investment Recommendation Under-Valued Date of Valuation 4/1/2005

PFE - NYSE (4/13/2005) $27.28 EPS Forecast52 week price range $21.99 - 37.90 FYE 12/31 2004(A) 2005(E) 2006(E) 2007(E)Revenue(2004 $52.5B EPS $1.87 $1.70 $1.93 $2.09Market Capitalization $203.53B

IndustryShares Outstanding 7.46B Valuation Ratio Comparison Pfizer Average

Trailing P/E 31.30 20.90Dividend Yield 2.80% Forward P/E 16.40 20.233-Month Avg. Daily Trading Volume 28.65M Forward PEG 1.08 1.82Percent Institutional Ownership 65% M/B 2.66 3.85

D/E 4.00 0.57

Book Value Per Share (mrq) $9.37 Valuation Estimates

ROE(2004) 17% Actual Current Price (4/1/2005) 26.15$ ROA(2004) 9%Est. 5 year EPS growth rate 12% Ratio Based Valuations

Trailing P/E 39.08$ Cost of Capital Estimations R Squared Beta Ke Forward P/E 37.84$

Forward PEG 21.84$ 5-Year Regression 0.132 0.458 4.58% D/E 44.98$ 3-Year Regression 0.234 0.595 4.99% M/B 35.58$ 2-Year Regression 0.061 0.436 4.52% Ford Epic Valuation 62.16$ Published 0.393

Intrinsic ValuationsKd 3.45% Discounted Dividends 35.58$ WACC(bt) 4.07% Free Cash Flows 58.27$

Residual Income 55.52$ Abnormal Earnings Growth 55.52$ Long-Run Residual Income Perpetuity 99.42$

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Mo MoneyRusty KleinJustin KimeRene JimenezTodd Johnson

Pfizer, Inc.

Investment Recommendation Under-Valued Date of Valuation 4/1/2005

PFE - NYSE (4/13/2005) $27.28 EPS Forecast52 week price range $21.99 - 37.90 FYE 12/31 2004(A) 2005(E) 2006(E) 2007(E)Revenue(2004 $52.5B EPS $1.87 $1.70 $1.93 $2.09Market Capitalization $203.53B

IndustryShares Outstanding 7.46B Valuation Ratio Comparison Pfizer Average

Trailing P/E 31.30 20.90Dividend Yield 2.80% Forward P/E 16.40 20.233-Month Avg. Daily Trading Volume 28.65M Forward PEG 1.08 1.82Percent Institutional Ownership 65% M/B 2.66 3.85

D/E 4.00 0.57

Book Value Per Share (mrq) $9.37 Valuation Estimates

ROE(2004) 17% Actual Current Price (4/1/2005) 26.15$ ROA(2004) 9%Est. 5 year EPS growth rate 12% Ratio Based Valuations

Trailing P/E 39.08$ Cost of Capital Estimations R Squared Beta Ke Forward P/E 37.84$

Forward PEG 21.84$ 5-Year Regression 0.132 0.458 4.58% D/E 44.98$ 3-Year Regression 0.234 0.595 4.99% M/B 35.58$ 2-Year Regression 0.061 0.436 4.52% Ford Epic Valuation 62.16$ Published 0.393

Intrinsic ValuationsKd 3.45% Discounted Dividends 35.58$ WACC(bt) 4.07% Free Cash Flows 58.27$

Residual Income 55.52$ Abnormal Earnings Growth 55.52$ Long-Run Residual Income Perpetuity 99.42$

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Executive Summary

Recommendation Undervalued Security

fter thorough forecasting and evaluations, we have recommended to

investors to buy market shares of Pfizer due to their continual

growth of price share with no signs of decreasing. With the recent

acquisition of Pharmacia, Pfizer has continued to maintain their dominant position in the

pharmaceutical industry.

A Even though many companies are in the pharmaceutical industry, competition is

limited to the handful of major drug manufacturers. Pfizer has now grown to be the top

pharmaceutical company in the United States and one of the top 10 in the world with

$52.5 billion in revenues in 2004.

Industry Demand Drivers

With new drug innovations serving as the driving force in the industry, companies

are forced to allocate larger amounts of capital each year to research and development. In

2004 Pfizer invested $7.7 billion on research and development which was almost twice

the amount of its nearest competitor, Novartis. Realizing this necessity of discovering

the next big drug, Pfizer plans to further increase R&D spending to over $8 billion in

2005.

One of the largest threats to any drug company, including Pfizer, is the

competition imposed by generic drug companies after patents have expired on highly

profitable prescription drugs, such as Viagra.

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Pfizers Industry Standing

Pfizers main competitors are Abbot Laboratories, Bristol-Meyers Squibb,

Novartis, and Merck. Pfizer expects to sustain long-term growth driven by innovative

products, strong research and development pipeline and operating efficiencies. Pfizer has

grown to be the industry leader, but doesnt settle for simply being the best. They are

constantly seeking to improve, and making the necessary changes to become more

effective, in order to further separate themselves from the competition. For example,

Pfizer is targeting $4 billion in total annualized cost savings by 2008, representing the

other 12% of their total current cost base. Pfizer continually strives to be the leader in the

innovation of new pharmaceutical products, such as the completion of 13 new drug

applications resulting in 20 filings with the FDA in the next five years.

Margin Expansion

In the pharmaceutical industry, mergers and acquisitions are increasing in

popularity as a means to capture a greater percentage of the market share. Evidence of

this trend is Pfizers acquisition of Warner-Lambert in 2001 and Pharmacia in 2003.

Another margin expansion method used by our company is competing in more than one

market such as: pharmaceuticals, consumer health, and animal health. The use of

modern technology, the internet, is yet another way to capture market share.

Financials

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The financials for Pfizer the last few years have fluctuated dramatically, due to

the acquisition of Pharmacia, in 2003. This proves to be true in the results of operating

income dropping from $9.1 billion in 2002 to $1.6 billion in 2003. Pfizer had shown a

relatively constant growth since initially going public until the Pharmacia acquisition, the

post acquisition years and the forecasts show continual growth in years to come. The

forecasted earning per share also confirms our expectations of Pfizers future growth.

Valuations

Based upon our valuations, Pfizers stock price is currently undervalued. Using

the three intrinsic valuation methods that we feel most confident in; free cash flows,

residual income, and abnormal earnings growth we arrived at the conclusion that the

stocks should be valued at a price in the vicinity of $50. Also, all five intrinsic valuations

used showed that the current stock price of $26.15 is lower than it should be, which only

increases our confidence that Pfizers stock price is undervalued.

Risks

The first mover advantage is huge in the pharmaceutical industry. The company

to first discover and patent a breakthrough drug will be the only company selling a drug

of that type for the next 8-10 years. While that company is raking in the cash, the other

companies in the industry can only sit idly by and wait for the patent to expire. The risk

in this situation comes from not being the first mover on one of these breakthrough drugs.

Legal risk also plays a very large role for companies such as Pfizer. If a drug is sent to

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market and side effects become apparent, legal fees and settlement costs can cost a

company millions of dollars.

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Business & Industry Analysis

fizer Inc. is a research-based, global pharmaceutical company that

discovers, develops, manufactures, and markets prescription medicines

for humans and animals, as well as consumer healthcare products.

Pfizer, whose corporate headquarters are located in New York, NY, got its start in 1862

by producing antacids. Pfizer has now grown to be the top pharmaceutical in the United

States and one of the top 10 in the world. In 2004 Pfizer had revenues of 52.5 billion and

spent 7.7 billion on Research and Development.

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Industry Overview

The pharmaceutical industry covers a broad base of segments that allows

companies to specialize and create a competitive advantage. The US has the largest

market share with five of the top ten Drug Companies in the world. Europe has the

second largest market share and the other five top ten companies. Internet pharmacies,

along with Canadian drug suppliers continue to increase competition in an already highly

competitive market. Generic Drug Manufacturers also diversify the industry by

providing lower cost drugs than the big name pharmaceutical companies. Patents which

do not last forever can create a temporary monopoly for a company that develops a new

drug. Regulation by the FDA and lawsuits also increase costs and draw out the process

of bringing a drug to market.

Trends

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As research and development costs continue to sky rocket pharmaceutical

companies tend to focus on products for chronic rather than acute diseases with large

patient populations such as cancer, arthritis, and cardiovascular conditions. The potential

benefit of pooling research and development has lead to large mergers such as Pfizer with

Pharmacia along with Glaxo Wellcome with SmithKline Beecham. Drug manufactures

are continuing to make their drugs available online which helps them further penetrate

the market and keep up with technology. Advertising decreases the drug companies

reliance on physicians and further educates the general population on new and innovative

drugs.

Five Forces

Current Competitors

Even though many companies are in the pharmaceutical industry competition is

limited to the handful of major drug manufacturers. Leaders in market capitalization

include companies such as Pfizer Inc, Johnson & Johnson, Glaxo SmithKline, and Merck

Co. Generic drugs are one of the most prevalent sources of competition for the major

drug companies. Companies providing consumers with low cost generic drugs take away

profitability from the major players in the industry. First mover advantage is huge in the

industry because of the protection offered by a patent.

New Entrants

The threat of new competitors in the pharmaceutical industry is relatively low

because of the amount of capital needed along with the high cost of research and

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development. Smaller firms attempting to enter the industry are often bought out by the

huge drug companies trying to protect themselves from competition. FDA regulations

and the threat of lawsuits discourage potential firms from entering the market.

Substitute Products

There is a high volume of substitute products between the leaders in the industry.

Competitive pricing and product marketing are essential factors that determine who leads

in a particular sector. Generic companies pose the largest threat to the major companies

because of low cost which sways consumers from name brand drugs. The increasing

popularity of herbal remedies continues to threaten the profitability of the large

companies.

Customer Bargaining Power

The bargaining power of buyers is low since products are differentiated and made

to meet specific consumer needs. Generic drugs are often unavailable to consumers for a

period of time because of patent restrictions. These patent restrictions allow the

developing company to dictate prices until the patent expires.

Supplier Bargaining Power

Suppliers are limited in their bargaining leverage due to the pharmaceutical

companies ability to dictate what products are to be made. Another way that companies

keep supplier bargaining power low is by easily being able to find an alternate supplier.

