CVS: priced at 6.2x FWD EBT only
The thesis of this article is really simple. I will explain why CVS Health Corporation (NYSE:CVS) is a good fit to the so-called Buffett 10x Pretax Rule (referred to as EBT, for earnings before taxes, in the remainder of this article). It demonstrates all the key traits for such a good fit. In the remainder of this article, I will elaborate on the following key traits that it demonstrates:
- It is only for sale only 6.2x FWD EBT at its current prices.
- It has no existential risks either in the short term or long term in my view.
- And it has a strong prospect for perpetual growth thanks to the secular support, its robust return on capital, and also organic cash flow to sustain reinvestment.
CVS and Buffett’s 10x pretax rule
For readers new to the rule, I have a blog article that describes the rule in a lot more details (plus all the Q&A I’ve received from my readers). Here, I will just quote the key points from the blog article to facilitate the rest of the discussion.
- The rule really is an observation that Buffett has paid ~10x pretax earnings for many of his largest and best deals, ranging from Coca-Cola, American Express, Wells Fargo, Walmart, Burlington Northern, and the more recent Apple investment.
- This is unlikely to be a coincidence, because buying a business that stagnates forever at 10xEBT would already provide a 10% pretax earnings yield, directly comparable to a 10% yield bond (as bond yields are quoted in pre-tax terms). Any growth is a bonus.
As such, if you hold a portfolio of stocks that have good compounding potential with an entry price around or below 10x EBT, you should have favorable odds of achieving 10% annual return. Both Buffett’s success and our own experience can testify to these odds.
Let’s apply the simple part of the rule on CVS first and see if it’s valued at 10x EBT or below. The chart below compares the historical prices of CVS to its 10xEBT in the past ~13 years since 2010. As you can clearly see, the stock price never strayed too far from 10x EBT. Whenever it did, it had been an excellent opportunity to either long or short the stock. And now is a time that the stock is trading far below 10x EBT. Consensus estimates for its FWD EPS is around $8.58 per share as seen in the second chart below.
The company’s effective tax rate has been around 27.5% in recent years. And its current stock price is about $74 per share as of this writing. If you put all these numbers above together, you would conclude that its FWD EBT multiple is only about 6.22x, translating into an EBT yield of more than 16%, far above the requirement in the Buffett rule.
CVS: perpetual growth prospects
Now, let’s apply the harder part of the rule on CVS and examine if it has compounding power in the long term. To compound in the long term, the company has to first survive in the long term. CVS caters to a perpetual human need and enjoys a leading scale in this space. But evaluating existential issues in the long term ultimately boils down to a subjective judgment (or speculation). So here I will just say that I don’t see any existential issues for CVS without delving into the topic too much.
If we agree to move past the existential risks, then evaluating its compounding potential is a more subjective discussion. In the long term, the compounding rate (or organic growth rate) is governed by two parameters: ROCE (the return on capital employed) and also reinvestment rates. The chart below shows my calculation of CVS’s ROCE since 2011. Note ROCE is different from ROE. ROCE only considers capital actually involved in the operation while equity includes items like idle cash, which is not involved in the operation of the business (but nice to have). Here, for a business like CVS, my ROCE calculation considers the following items: payables, receivables, inventory, Property, Plant, and Equipment. As seen, under this consideration, CVS has been maintaining a robust ROCE on average of 28.7% in the long-term. Its current ROCE is quite close to the long-term average.
In terms of reinvestment rate, the company has been maintaining investment rates of around 7.5% to 10% in recent years. Based on these inputs, the next table shows my projection for its long-term compounding rates under different scenarios. And I think the most likely scenario would be somewhere around 4% as highlighted in the table.
If you recall from an earlier chart, consensus estimates project a growth rate of 5.8% on average for the next few years, which is pretty close to my projection. The discrepancy here is largely due to the difference between real growth and nominal growth rates. My calculation is for its real growth rate, i.e., before inflation. I believe consensus estimation is for its nominal growth rate, which includes inflation.
Risks and final thoughts
Before closing, it is important to remind potential investors that CVS faces risks despite all the positives mentioned above. CVS faces all the risks common to the broader healthcare industry and also some unique risks specific to its own business model. Here I will just focus on the latter. The top two risks/uncertainties that are more unique to CVS are the Pharmacy Benefits Managers, or PBM, reimbursem*nt pressure and its clinic MinuteClinic expansion in my mind. PBMs constantly face scrutiny pressure from regulators and policymakers due to concerns about potential conflicts of interest and inflated drug prices. Changes in regulations or reimbursem*nt models could negatively impact its profitability. CVS has been heavily investing in its MinuteClinic walk-in clinic business in recent years. While this initiative offers potential for growth, it also carries considerable risks in my view. It expands into a rather crowded and competitive market with new operational challenges, regulatory hurdles, and continuous capital investment requirements in the near future.
All told, I think the positives easily outweigh the negatives under current conditions. And the cleanest way to encapsulate the positives is through the 10xEBT framework. Under this framework, paying a price of 10xEBT to buy a business is like owning a bond with a 10% yield even if it stagnates forever (as long as it does not shrink). Under current conditions, CVS is for sale at 6.22x FWD EBT and offers a healthy growth prospect ahead at the same time.
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