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Classification of Industry

Pfizer operates in the three particular segments of the pharmaceutical industry.

They separate themselves from competition by producing pharmaceutical, consumer

health care, and animal health products.

Key Success Factors

Global research and development have helped Pfizer maintain a competitive

advantage in the major drug industry. Also contributing to Pfizers advantage is

operating worldwide with a multi-domestic strategy. Pfizer further set itself apart from

competition by merging with Pharmacia in 2003. Because of these advantages Pfizer was

able to generate 52.5 billion dollars in revenue for 2004.

Drug companies focus on the baby boomer generation because people over the

age of 65 consume three times as many drugs as younger populations. Pfizer continues to

cater to its customers by offering its drugs online and accepting discount cards. In

addition to providing drugs online Pfizer distributes its drugs with various vendors and

wholesalers.

Pfizer is lead by CEO Henry McKinnell and a board of directors with 16

members. Also managing Pfizer is CFO, Alan Levin. Management focus is concentrated

on maintaining performance while creating an inclusive environment.

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Pfizer operates research and development facilities in a several US states as well

as England, Japan, and France. Its consumer health care branch is based out of New

Jersey. With facilities strategically located around the globe Pfizer is able to stay

competitive in the market.

Pfizer is prone to several risks. One of the principal concerns is lawsuits

stemming from side affects caused by medication. Merck, one of Pfizers largest rivals,

is constantly being investigated on its popular painkiller, Vioxx. This will cost Merck

millions of dollars and take focus away from innovating and developing new drugs.

Another risk Pfizer has to be aware of is time. With companies in a race to develop the

cure for certain diseases such as cancer and diabetes anybody who isnt on pace with the

industry could be left out and lose a huge portion of their market share. Patents also

correspond to the time risk involved in pharmaceuticals. A patent lasts for 20 years but

with the numerous FDA regulations and testing involved, a drug could be eight to ten

years into the patent by the time it is ready to distribute. This cuts back on the length of

time the company is able to exclusively produce the drug.

Firm & Industry Conclusions

Pfizer is able to maintain its position as a market leader in the pharmaceutical industry by

exploiting its competitive advantage, key success factors, and by being diversified within

the industry. Pfizers size plays to its advantage by creating the ability to invest huge

quantities of money in research and development.

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With the threat of substitute products extremely high coupled with the huge cost

of research and development the industry is highly competitive. Companies must keep

up with competition and produce and vital innovative drugs to be successful. Low

bargaining power of suppliers and customers and low power of shareholders plays in

favor of the drug companies. As the world population becomes increasingly dependant

on pharmaceutical products the industry will continue to grow and stay competitive as

companies seek to generate the next wonder drug.

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Accounting Analysis

o properly evaluate the performance of Pfizer it is necessary to

evaluate certain qualitative and quantitative measures. After

evaluating Pfizers financial statements it is apparent that Pfizer is

transparent and discloses all relevant information that is pertinent to investors and

regulators.

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Key Accounting Policies

Pfizer competes on a strategy that is designed to differentiate itself from

competitors, but also competes on cost leadership once a patent expires and they no

longer exclusively control production rights for that drug. It is necessary to identify key

accounting policies that are used in operation and in material disclosure in financial

statements. The more significant accounting policies are outlined below.

Consolidation and Basis of Presentation

The consolidated financial statements include Pfizers parents company along

with all subsidiaries operated in the US and internationally. Financial information

included for companies operated internationally is included as of November 30th of each

year. Also, all remitted earnings of international subsidiaries are free of legal and

contractual restrictions.

On April 16, 2003 Pfizer purchases Pharmacia Corporation in a stock for stock

transaction which was accounted for using the purchase method of accounting. Assets

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acquired and liabilities assumed as a result of the transaction are included in the

consolidated financials. Also included in the consolidated financial statements ending

December 31, 2003 are the results of seven months of international operations along with

the results of eight months of US operations of the former company, Pharmacia.

Business Acquisitions

Pfizer uses the purchase method of accounting when acquiring other businesses.

This requires the assets acquired and liabilities assumed to be stated at fair value by the

date of acquisition. The transaction costs and other related costs when acquiring another

company are allocated to the underlying assets of that company in proportion to the

related values. If purchase price is above the fair value of net assets, any difference is

recorded as goodwill.

Revenues

Pfizer revenue recognition policy records revenue when the products are shipped

and legal title is transferred to the customer. This type of policy prevents the

accumulation of unearned revenues.

Estimates and assumption are used in the process of preparing the financial

statements. These estimates include values used to account for sales discounts and

allowances, and incentives. The estimates used have the potential to affect the reported

numbers and quality of disclosure.

Pfizer helps co-promote other pharmaceutical companies products in exchange for

additional revenue. Pfizer earns revenue when the co-promotion partners ship the good

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and the title is passed to their customer. The revenue received from the alliance is

included in revenues and is based upon a percentage of the partners net sales. Expenses

related to the alliance are recorded in selling, informational, and administrative expenses.

Research and Development Expenses

Costs associates with Research and Development are expenses as they are

incurred. Pfizers own R&D costs as well as those of associated third parties are

included. Milestone payments received from third parties are expensed when the specific

milestone is achieved. Pfizer has no R&D arrangement that results in recognition of

revenue (Pfizer 10-K, 2003).

Inventories

Inventories are valued at the lower of the two either cost of fair value. Costs for

work in process and finished goods are determined by average actual cost. Cost for

supplies and raw materials are calculated at average or latest actual cost.

Long Lived Assets

Included under long lived assets are property, plant, and equipment, which are

recorded at original cost and then adjusted for any improvements made. Also recorded

under long lived assets are goodwill and other intangible assets such as deferred taxes and

deferred charges.

Stock Based Compensation

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Compensation of employees with the issuance of stock options is accounted for

using Accounting Principle Board(APB) Opinion No. 251, Accounting for Stock Issued to

Employees. This is in accordance with SFAS No. 123, Accounting for Stock Based

Compensation. The market price on the day the stock option is issued is the exercise

price of the option. The grants of stock options incur no related expenses. (Pfizer 2004

10-K)

Degree of Potential Accounting Flexibility

Pfizer has a moderate degree of flexibility when disclosing financial reports. One

of the key accounting policies Pfizer has relates to inventory. Pfizer determines the value

of work in process and finished goods inventory by average actual cost. This

conservatively states the value of inventory, as the market value of this inventory is

noticeably bigger than the stated value. Costs for supplies and raw materials is calculated

by average costs or latest actual costs which helps keep costs stable and helps prevent

large fluctuations in the cost level.

Estimates are used when calculating values that account for sales discounts and

allowances, as well as customer incentives. The values Pfizer uses to calculate these

values have the ability to distort the actual underlying reality of the company.

Pfizer is required by GAAP to record Research and Development expenditures as

an expense and not allowed to classify this as an asset. This limits the degree of

flexibility that the company has. Because Pfizer spends large quantities of money on

R&D which is a large part of the pharmaceutical industry this has a significant impact on

their bottom line.

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Actual Accounting Strategy

Pfizers accounting strategy and policies are conservative in nature and reflect the

underlying economic reality of the company. Pfizers policy is in accordance with

generally accepted accounting procedures as set forth by the Financial Accounting

Standards Board. GAAP is subject to choices and multiple methods of valuation. Pfizer

has chosen a policy that accurately reflects the situation of the company and does not

capitalize on the accounting flexibility offered by GAAP to manipulate its financial

statements to look more appealing to investors. Overall, Pfizer is conservative in nature

with its financials and discloses all pertinent information.

The pharmaceutical industry is dominated by large companies in the US and

Europe. Merck & Co. along with Bristol-Meyers Squibb are two of Pfizers competitors

in the US. Pfizer and Merck do a good job in disclosing financial information while

Bristol-Meyers is slightly more hesitant isnt as transparent as the other two companies.

The three companies accounting policies are similar in regard to the key accounting

policies such as revenue recognition, inventory, principles of consolidation, etc. with no

major differences. Bristol-Meyers is more aggressive in its accounting policies and

because of this has to restate its consolidated balance sheet at December 31, 2002. Also

restated were consolidated earnings, cash flows, comprehensive income, and retained

earnings for 2002, 2001, and its financial statements for the first three quarters of 2003.

Revenue Recognition

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Pfizer has adopted a revenue recognition policy that is simple and is in

accordance with GAAP. It records revenues when the products are shipped and title

passes to the customer. This method is the norm for the industry since there are no

alternative ways to record revenue under GAAP.

Research and Development

Research and Development is one of the key investments in the pharmaceutical

industry. In 2004 Pfizer spent 7.7 billion on R&D and brought in 52.5 billion in

revenues. Pfizer records Research and Development costs as expenses when they are

incurred. These costs also include related of costs of third parties. When milestone

agreements are made and Pfizer receives payments, these are expensed when the specific

milestone is achieved. Pfizer is conservative in regard to R&D in that they have no R&D

arrangements that result in recognition of revenue.

Business Acquisition

Pfizer uses the purchase method of accounting which states that the assets

acquired and liabilities assumed be recorded at their respective fair values on the date of

acquisition. For valuing the value of significant items Pfizer gets assistance from

independent valuation specialists.

When determining the fair value of assets and liabilities obtained through an

acquisition Pfizer uses the income method. This method forecasts the expected future net

cash flows and then adjusts this to present value with an appropriate discount rate, which

reflects the risks associated with these cash flows.

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Quality of Disclosure

While other firms in the industry arent as transparent and dont fully disclose the

actual situation Pfizer goes beyond GAAP requirements and makes the effort to disclose

all information relevant to investors and regulators. In a portion of the 2003 10-K Pfizer

discloses the adjusted net income. This is the state the company would have been in prior

to the Pharmacia acquisition. Pfizer is committed to showing the true economic situation

of the company by choosing an accounting strategy that accurately depicts the

circumstances at the time of disclosure.

The footnotes provided in the 10-K discloses the revenue recognition, and

inventory calculation methods. They also provide information on other key policies and

give further insight to the companys management activities. Also in the management

discussion and analysis Pfizer gives clear insight to the formal structure of the financial

reports. Given the extensive level of disclosure of internal controls and recollection of

independent Certified Public Accountants that audited the reports, Pfizer took the

recommendations made by auditing firm KPMG LLP and their own internal auditors.

Management claims, We believe that our system of internal control is effective and

adequate to accomplish the objectives discussed. (Pfizer 10-K 2003)

Sales Manipulation Diagnostics

2003 2002 2001 2000 1999

Net Sales / Cash From Sales 1.00 1.10 1.02 0.99 1.00

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Net Sales /Accounts Receivable 5.15 5.60 5.44 5.39 5.10

Net Sale / Inventory 7.74 12.09 10.59 10.95 10.58

Appendix A: Sales Manipulation Diagnostics

These ratios remained steady throughout the five year observation period with the

exception of net sales to inventory. Net sales to inventory showed a noticeable increase

in 2002 which can be explained by an increase in sales. The next year net sales to

inventory decreases by a substantial amount. This is explained by an increase in

inventory due to the acquisition of Pharmacia. The net sales to unearned revenues ratio is

not applicable to Pfizer because of Pfizers revenue recognition policy. Pfizers revenue

recognition policy is set up to record revenue after products have been shipped to

consumers, which results in zero unearned revenues. Net sales to warranty liabilities are

also not applicable to Pfizer because Pfizer does not produce products which are subject

to warranties. The FDA may force Pfizer to recall a certain drug to do health concerns

but this will result in an extraordinary loss, and not a warranty liability.

Expense Manipulation Diagnostics

2003 2002 2001 2000 1999

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Asset Turnover 0.39 0.70 0.74 0.88 0.87

CFFO/OI 7.15 1.07 1.18 1.67 1.10

CFFO/NOA 0.26 0.64 0.59 0.45 0.72

Total Accruals / Change in Sales 1.28 0.43 -2.79 0.70 0.23

Pension Expense / SG&A 0.01 0.01 0.01 0.01 0.01

Appendix B: Expense Manipulation Diagnostics

The ratios were relatively constant for the five years of observation with a few

exceptions. In 2000 Pfizer acquired Warner-Lambert and thus affecting certain ratios

such as cash flow from operations to operating income as well as total accruals to change

in sales. Also, the acquisition of Pharmacia affected nearly all ratios for 2003. From

2002 to 2003 the CFFO/OI income ratio jumped from 1.07 to 7.15. This large of an

increase should be investigated to determine any manipulation by Pfizers management.

The Pharmacia merger had drastic affects on Pfizers financial statements. The Cash

Flow From Operations increases from $9.9 billion to $11.7 billion. Operating Income

decreased from $9.2 billion to $1.6 billion. This is the reason that the change in

CFFO/OI was so drastic.

After evaluating a companys sales and expense manipulation ratios, it is also

necessary to compare the company to its competitors as an additional check. Because of

the increasing number of mergers and acquisitions it is hard to directly compare these

manipulation ratios to do the volatility and fluctuations.

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The net sales to cash from sales ratios for all companies stayed very closely to 1.

There were no large fluctuations in Pfizer or any other company which would suggest

foul play. The net sales to accounts receivable ratio was prone to large fluctuations.

Pfizer was the most stable of all companies in regard to this ratio which suggests sound

management and no creation of false sales. Net sales to inventory was another ratio

which large variances from year to year. Pfizer had noticeable increase and decreases

like all companies due to the acquisitions of Warner Lambert and Pharmacia. This was

consistent for all companies in the industry and did not raise any red flags.

The expense manipulation diagnostics had the same patterns as the sales

manipulation ratios with large fluctuations. Pfizers asset turnover ratio was constant

until 2003 when it had a noticeable drop. This was due to the large and sudden increase

in assets due to the acquisition of Pharmacia. CFFO/OI had the same degree of

fluctuation as most ratios with Pfizer again having a large rise in 2003 due primarily to

the decrease in operating income. This also did not raise any red flags because the

material increase was due again to the acquisition of Pharmacia. Total accruals to change

in sales were relatively constant for Pfizer when compared to other companies in the

industry. Merck for example, increased from -.35 to 42.72 in one year. Pfizers largest

fluctuation was .7 to -2.79 which suggests that Pfizers management is doing a good job

of preventing large swings in this ratio when compared to other companies in the

industry. Pension expense to SG&A is a ratio which should be carefully looked into

because of the rising cost of health care. Pfizers ratio was consistently around 1% while

other companies had fluctuations as large as around 80%. Pension expense is hard to not

explicitly listen on most income statements, with Pfizer being no exception. To

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accurately compute this ratio, the footnotes of the income statement must carefully be

examined to determine actual expenses as well as discount rates used.

Percentage Change in Ratios

2000 2001 2002 2003

Net Sales / Cash From Sales -0.95% 2.09% 8.48% -9.24%

Net Sales /Accounts Receivable 5.65% 0.94% 2.90% -7.98%

Net Sale / Inventory 3.47% -3.26% 14.16% -35.96%

Asset Turnover 1.14% -16.00% -5.79% -44.59%

CFFO/OI 50.82% -29.44% -8.61% 565.84%

CFFO/NOA -37.36% 31.76% 7.59% -58.65%

Total Accruals / Change in Sales 198.42% -499.64% -115.49% 195.86%

Pension Expense / SG&A 45.86% 0.36% 21.84% 8.83%

Potential Red Flags

As explained earlier Pfizer maintains transparent records in its financial

disclosure. Although there have been some potential discrepancies in the raw data, the

causes of these have been well explained by mergers, acquisitions, and supplemental data

in the footnotes. For example, the acquisitions of Warner-Lambert and Pharmacia caused

fluctuations in inventory levels, sales, and accruals, which affected many of the

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diagnostic ratios. Although these changes might raise concerns of revenue and expense

manipulation, Pfizers quality of disclosure and reporting justified all causes of variation.

Because Pfizer is the worlds leading pharmaceutical company with 14 drugs that

are the high sellers in their respective categories, this lowers the level of concern because

the company continues to improve and dominate the industry.

Accounting Distortions

After reviewing five years of financial statements for Pfizer, there appears to be

no symptoms of accounting distortions. The financial statements were in accord with the

supplemental data disclosed in the footnotes. While Pfizer had a moderate degree of

accounting flexibility within GAAP regulations, it did not use this to manipulate its

financial position. All methods of accounting used were well explained in the footnotes.

As there were no distortions in the financial statements, there is no need to correct for

accounting misrepresentation.

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Ratio Analysis & Forecast Financials

he financial ratio analysis and forecasting methods are essential to

understanding potential performance based on a companys past and

present operations. The financial ratio analysis utilizes a variety of

methods, using past financial data to evaluate past performances. Methods used, such as

liquidity, profitability, capital structure, and others are used to help show the history of

overall success.

T Not only does the financial ratio analysis take the financial data of the company at

focus, but as well of that of the competitors and industry. Financial statement forecasting

methods are used to give insight on possible future performances. Forecasting methods

used for Pfizer will take into account of the recent acquisition of Pharmacia. The forecast

will span a ten year period because, a longer forecast period shows possible trends over

time. The purpose of the financial ratio analysis and forecasting methods is to provide

the company as well as investors a picture of what the future may hold.

Financial Ratio Analysis

The Financial ratio analysis section covers the past five years of financial data;

with this data such ratios used will help determine liquidity, profitability, and capital

structure. Other ratios will be used to help show past performances of Pfizer that is

crucial to this particular company and it success. The sustainable growth rate (SGR) will

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be used, which says that the increase in sales must be below the SGR in order to grow.

All the information presented in the financial ratio analysis will be vital to accurately

forecast future performance of Pfizer.

Pfizer Financial Ratios 1999 2000 2001 2002 2003 2004Liquidity Analysis

Current Ratio 1.37 1.43 1.40 1.34 1.26 1.50Quick Asset Ratio 0.99 1.03 0.98 0.99 0.88 1.11Inventory Turnover(Days) 172.88 200.98 237.25 241.65 216.69 322.36Accounts Receivable Turnover(Days) 71.57 67.74 60.34 65.22 70.88 65.10

Profitability Analysis

Gross Profit Margin 0.80 0.83 0.87 0.88 0.78 0.86Operating Profit Margin 0.25 0.20 0.34 0.36 0.07 0.27Net Profit Margin 0.18 0.13 0.27 0.28 0.09 0.22Asset Turnover 0.87 0.88 0.74 0.70 0.39 0.42Return on Assets 0.16 0.11 0.20 0.20 0.03 0.09Return on Equity 0.35 0.23 0.43 0.46 0.06 0.17

Capital Structure Analysis

Total Liabilities/Total Equity 1.25 1.08 1.14 1.32 0.79 0.81Times Interest Earned 18.32 12.57 34.31 46.08 9.32 28.24Debt Service Margin 2.91 3.60 6.28 6.09 4.51 6.12

Sustainable growth rate 22.45% 9.51% 27.73% 29.86% -0.68% 9.20%

Pfizers sustainable growth rate is very volatile. This is due in large parts to

sizeable acquisitions. Pfizers return on equity ratio fluctuates largely from year to year

because of these mergers which causes a large part of the volatility in the sustainable

growth rate. Pfizers sustainable growth rate is probably around 9%, which is drawn

27

from the 2 years of observation where conditions were favorable enough to let the SGR

smooth out to realistic levels. This implies that Pfizer will be able to grow at roughly

nine percent per year without becoming constrained.

.

Liquidity Analysis

Pfizers liquidity has improved over the past 5 years. The current ratio and quick

asset ratio showed constant improvement from 1999 through 2004. The inventory

turnover decreased slightly over the same five year period, making Pfizer slightly less

efficient. Some of this is attributable to large acquisitions in 2000 and 2003. Pfizers

inventory turnover while fluctuating between years has increased marginally over the five

year period. This also shows Pfizer becoming less efficient. Even though the liquidity

ratios yield mixed results, Pfizer continues to expand and remain liquid in respect to

competitors.

Profitability Analysis

Pfizers gross profit margin has fluctuated slightly for the analysis period but ends

up six percent higher at 86%. While this rate of gross profit is likely to fall slightly in the

future because of regulation and public attitude toward pharmaceutical companies Pfizer

is in position to maintain its market power. Operating profit had varied it is up slightly

higher, showing a slight increase in operating efficiency. Net profit has had a range of

almost 20 percent but ends up 4 percent higher in 2004 than 1999. The dramatic

variation is due to acquisitions of large firms such as Pharmacia. Asset turnover has been

cut roughly in half because the acquisition of Pharmacia caused Pfizers asset base to

double. As Pfizer sells off some of Pharmacias assets this ratio will improve but will

28

probably not reach the level it was at prior to the acquisition. Return on assets and equity

has also dropped noticeably during the period of observation. It stayed relatively

constant but was also affected by the acquisition. Pfizer has experienced surges and

drops in its profitability over the past six years due in large part to its level of assets. It

remains a leader in almost every profitability ratio except for asset turnover proving that

it is able to continue its domination of other firms.

Capital Structure

Pfizer has constantly improved its capital structure over the past five years. It is

now twenty percent lower than its nearest competitor, Abbot, in the debt to equity ratio.

While Pfizers times interest earned ratio is low compared to competitors it has a

favorable debt service margin. It is the leader in the industry in debt service margin.

Pfizer is able to generate six dollars of operating income for every dollar of current notes

payable.

Cross Sectional (Benchmark) Analysis

The following ratios were calculated for Pfizer, Pfizers main competitors, and the

industry average. The industry average was calculated from Pfizers three main

competitors. Merck Companys 10-K was not released at the time of analysis, therefore

its numbers for 2004 are labeled N/A.

Financial Ratios

Appendix C: Financial Ratio Analysis

29

Current Ratio

1.001.101.201.301.401.501.601.701.80

2000 2001 2002 2003 2004

Pfizer Abbot Bristol Meyers Merck Industry Average

Quick Asset Ratio

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

2000 2001 2002 2003 2004

Pf izer Abbot Bristol Meyers Merck Industry Average

30

Accounts Recievable Turnover

0.001.00

2.003.00

4.005.00

6.007.00

8.009.00

2000 2001 2002 2003 2004

Pf izer Abbot Bristol Meyers Merck Industry Average

Days Supply of Recievables

0.00

50.00

100.00

150.00

200.00

250.00

300.00

2000 2001 2002 2003 2004

Pf izer Abbot Bristol Meyers Merck Industry Average

31

Inventory Turnover

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

2000 2001 2002 2003 2004

Pf izer Abbot Bristol Meyers Merck Industry Average

Days Supply of Inventory

0.00

100.00

200.00

300.00

400.00

500.00

600.00

700.00

800.00

900.00

1000.00

2000 2001 2002 2003 2004

Pf izer Abbot Bristol Meyers Merck Industry Average

32

Gross Profit Margin

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2000 2001 2002 2003 2004

Pfizer Abbot Bristol Meyers Merck Industry Average

Operating Profit Margin

0%

10%

20%

30%

40%

50%

60%

2000 2001 2002 2003 2004

Pf izer Abbot Bristol Meyers Merck Industry Average

33

Net Profit Margin

0%

5%

10%

15%

20%

25%

30%

35%

40%

2000 2001 2002 2003 2004

Pfizer Abbot Bristol Meyers Merck Industry Average

Asset Turnover

0.00

0.20

0.40

0.60

0.80

1.00

1.20

2000 2001 2002 2003 2004

Pfizer Abbot Bristol Meyers Merck Industry Average

34

Return on Assets

0%

5%

10%

15%

20%

25%

30%

2000 2001 2002 2003 2004

Pfizer Abbot Bristol Meyers Merck Industry Average

Return on Equity

0%

10%

20%

30%

40%

50%

60%

2000 2001 2002 2003 2004

Pfizer Abbot Bristol Meyers Merck Industry Average

35

Debt to Equity

0.00

0.50

1.00

1.50

2.00

2.50

2000 2001 2002 2003 2004

Pfizer Abbot Bristol Meyers Merck Industry Average

Times Interest Earned

-5.00

5.00

15.00

25.00

35.00

45.00

55.00

65.00

75.00

85.00

95.00

2000 2001 2002 2003 2004

Pfizer Abbot Bristol Meyers Merck Industry Average

36

Debt Service Margin

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

2000 2001 2002 2003 2004

Pfizer Abbot Bristol Meyers Merck Industry Average

Operating Cash Flow as a Percentage of Operating Income

0%

50%

100%

150%

200%

250%

300%

350%

400%

2000 2001 2002 2003 2004

Pfizer Abbot Bristol Meyers Merck Industry Average

37

Financial Statement Forecasting

To accurately forecast financial statements needed to perform intrinsic valuations, considerable effort, time, and care is needed. All the financial ratios must be calculated

and analyzed for a period of five years. Pro-forma financial statements are also a tool

used to forecast the financial statements. These are created by stating everything in

percentages of the biggest number on the financial statement or section of the financial

statements. Once this is completed future values can be computed by looking at

historical patterns and impacts of current market conditions.

When forecasting the income statement, balance sheet, and statement of cash

flows the acquisition of Pharmacia played a key role. This acquisition caused drastic

fluctuations in Pfizers ratios in 2003 as compared to 2002. When taking this into

account, historical patterns of past acquisitions were used to provide a basis for future

predictions. The acquisition of Warner Lambert in 2001 showed increases in sales,

inventory, and assets. This acquisition also showed decreases in operating cash flows

and net income. After a year these numbers and financial ratios were at levels slightly

higher than before the acquisition. These cyclical impacts were used in forecasting

Pfizers financial reports for the future ten years which are used in the intrinsic valuation

models.

Although many percentage based growth rates are used, some drive many key

aspects of forecasts. In 2005, a 5% growth rate in sales is used. This number is increased

to 6.5% in 2006 and then to 8% in 2007. For the remaining years, Pfizers growth rate in

sales is estimated to be 10%. Another key number used in calculations is the gross profit

38

margin. Pfizers growth profit margin at the end of 2004 was 86%. With the hostile

attitude towards drug manufacturers for charging high prices, Pfizers gross profit margin

in our models is 83% in 2005 and 80% for the remaining years. With many growth rates

and assumptions used in the models, these are two of the most important numbers which

carry through to all the financial statements.

Appendix D: Forecasted Financial Statements

39

Valuation Analysis

fter financial statements and ratios have been forecast, in this case

for ten years, valuation methods can be performed. Different

valuation methods have different underlying theoretical support

which will provide different suggested share prices. One method alone cannot provide a

sound basis for a firm valuation. Many intrinsic methods along with comparable ratios

from firms in the same industry are necessary to get a complete feel for the firm. Also,

sensitivity analysis must be performed to ensure that misestimating costs of capital and

growth rates will not provide unreliable results. Accurate and believable costs of capital

along with the forecasted financial statements are necessary before any valuations can be

performed. The following sections provide detailed methods of cost of capital estimation

and the implementation of those numbers in the various intrinsic valuation methods.

Methods of comparables are also included to value firms against industry averages.

A

Cost of Capital Estimation

To properly value Pfizer using intrinsic valuation models, the cost of debt, equity,

and weighted average cost of capital must first be estimated. This in itself requires

considerable work and attention to detail.

The cost of debt is the easiest to estimate and also the most reliable. In the notes

of its 10-K Pfizer explained its short and long term borrowings in detail to allow easy

estimation of its cost of debt. The cost of debt for short term borrowings was given in the

10-K at 2.5%. The cost of long term borrowings had to be calculated from a list of

borrowings including bonds, debentures, and mortgages. The cost of long term debt was

40

estimated at 4.38%. These percentages were then used to compute a weighted average

cost of debt from the liabilities section from the 2004 Balance Sheet. The Balance Sheet

debt was calculated to be 3.45%. This calculation was performed by excluding deferred

taxes on income because the number has been staying at a constant level, without

material increases or decreases. This implies that it will continue to stay at a constant

level and is not needed in determining Pfizers weighted average cost of debt.

The beta () for Pfizer was calculated using three different time periods. Used in

the calculations were the firms monthly returns, and the Standard and Poors index fund

monthly returns from 2000 to 2005. Also used in calculating the risk free rate was the

monthly yield on the five year US treasury bonds. The risk free rate was estimated to be

3.21% and was used in the calculations of Pfizers cost of equity. The long run average

market risk premium since 2002 and used in the calculations was 3%. The beta which

showed the highest degree of explanation by the R-Squared measure was for the time

period 2002-2005. The R-squared variable for this time period was .234 and computed

the beta to be .59. This was used to compute a cost of equity at 4.99%. The implied cost

of equity which supports Pfizers current share price was 4.56%.

Appendix E: Cost of Debt Calculations

Time Period Beta Estimate R-Squared

Estimated Ke

2002-2005 0.594927185 0.233958482 4.99%2003-2005 0.435905178 0.060637378 4.52%2000-2005 0.458094958 0.131888494 4.58%Implied 4.56%

41

The estimated costs of debt and equity are consistent with a company of Pfizers

size and organization. A large corporation such as Pfizer that has operations

internationally is able to borrow money from many different sources and keep their costs

of capital down to reasonable levels.

Time Period

Estimated Ke

Estimated WACCbt

Estimated WACCat

2002-2005 4.99% 4.07% 3.78%2003-2005 4.52% 4.04% 3.74%2000-2005 4.58% 4.30% 4.01%Implied 4.56% 4.06% 3.77%

The weighted average cost of capital (WACC) before tax consideration was

calculated to be 4.07%. A 4.99 % cost of equity was used in this calculation. The after

tax WACC was estimated to be 3.78%.

Appendix F: Regression Analysis

The values used in the intrinsic valuations are as follows:

Beta() 0.595Cost of Equity(Ke) 4.99%Cost of Debt(Kd) 3.45%WACCbt 4.07%WACCat 3.78%

Intrinsic Valuation Methods

Various intrinsic valuation methods are needed to accurately value a companys

stock price. The different methods used take into account different variables and

42

different discount rates. Once each model has been worked out an accurate investment

recommendation can be made.

Appendix G: Intrinsic Valuation Methods

Discounted Dividends

The discounted dividend model uses forecasted dividends per share, cost of

equity, and an estimated growth rate to discount the nominal amounts back to the current

year.

( )PPSt = +

+

=

E dk

t

et

t

~

1

1 1

This model relies on assumptions and the accuracy of the discount rate. Pfizer

has an estimated cost of equity of 4.99% and a growth rate of 2%. This model gives

Pfizer an estimated price per share of $36.02. When assuming a growth rate of zero for

the terminal year perpetuity the model yields an intrinsic valuation of $23.76 a share.

The model is limited by the accuracy of the forecasted dividends and the growth rate in

the terminal year. This model shows Pfizer to be undervalued.

Sensitivity Analysisg

0 0.015 0.03 0.045Ke 0.03 $35.48 $64.88 N/A N/A

0.04 $28.13 $41.36 $94.29 N/A0.05 $23.72 $31.28 $50.18 $182.500.06 $20.78 $25.68 $35.48 $64.880.07 $18.68 $22.12 $28.13 $41.36

43

Discounted Free Cash Flows

The discounted free cash flow model uses the free cash flows to the firm to

estimate a price per share. The free cash flows to the firm include cash flows from

operations and investing. It does not include cash flows from financing activities. The

free cash flows to the firm are then discounted to the current year using the firms before

tax WACC.

( )VE, t = +++

=

E FCFk

t t

e

tt

( )~

11

0 1

In Pfizers case this before tax WACC is estimated to be 4.07%. Assuming a 2%

growth rate this model yields an intrinsic valuation of 58.98. Using a growth rate of 0%

yields a value of $29.50 which is closer to the firms actual share price. This model takes

more data into consideration than the discounted dividend model does. This model is

also prone to the limitations of forecast accuracy and growth rate estimation.

Sensitivity Analysisg

0 0.015 0.03 0.045WACC 0.03 $44.50 $88.83 N/A N/A

0.04 $30.23 $48.52 $121.68 N/A0.05 $21.75 $31.34 $55.31 $223.100.06 $16.14 $21.85 $33.26 $67.500.07 $12.18 $15.86 $22.29 $36.45

Discounted Residual Income

44

This model uses beginning equity per share, forecasted earnings per share, and

dividends per share to determine normal and residual income. Normal income is the

beginning book value of equity multiplied by the firms cost of equity. Residual income is

equal to earnings per share minus normal income. The residual income values are then

discounted back to the current year to give an intrinsic valuation.

( )VE, t = +

++

+=

BVE E NI k BVEk

t

t t e t

et

t

( ) ( )~

1

10 1

In Pfizers case, using a cost of equity of 4.99% and a growth rate of 0% this

model yields an intrinsic valuation of $56.20 per share. For this model a zero percent

growth rate was used because residual income is more likely to fluctuate and a aggressive

growth rate is likely to over-value the firm.

Sensitivity Analysisg

0 0.015 0.03 0.045Ke 0.03 $103.17 $180.52 N/A N/A

0.04 $73.13 $102.67 $220.84 N/A0.05 $55.37 $69.62 $105.24 $354.580.06 $43.75 $51.49 $66.97 $113.420.07 $35.60 $40.12 $48.01 $65.39

Abnormal Earnings Growth

The abnormal earnings growth model is a more complicated model that uses

earnings per share and dividends per share along with the firms cost of equity. It

assumes that dividends are reinvested at the cost of equity. The abnormal earnings

growth is the difference between the cumulative dividend earnings and normal earnings.

45

Cumulative dividend earnings are equal to the beginning price per share plus the

percentage earned off of the reinvested dividends.

++++= L34

2321

0 11

1 EEEEEE AEGAEGAEGEarnV

++++= L34

232

111

EEEE

AEGAEGAEGEarn

This model yields a price per share of $56.20 for Pfizer. This model assumes no

terminal year perpetuity because of the volatility on earnings per share. Because of this

the growth rate is not a factor in the intrinsic valuation.

Sensitivity Analysisg

0 0.015 0.03 0.045Ke 0.03 $62.03 $62.03 $62.03 $62.03

0.04 $59.20 $59.20 $59.20 $59.200.05 $55.49 $55.49 $55.49 $55.490.06 $52.60 $52.60 $52.60 $52.600.07 $50.80 $50.80 $50.80 $50.80

Long Run Average Residual Income Perpetuity

The long run average residual income perpetuity is based on the price to book

ratio. This valuation method is performed by multiplying the book value of equity times

(the long run ROE minus the cost of equity) divided by (the cost of equity minus the

expected growth rate). This value is then added back to the book value of equity.

Assuming a 2% growth rate, this method of valuation yield an expected price per share of

$99.42, which is greatly higher than that current share price. If a 0% growth rate is

46

substituted into the formula the model then yields a price per share of $63.33 which is

closer to the other valuation models.

Sensitivity Analysisg

0 0.015 0.03 0.045Ke 0.03 $105.34 $201.30 N/A N/A

0.04 $79.00 $120.78 $287.90 N/A0.05 $63.20 $86.27 $143.95 $547.690.06 $52.66 $67.10 $95.97 $182.560.07 $45.14 $54.90 $71.98 $109.54

Method of Comparables

This method utilizes ratios from the firms competitors to find an industry average

and an expected share price for the company. Pfizers main competitors which were used

in this valuation are Abbot Laboratories, Bristol-Meyers Squibb, Glaxo-Smith Kline, and

Merck. These companies provide a solid basis for performing the ratio based valuations.

PPSassessed, tcomparable firms

= +E EPS

PEt

average

( ) *1

The actual firm being valued is not included when calculating the industry

average to prevent bias. It may also be necessary to eliminate firms with an outlying

ratio from the average to provide a stronger basis of valuation.

Appendix H: Method of Comparables

47

The average P/E trailing ratio for Pfizers competitors was 20.9. There were no

outliers for this ratio. When multiplied by Pfizers earnings per share of $1.87, this gives

a valuation of $39.08. This is higher than Pfizers actual share price of $26.15

The forward looking P/E average ratio was 18.125. When eliminating Mercks

outlying value of 11.8 a more reliable average of 23.23 is attained. When this is

multiplied by Pfizers earnings per share this gives a valuation of $37.84 which is always

over the actual price per share.

It was necessary to take out Abbot Labs P/B ratio of 5.27 from the industry

average to get a more accurate and reliable average of 3.85 as compared to 4.20. When

the 3.85 is multiplied by Pfizers book value of equity this yields a valuation of $35.58.

When evaluating the dividend yield ratio it was necessary to eliminate both Abbot

Labs and Novartis from the average. The remaining two firms had an average dividend

yield percentage of 4.8. When this was multiplied by Pfizers book value of equity it

gives a suggested price per share of $44.40. This number indicated that Pfizer is an

undervalued security.

The price to sales ratio industry average after excluding Bristol-Meyers Squibb

outlying value was 3.53. When multiplied by Pfizers sales per share of 7.21 gives a

suggested price per share of $25.43. This is only $.72 lower than Pfizers actual share

price which suggests Pfizer is just slightly undervalued.

After excluding Bristol-Meyers Squibb outlying value of 2.82 the industry

average was 1.82. When this average is multiplied by Pfizers projected growth rate of

12% gives a share price of $21.84 which suggests that Pfizer is undervalued by $4.31.

48

Conclusions

After analyzing the results of the intrinsic valuations and comparables suggested

valuations, Pfizer appears to be overvalued. Every intrinsic valuation method provides a

suggested share price above the actual price of $26.15. Four out of the six comparable

ratios also suggest a share price higher than Pfizers actual price. The other two

comparable ratios are just slightly under Pfizers actual price per share. Even after

looking at the sensitivity analysis performed for every intrinsic valuation model, Pfizers

cost of capital would have to be over-estimated by a large amount for Pfizers stock price

to be undervalued.

49

References

United States. Securities and Exchange Commission. Edgar Database. Retrieved

February 1, 2005 from the World Wide Web:

http://sec.gov/edgar/searchedgar/webusers.htm

Pricewaterhouse Coopers. Edgarscan. Retrieved February 1, 2005 from the World Wide

Web:

http://edgarscan.pwcglobal.com/servlets/edgarscan

Yahoo Finance. Retrieved February 1, 2005 from the World Wide Web:

http://finance.yahoo.com/

Wilde Mathews, A. & Hensly S. (2005, April 8). FDA Stiffens Painkiller Warnings,

Pushed Pfizer to Suspend Bextra. TheWall Street Journal, p. A1

Hensly, S. (2005 February 11). Pfizer Plans $2 Billion In Cost Cuts. The Wall Street

Journal, p. A3

Pfizer, Inc. Retrieved February 1, 2005 from the World Wide Web:

http://pfizer.com/main.html

50

Moore, M. Chapter 7 Prospective Analysis: Valuation Theory Basics. Retrieved

February 1, 2005 from the World Wide Web: http://mmoore.ba.ttu.edu/Fin3321-

Spring-05/Lecture_Notes/Chapter-7.doc

Moore, M. Chapter 8 Prospective Analysis: Valuation. Retrieved February 1, 2005

From the World Wide Web: http://mmoore.ba.ttu.edu/Fin3321-Spring-

05/Lecture_Notes/Chapter-8.doc

51

Appendix

Appendix A: Sales Manipulation Diagnostics

Net Sales/Cash From Sales 2003 2002 2001 2000Pfizer 1.00 1.10 1.02 0.99Abbot Labs 1.00 1.03 1.03 1.22Bristol Meyers Squibb 1.00 1.04 0.95 1.02Merck 1.00 0.94 1.01 1.00Industry Average 1.00 1.00 1.00 1.08

Net Sales/Accounts Recievable 2003 2002 2001 2000Pfizer 5.15 5.60 5.44 5.39Abbot Labs 5.22 5.22 1.35 1.62Bristol Meyers Squibb 5.10 5.46 4.51 4.76Merck 5.59 3.95 4.06 7.67Industry Average 5.30 4.88 3.31 4.69

Net Sales/Inventory 2003 2002 2001 2000Pfizer 7.74 12.09 10.59 10.95Abbot Labs 6.31 6.26 1.71 2.03Bristol Meyers Squibb 11.65 10.30 10.59 9.09Merck 8.80 7.23 5.92 13.36Industry Average 8.92 7.93 6.07 8.16

Appendix B: Expense Manipulation Diagnostics

Asset Turnover 2003 2002 2001 2000Pfizer 0.39 0.70 0.74 0.88Abbot Labs 0.66 0.65 0.16 0.23Bristol Meyers Squibb 0.68 0.65 0.65 0.99Merck 0.55 0.45 0.48 1.01Industry Average 0.63 0.58 0.43 0.74

CFFO/OI 2003 2002 2001 2000Pfizer 7.15 1.07 1.18 1.67Abbot Labs 1.35 1.43 3.09 2.34Bristol Meyers Squibb 1.13 0.46 2.64 1.21Merck 1.28 1.28 1.18 0.81Industry Average 1.25 1.06 2.31 1.46

CFFO/NOA 2003 2002 2001 2000Pfizer 0.26 0.64 0.59 0.45Abbot Labs 0.19 0.23 0.25 0.29Bristol Meyers Squibb 0.33 0.09 0.54 0.79Merck 0.38 0.35 0.32 0.32Industry Average 0.30 0.22 0.37 0.46

52

Total Accruals/Change in Sales 2003 2002 2001 2000Pfizer 1.28 0.43 -2.79 0.70Abbot Labs 1.40 0.24 11.45 0.55Bristol Meyers Squibb 1.64 -1.67 7.07 N/AMerck 9.81 42.72 -0.35 N/AIndustry Average 4.28 13.76 6.06 0.55

Pension Expense/SG&A 2003 2002 2001 2000Pfizer 0.01 0.01 0.01 0.01Abbot Labs 0.53 0.62 1.35 1.22Bristol Meyers Squibb N/A N/A N/A N/AMerck N/A N/A N/A N/AIndustry Average 0.53 0.62 1.35 1.22

Appendix C: Financial Ratio Analysis

Current Ratio 2000 2001 2002 2003 2004Pfizer 1.43 1.40 1.34 1.26 1.50Abbot 1.72 1.06 1.33 1.38 1.57Bristol Meyers 1.44 1.19 1.21 1.61 1.50Merck 1.37 1.12 1.16 1.20 N/AIndustry Average 1.51 1.13 1.24 1.40 1.54

Quick Asset Ratio 2000 2001 2002 2003 2004Pfizer 1.03 0.98 0.99 0.88 1.11Abbot 0.78 0.44 0.61 0.66 0.84Bristol Meyers 1.00 0.87 0.85 1.24 1.20Merck 0.96 0.74 0.84 0.86 N/AIndustry Average 0.91 0.68 0.77 0.92 1.02

Accounts Receivable Turnover 2000 2001 2002 2003 2004Pfizer 5.39 6.05 5.60 5.15 5.61Abbot 1.62 1.35 5.22 5.22 5.32Bristol Meyers 4.76 4.51 5.46 5.10 4.43Merck 7.67 4.06 3.95 5.59 N/AIndustry Average 4.69 3.31 4.88 5.30 4.88

53

Days Supply of Receivables 2000 2001 2002 2003 2004Pfizer 67.74 60.34 65.22 70.88 65.10Abbot 224.79 271.08 69.93 69.99 68.55Bristol Meyers 76.63 81.01 66.84 71.62 82.36Merck 47.59 89.80 92.30 65.31 N/AIndustry Average 77.90 110.42 74.82 68.87 74.82

Inventory Turnover 2000 2001 2002 2003 2004Pfizer 1.82 1.54 1.51 1.68 1.13Abbot 0.51 0.42 2.79 2.84 3.39Bristol Meyers 2.45 3.21 2.98 3.18 3.81Merck 7.43 1.01 1.32 1.69 N/AIndustry Average 3.46 1.55 2.36 2.57 3.60

Days Supply of Inventory 2000 2001 2002 2003 2004Pfizer 200.98 237.25 241.65 216.69 322.36Abbot 721.06 860.22 130.65 128.57 107.66Bristol Meyers 148.93 113.72 122.39 114.71 95.87Merck 49.14 360.42 276.92 216.08 N/AIndustry Average 105.44 235.66 154.35 142.02 101.42

Gross Profit Margin 2000 2001 2002 2003 2004Pfizer 83% 87% 88% 78% 86%Abbot 75% 75% 55% 55% 55%Bristol Meyers 73% 70% 71% 71% 69%Merck 44% 83% 82% 81% N/AIndustry Average 64% 76% 69% 69% 62%

Operating Profit Margin 2000 2001 2002 2003 2004

54

Pfizer 20% 34% 36% 7% 27%Abbot 30% 51% 22% 20% 21%Bristol Meyers 30% 12% 17% 25% 23%Merck 24% 47% 45% 40% N/AIndustry Average 28% 37% 28% 28% 22%

Net Profit Margin 2000 2001 2002 2003 2004Pfizer 13% 27% 28% 9% 22%Abbot 26% 18% 18% 16% 16%Bristol Meyers 25% 27% 13% 17% 12%Merck 17% 34% 33% 30% N/AIndustry Average 23% 26% 22% 21% 14%

Asset Turnover 2000 2001 2002 2003 2004Pfizer 0.88 0.74 0.70 0.39 0.42Abbot 0.23 0.16 0.65 0.66 0.68Bristol Meyers 0.99 0.65 0.65 0.68 0.64Merck 1.01 0.48 0.45 0.55 N/AIndustry Average 0.74 0.43 0.58 0.63 0.66

Return on Assets 2000 2001 2002 2003 2004Pfizer 11% 20% 20% 3% 9%Abbot 6% 3% 12% 11% 11%Bristol Meyers 25% 17% 9% 11% 8%Merck 17% 17% 15% 17% N/AIndustry Average 16% 12% 12% 13% 10%

Return on Equity 2000 2001 2002 2003 2004Pfizer 23% 43% 46% 6% 17%Abbot 11% 7% 26% 21% 23%Bristol Meyers 57% 53% 24% 32% 23%

55

Merck 46% 45% 39% 44% N/AIndustry Average 38% 35% 30% 32% 23%

Debt to Equity Ratio 2000 2001 2002 2003 2004Pfizer 1.08 1.14 1.32 0.79 0.81Abbot 0.78 1.57 1.21 0.99 1.01Bristol Meyers 1.25 2.06 1.77 1.80 1.98Merck 1.71 1.74 1.61 1.61 N/AIndustry Average 1.25 1.79 1.53 1.47 1.50

Times Interest Earned 2000 2001 2002 2003 2004Pfizer 12.57 34.31 46.08 9.32 28.24Abbot N/A N/A 16.16 23.14 27.67Bristol Meyers 48.58 12.19 6.46 26.15 84.96Merck 0.32 0.88 0.82 0.67 N/AIndustry Average 24.45 6.54 7.81 16.65 56.32

Debt Service Margin 2000 2001 2002 2003 2004Pfizer 3.60 6.28 6.09 4.51 6.12Abbot 2.29 2.34 3.67 3.14 4.08Bristol Meyers 2.79 3.65 0.61 1.86 1.49Merck 1.67 1.63 3.61 11.46 N/AIndustry Average 2.25 2.54 2.63 5.49 2.79

56

Appendix D: Forecasted Financial Statements

Income Statement

Actuals(Millions) Forecasts(Millions)1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Revenues $27,376 $29,574 $29,024 $32,373 $45,188 $52,516 $55,142 $58,726 $63,424 $69,767 $76,743 $84,417 $92,859 $102,145 $112,360 $123,596 Cost of sales $5,464 $4,907 $3,823 $4,045 $9,832 $7,541 $11,028 $11,745 $12,685 $13,953 $15,349 $16,883 $18,572 $20,429 $22,472 $24,719Gross Profit $21,912 $24,667 $25,201 $28,328 $35,356 $44,975 $44,113 $46,981 $50,739 $55,813 $61,395 $67,534 $74,287 $81,716 $89,888 $98,877Operating Expenses: Selling, informational and administrative expenses $10,810 $11,442 $9,717 $10,846 $15,242 $16,903 $17,645 $17,094 $16,543 $16,543 $16,543 $16,543 $16,543 $16,543 $16,543 $16,543 Research and development expenses $4,036 $4,435 $4,776 $5,176 $7,131 $7,684 $8,271 $8,271 $8,271 $8,271 $8,271 $8,271 $8,271 $8,271 $8,271 $8,271 Merger-related costs $33 $3,257 $819 $630 $1,058 $1,193 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Merger-related in-process research and development charge Other (income)/deductions-net $88 ($248) ($95) ($120) $3,610 $753 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Income from continuing operations before provision for taxes on income and minority interests $6,945 $5,781 $9,984 $11,796 $3,263 $14,007 $15,440 $17,618 $19,661 $21,628 $23,790 $26,169 $28,786 $31,665 $34,831 $38,315 Provision for taxes on income $1,968 $2,049 $2,433 $2,609 $1,621 $2,665 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Minority interests $5 $14 $14 $6 $3 $10 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Income from continuing operations $4,972 $3,718 $7,537 $9,181 $1,639 $11,332 $13,234 $15,562 $16,807 $18,488 $20,337 $22,371 $24,608 $27,068 $29,775 $32,753Discontinued operations:

$0 $0 $251 $278 $16 ($22) $0 $0 $0 $0 $0 $0 $0 $0 $0 $0$0 $0 $0 $77 $2,285 $51 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0

Discontinued operations-net of tax ($20) $8 $251 $355 $2,301 $29 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0$0 $0 $7,788 $9,536 $3,940 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0$0 $0 $0 ($410) ($30) $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0

Net income $4,952 $3,726 $7,788 $9,126 $3,910 $11,361 $12,407 $14,094 $15,222 $16,744 $18,418 $20,260 $22,286 $24,515 $26,966 $29,663

57

Pro-forma Income Statement

Actuals Forecasts1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Revenues 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% Cost of sales 19.96% 16.59% 13.17% 12.49% 21.76% 14.36% 20.00% 20.00% 20.00% 20.00% 20.00% 20.00% 20.00% 20.00% 20.00% 20.00%Gross Profit 80.04% 83.41% 86.83% 87.51% 78.24% 85.64% 80.00% 80.00% 80.00% 80.00% 80.00% 80.00% 80.00% 80.00% 80.00% 80.00%Operating Expenses: 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% Selling, informational and administrative expenses 39.49% 38.69% 33.48% 33.50% 33.73% 32.19% 32.00% 31.00% 30.00% 30.00% 30.00% 30.00% 30.00% 30.00% 30.00% 30.00% Research and development expenses 14.74% 15.00% 16.46% 15.99% 15.78% 14.63% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% Merger-related costs 0.12% 11.01% 2.82% 1.95% 2.34% 2.27% Merger-related in-process research and development charge 0.00% 0.00% 0.00% 0.00% 11.18% 2.04% Other (income)/deductions-net 0.32% -0.84% -0.33% -0.37% 7.99% 1.43% Income from continuing operations before provision for taxes on income and minority interests 25.37% 19.55% 34.40% 36.44% 7.22% 26.67% 28.00% 30.00% 31.00% 31.00% 31.00% 31.00% 31.00% 31.00% 31.00% 31.00% Provision for taxes on income 7.19% 6.93% 8.38% 8.06% 3.59% 5.07% Minority interests 0.02% 0.05% 0.05% 0.02% 0.01% 0.02% Income from continuing operations 18.16% 12.57% 25.97% 28.36% 3.63% 21.58% 24.00% 26.50% 26.50% 26.50% 26.50% 26.50% 26.50% 26.50% 26.50% 26.50%Discontinued operations: 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%

0.00% 0.00% 0.86% 0.86% 0.04% -0.04%0.00% 0.00% 0.00% 0.24% 5.06% 0.10%

Discontinued operations-net of tax -0.07% 0.03% 0.86% 1.10% 5.09% 0.06%0.00% 0.00% 26.83% 29.46% 8.72% 0.00%0.00% 0.00% 0.00% -1.27% -0.07% 0.00%

Net income 18.09% 12.60% 26.83% 28.19% 8.65% 21.63% 22.50% 24.00% 24.00% 24.00% 24.00% 24.00% 24.00% 24.00% 24.00% 24.00%

58

Balance Sheet

Actuals(Millions) Forecasts(Millions) FORECASTS1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Assets Current Assets Cash and cash equivalents $2,358 $1,099 $1,036 $1,878 $1,520 $1,808 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Short-term investments $4,028 $5,764 $7,579 $10,673 $10,432 $18,085 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Accounts receivable, less allowance for doubtful accounts: $5,368 $5,489 $4,798 $5,785 $8,775 $9,367 $9,803 $11,623 $12,685 $13,953 $15,349 $15,477 $17,024 $18,727 $20,599 $22,659 Short-term loans $273 $140 $269 $399 $391 $653 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Inventories $0 $0 $1,011 $1,133 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Finished goods $1,147 $1,195 $0 $0 $2,308 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Work in process $977 $1,074 $1,062 $1,142 $2,219 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Raw materials and supplies $464 $433 $412 $403 $1,310 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Total inventories $2,588 $2,702 $2,485 $2,678 $5,837 $6,660 $6,740 $6,729 $6,977 $6,977 $7,674 $7,738 $8,512 $9,363 $10,300 $11,330 Prepaid expenses and taxes $1,696 $1,993 $1,418 $1,797 $2,786 $2,939 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Assets of discontinued businesses held for sale $0 $0 $1,627 $1,571 $0 $182 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Total current assets $16,311 $17,187 $19,212 $24,781 $29,741 $39,694 $46,564 $53,832 $63,424 $63,424 $69,767 $70,348 $77,383 $85,121 $93,633 $102,996 Long-term loans and investments $1,764 $2,529 $5,724 $5,161 $6,142 $3,873 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Property, plant and equipment, less accumulated depreciation $8,685 $9,425 $9,783 $10,712 $18,287 $18,385 $18,381 $18,352 $19,027 $19,027 $20,930 $21,104 $23,215 $25,536 $28,090 $30,899 Goodwill, less accumulated amortization: 2000-$300; 1999-$256 $1,870 $1,791 $1,689 $1,200 $22,306 $23,756 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0Identifiable intangible assets, less accumulated amortization $0 $0 $0 $0 $36,350 $33,251 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Other assets, deferred taxes and deferred charges $2,742 $2,578 $2,745 $4,502 $3,949 $4,725 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Total non-current assets $15,061 $16,323 $19,941 $21,575 $87,034 $83,990 $75,973 $68,514 $63,424 $63,424 $69,767 $70,348 $77,383 $85,121 $93,633 $102,996 Total assets $31,372 $33,510 $39,153 $46,356 $116,775 $123,684 $122,537 $122,346 $126,848 $126,848 $139,533 $140,696 $154,765 $170,242 $187,266 $205,993

Liabilities and Shareholders Equity Current Liabilities Short-term borrowings, including current portion of long-term debt $5,299 $4,289 $6,263 $8,669 $8,818 $11,266 $14,924 $18,098 $19,373 $19,732 $21,705 $21,886 $24,075 $26,482 $29,130 $32,043 Accounts payable $1,889 $1,719 $1,411 $1,620 $2,601 $2,672 $2,985 $3,232 $3,459 $3,524 $3,876 $3,908 $4,299 $4,729 $5,202 $5,722 Dividends payable $349 $696 $819 $926 $1,300 $1,418 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Income taxes payable $748 $850 $775 $2,231 $1,919 $1,963 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Accrued compensation and related items $905 $982 $1,026 $1,084 $1,753 $1,939 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0Accrued litigation settlements $0 $0 $0 $0 $1,402 $264 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Other current liabilities $2,706 $3,445 $2,866 $3,448 $5,864 $6,872 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Liabilities of discontinued businesses held for sale $0 $0 $569 $577 $0 $64 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Total current liabilities $11,896 $11,981 $13,729 $18,555 $23,657 $26,458 $29,849 $36,196 $42,898 $45,806 $50,387 $50,807 $55,887 $61,476 $67,624 $74,386 Long-term debt $1,774 $1,123 $2,609 $3,140 $5,755 $7,279 $6,567 $7,110 $7,611 $7,752 $8,527 $8,598 $9,458 $10,404 $11,444 $12,588Pension benefit obligations $0 $0 $0 $0 $2,861 $2,821 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Postretirement benefit obligation other than pension plans $515 $564 $587 $623 $1,451 $1,450 $1,672 $1,810 $1,937 $1,973 $2,171 $2,189 $2,407 $2,648 $2,913 $3,204 Deferred taxes on income $485 $380 $398 $364 $13,238 $12,632 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Other noncurrent liabilities $2,752 $3,386 $3,537 $3,724 $4,436 $4,766 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Total non-current liabilities $5,526 $5,453 $7,131 $7,851 $27,741 $28,948 $29,849 $28,440 $26,292 $24,665 $27,131 $27,358 $30,093 $33,103 $36,413 $40,054 Total liabilities $17,422 $17,434 $20,860 $26,406 $51,398 $55,406 $59,698 $64,636 $69,190 $70,471 $77,518 $78,164 $85,981 $94,579 $104,037 $114,440 Shareholders Equity $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Preferred stock, without par value; $0 $0 $0 $0 $219 $193 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Common stock, $.05 par value $332 $337 $340 $341 $435 $438 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Additional paid-in capital $5,943 $8,895 $9,300 $9,368 $66,396 $67,098 $67,098 $0 $0 $0 $0 $0 $0 $0 $0 $0 Retained earnings $18,459 $19,599 ($2,650) ($1,786) ($1,898) $35,492 $43,267 $52,781 $62,890 $74,011 $86,244 $99,700 $114,502 $130,784 $148,694 $168,395 Accumulated other comprehensive expense ($1,045) ($1,515) ($11,378) ($16,341) ($29,352) $2,278 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Employee benefit trusts ($2,888) ($3,382) $24,430 $30,243 $29,382 ($1,229) ($1,229) $0 $0 $0 $0 $0 $0 $0 $0 $0 Treasury stock, shares at cost: 2000-435; 1999-413 ($6,851) ($7,858) ($1,749) ($1,875) $195 ($35,992) ($35,992) $0 $0 $0 $0 $0 $0 $0 $0 $0 Total shareholders equity $13,950 $16,076 $18,293 $19,950 $65,377 $68,278 $62,840 $57,710 $57,658 $56,377 $62,015 $62,531 $68,785 $75,663 $83,229 $91,552 Total liabilities and shareholders equity $31,372 $33,510 $39,153 $46,356 $116,775 $123,684 $122,537 $122,346 $126,848 $126,848 $139,533 $140,696 $154,765 $170,242 $187,266 $205,993

59

Pro-forma Balance Sheet

Actuals Forecasts1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Assets Current Assets Cash and cash equivalents 7.52% 3.28% 2.65% 4.05% 1.30% 1.46% Short-term investments 12.84% 17.20% 19.36% 23.02% 8.93% 14.62% Accounts receivable, less allowance for doubtful accounts: 17.11% 16.38% 12.25% 12.48% 7.51% 7.57% 8.00% 9.50% 10.00% 11.00% 11.00% 11.00% 11.00% 11.00% 11.00% 11.00% Short-term loans 0.87% 0.42% 0.69% 0.86% 0.33% 0.53% Inventories 0.00% 0.00% 2.58% 2.44% 0.00% 0.00% Finished goods 3.66% 3.57% 0.00% 0.00% 1.98% 0.00% Work in process 3.11% 3.21% 2.71% 2.46% 1.90% 0.00% Raw materials and supplies 1.48% 1.29% 1.05% 0.87% 1.12% 0.00% Total inventories 8.25% 8.06% 6.35% 5.78% 5.00% 5.38% 5.50% 5.50% 5.50% 5.50% 5.50% 5.50% 5.50% 5.50% 5.50% 5.50% Prepaid expenses and taxes 5.41% 5.95% 3.62% 3.88% 2.39% 2.38% Assets of discontinued businesses held for sale 0.00% 0.00% 4.16% 3.39% 0.00% 0.15% Total current assets 51.99% 51.29% 49.07% 53.46% 25.47% 32.09% 38.00% 44.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% Long-term loans and investments 5.62% 7.55% 14.62% 11.13% 5.26% 3.13% Property, plant and equipment, less accumulated depreciation 27.68% 28.13% 24.99% 23.11% 15.66% 14.86% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% Goodwill, less accumulated amortization: 2000-$300; 1999-$256 5.96% 5.34% 4.31% 2.59% 19.10% 19.21%Identifiable intangible assets, less accumulated amortization 0.00% 0.00% 0.00% 0.00% 31.13% 26.88% Other assets, deferred taxes and deferred charges 8.74% 7.69% 7.01% 9.71% 3.38% 3.82% Total current assets 48.01% 48.71% 50.93% 46.54% 74.53% 67.91% 62.00% 56.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% Total assets 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

Liabilities and Shareholders Equity Current Liabilities Short-term borrowings, including current portion of long-term debt 30.42% 24.60% 30.02% 32.83% 17.16% 20.33% 25.00% 28.00% 28.00% 28.00% 28.00% 28.00% 28.00% 28.00% 28.00% 28.00% Accounts payable 10.84% 9.86% 6.76% 6.13% 5.06% 4.82% 5.00% 5.00% 5.00% 5.00% 5.00% 5.00% 5.00% 5.00% 5.00% 5.00% Dividends payable 2.00% 3.99% 3.93% 3.51% 2.53% 2.56% Income taxes payable 4.29% 4.88% 3.72% 8.45% 3.73% 3.54% Accrued compensation and related items 5.19% 5.63% 4.92% 4.11% 3.41% 3.50%Accrued litigation settlements 0.00% 0.00% 0.00% 0.00% 2.73% 0.48% Other current liabilities 15.53% 19.76% 13.74% 13.06% 11.41% 12.40% Liabilities of discontinued businesses held for sale 0.00% 0.00% 2.73% 2.19% 0.00% 0.12% Total current liabilities 68.28% 68.72% 65.81% 70.27% 46.03% 47.75% 50.00% 56.00% 62.00% 65.00% 65.00% 65.00% 65.00% 65.00% 65.00% 65.00% Long-term debt 10.18% 6.44% 12.51% 11.89% 11.20% 13.14% 11.00% 11.00% 11.00% 11.00% 11.00% 11.00% 11.00% 11.00% 11.00% 11.00%Pension benefit obligations 0.00% 0.00% 0.00% 0.00% 5.57% 5.09% Postretirement benefit obligation other than pension plans 2.96% 3.24% 2.81% 2.36% 2.82% 2.62% 2.80% 2.80% 2.80% 2.80% 2.80% 2.80% 2.80% 2.80% 2.80% 2.80% Deferred taxes on income 2.78% 2.18% 1.91% 1.38% 25.76% 22.80% Other noncurrent liabilities 15.80% 19.42% 16.96% 14.10% 8.63% 8.60% Total non-current liabilities 31.72% 31.28% 34.19% 29.73% 53.97% 52.25% 50.00% 44.00% 38.00% 35.00% 35.00% 35.00% 35.00% 35.00% 35.00% 35.00% Total liabilities 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

Shareholders Equity Preferred stock, without par value; 0.00% 0.00% 0.00% 0.00% 0.33% 0.28% Common stock, $.05 par value 2.38% 2.10% 1.86% 1.71% 0.67% 0.64% Additional paid-in capital 42.60% 55.33% 50.84% 46.96% 101.56% 98.27% Retained earnings 132.32% 121.91% -14.49% -8.95% -2.90% 51.98% Accumulated other comprehensive expense -7.49% -9.42% -62.20% -81.91% -44.90% 3.34% Employee benefit trusts -20.70% -21.04% 133.55% 151.59% 44.94% -1.80% Treasury stock, shares at cost: 2000-435; 1999-413 -49.11% -48.88% -9.56% -9.40% 0.30% -52.71% Total shareholders equity 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

60

Statement of Cash Flows

Actuals(Millions) Forecasts(Millions)1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Operating Activities Income from continuing operations $4,972 $3,718 $7,788 $9,126 $3,910 $11,361 $11,580 $13,213 $14,746 $16,221 $17,843 $19,627 $21,590 $23,749 $26,124 $28,736 Adjustments to reconcile income from continuing operations to net cash provided by operating activities: Cumulative effect of a change in accounting principle $0 $0 $0 $410 $30 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Discontinued operations $0 $0 ($251) ($278) ($16) $22 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Harmonization of accounting methodology $0 $0 ($175) $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Loss on sale of animal health feed-additive products $0 $85 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Trovan inventory write-off $310 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Merger-related in-process research and development charge $0 $0 $0 $0 $5,052 $1,071 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0

Costs associated with the withdrawal of Rezulin $0 $102 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Gain on sale of business $0 $0 $0 ($77) ($3,885) ($51) $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Gains on sales of product lines $0 $0 $0 ($34) ($87) ($12) $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Gains on sales of equity investments $0 ($216) ($17) $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Asset impairment charges $0 $0 $0 $63 $2,820 $702 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Depreciation and amortization $905 $968 $972 $1,036 $4,078 $5,093 $4,632 $3,524 $2,359 $2,595 $2,855 $3,140 $3,454 $3,800 $4,180 $4,598 Deferred taxes and other $213 ($265) $193 ($385) ($104) ($1,579) $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Charges to write-down equity investments $0 $0 $0 $0 $16 $40 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Other $0 $0 $0 $0 $604 $555 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Changes in assets and liabilities, net of effect of businesses divested: Accounts receivable ($1,274) ($498) $81 ($963) ($904) ($465) $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Inventories ($278) ($436) ($110) ($129) ($202) ($542) ($618) ($705) ($786) ($865) ($952) ($1,047) ($1,151) ($1,267) ($1,393) ($1,533) Prepaid and other assets ($127) $365 $106 ($1,423) ($905) ($640) $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Accounts payable and accrued liabilities $378 $807 ($412) $461 $670 ($708) $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Income taxes payable $144 $1,315 $332 $1,736 ($550) $805 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Other deferred items $250 $250 $354 $321 $1,198 $688 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Net cash provided by operating activities $5,493 $6,195 $8,861 $9,864 $11,725 $16,340 $15,440 $15,856 $16,712 $17,951 $19,746 $21,721 $23,893 $26,282 $28,910 $31,801

Investing Activities Purchases of property, plant and equipment ($2,493) ($2,191) ($2,105) ($1,758) ($2,641) ($2,601) ($3,860) ($4,404) ($4,915) ($5,407) ($5,948) ($6,542) ($7,197) ($7,916) ($8,708) ($9,579) Proceeds from disposals of property, plant and equipment $83 $91 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Purchases of short-term investments, net of maturities ($9,270) ($7,982) ($14,218) ($12,652) ($9,931) ($17,499) $20,072 $22,903 $25,560 $28,116 $30,927 $34,020 $37,422 $41,164 $45,281 $49,809 Proceeds from redemptions of short-term investments $7,785 $6,592 $12,808 $9,781 $12,060 $11,723 $13,124 $15,856 $19,661 $21,628 $23,790 $26,169 $28,786 $31,665 $34,831 $38,315 Purchases of long-term investments ($40) ($618) ($3,708) ($2,877) ($1,883) ($1,329) $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Proceeds from redemptions of long-term investments $42 $346 $80 $3,477 $356 $1,570 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Increases in long-term loans ($41) ($220) $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Purchases of other assets ($253) ($174) ($227) ($528) ($788) ($327) $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Proceeds from sales of other assets $193 $184 $132 $272 $360 $6 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Proceeds from sales of businesses $26 $193 $8 $220 $5,602 $1,276 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Cash and cash equivalents acquired through acquisition of Pharmacia $0 $0 $0 $0 $1,789 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Other investing activities $62 $26 $95 ($273) ($86) $22 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Net cash used in investing activities ($3,906) ($3,753) ($7,135) ($4,338) $4,838 ($9,422) $9,264 $10,571 $11,797 $12,977 $14,274 $15,702 $17,272 $18,999 $20,899 $22,989

Financing Activities Proceeds from issuances of long-term debt $14,025 $18 $1,837 $603 $600 $2,586 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Repayments of long-term debt ($14,046) ($529) ($151) ($374) ($439) ($664) $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Increase in short-term debt $2,134 $1,247 $2,344 $2,815 $194 $2,466 $2,934 $3,876 $4,915 $5,407 $5,948 $6,542 $7,197 $7,916 $8,708 $9,579 Decrease in short-term debt ($14) ($2,427) ($519) ($539) ($946) ($288) $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Proceeds from common stock issuances $62 $59 $62 $66 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Purchases of common stock ($2,542) ($1,005) ($3,665) ($4,996) ($13,037) ($6,659) ($6,948) ($7,047) ($6,882) ($7,570) ($8,327) ($9,159) ($10,075) ($11,083) ($12,191) ($13,410) Cash dividends paid ($1,820) ($2,197) ($2,715) ($3,168) ($4,353) ($5,082) ($4,632) ($4,581) ($5,112) ($5,623) ($6,185) ($6,804) ($7,484) ($8,233) ($9,056) ($9,962) Stock option transactions and other $574 $1,129 $711 $594 $1,072 $1,012 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0Net cash used in financing activities ($1,627) ($3,705) ($2,096) ($4,999) ($16,909) ($6,629) ($6,485) ($6,166) ($5,898) ($6,488) ($7,137) ($7,851) ($8,636) ($9,499) ($10,449) ($11,494)

61

FORECASTS1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Operating Income $6,945,000,000 $5,781,000,000 $9,984,000,000 $11,796,000,000 $3,263,000,000 $14,007,000,000 15,439,704,000.00$ 17,617,805,100.00$ 19,661,470,491.60$ 21,627,617,540.76$ 23,790,379,294.84$ 26,169,417,224.32$ 28,786,358,946.75$ 31,664,994,841.43$ 34,831,494,325.57$ 38,314,643,758.13$

Operating Activities Income from continuing operations 71.59% 64.31% 78.00% 77.37% 119.83% 81.11% 75.00% 75.00% 75.00% 75.00% 75.00% 75.00% 75.00% 75.00% 75.00% 75.00% Adjustments to reconcile income from continuing operation