Top 4 Pharma Stocks Comparison Using Magic Formula

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This is the 3rd article of the series on Pharma Sector Analysis by Sadhan.

Read Part-1 here: The Building Blocks of Pharma Sector

Read Part-2 here: The Regulatory Framework in the Pharma Sector

During this 5-weeks course series, we target to capture the following modules:

Moving on with Module-3 of this course, this blog intends to present you a financial overview of the sector.

We shall also be using the Magic Formula of Joel Greenblatt to analyze the pharma stocks in the pharma sector.

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Let us first have a financial overview first:

Pharma Sector: Financial Overview

Pharmaceuticals is a huge industry with hundreds of listed pharma stocks. So for the ease of analysis, we have picked the Top 10 Pharma stocks by Market Capitalisation as the universe for presenting this financial analysis.

Also, these 10 Stocks constitute the Nifty Pharma Index.

Stock Market Cap (Rs cr)
Sun Pharma 1,20,747
Divi’s Labs 92,094
Dr. Reddys Labs 77,671
Cipla 59,669
Biocon 50,394
Aurobindo Pharma 48,832
Torrent Pharma 44,165
Cadila Health 43,591
Lupin 39,829
Alkem Lab 32,033
This is the pecking order by market cap with Sun Pharma leading the bandwagon.

Let us look at companies by highest Sales. The list is as below:

Stock Sales (Rs cr)
Sun Pharma 32,478
Aurobindo Pharma 24,461
Dr. Reddys Labs 18,183
Cipla 18,131
Lupin 14,977
CadilaHealth 14,850
Alkem Lab 8,597
Biocon 6,745
Torrent Pharma 6,329
Divi’s Labs 6,265
While Sun maintains its market cap rank with Highest Sales also whereas No 2 co by Market cap i.e. Divi’s Lab is at the bottom of the list.

Price/Sales or Market Cap/Sales

If we tally the 2 above-mentioned tables then we can calculate Market Capitalisation/Sales for all these top 10 pharma stocks.

Price/Sales or Market Cap/Sales shows how much investors are willing to pay per Rupee of sales for a stock.

Analysis of Pharma Stocks

The key finding here is: Divi’s Lab and Biocon share moves higher/faster for incremental sales than other large-cap pharma majors.

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ROCE Analysis

We consider ROCE as a paramount ratio for analyzing the capital efficiency of the pharma stocks. So, we have calculated the ROCE for all 10 stocks and the result is below:

Stock ROCE ( %)
Alkem Labs 29%
Divis Labs 19%
Cipla 15%
Biocon 13%
Lupin 12.%
CadilaHealth 11.8%
Dr Reddys Labs 11.1%
Torrent Pharma 11%
Sun Pharma 9%
Aurobindo Pharma 9%

Companies with a large share of EBITDA from India (e.g. ALKEM) have reported better ROCE against export-oriented companies (e.g. Aurobindo, Sun, DRL) during the last 5 years

What Does EBITDA Margin Tell Us About Pharma Stocks?

EBITDA Margin tells us a lot about the business model of these Pharma companies below:

EBITDA Margins of Pharma Companies

DIVI’S Lab score high with 40% EBITDA Margin as it earns 41% Revenue from custom synthesis business where it enjoys strong relationships with big pharma

Mr. Joel Greenblatt a legendary Investor had written a small book (76 pages if I am not wrong) named “The Little Book That Beats the Market” and had propagated the idea /framework he calls “Magic Formula Investing”.

The performance of this portfolio has been stellar as shown below:

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Magic Formula Performance

The Value of $10,000 invested using the Magic Formula after 20 year shows the magic

What is Magic Formula?

Magic Formula Investing

Magic Formula Framework in 5-easy Steps

We have broken down this framework into 5 easy steps:

First, we define the universe: As we have seen that by market cap, all top 10 companies are formulation companies, so we have expanded the universe by adding Top 10 API manufacturers in the list so that we get a balanced view and representation.

Here goes our list:

Step 1: Calculate ROCE

Pharma Stocks Analysis Using Magic Fomula

Step 1 is calculating ROCE using the above mentioned formula
Pharma Stocks Analysis Using Magic Fomula

Step 2: Rank High ROCE Cos

Rank the Pharma Stocks (or any other set of stocks) with the highest ROCE as 1 and others similarly. So the list looks like this:

Pharma Stocks Analysis Using Magic Fomula

High ROCE ensures efficient business management & fund utilization
Pharma Stocks Analysis Using Magic Formula

Step 3: Calculate the Earning Yield

Calculate Earning yield using above mentioned formula
Pharma Stocks Analysis Using Magic Formula

Step 4: Rank basis high Earning Yield

Rank the stocks with the highest Earning Yield as 1 and others similarly. High Earning Yield means that the company is undervalued

Step 5: RankSum i.e. Best of both world

Add both the Ranks and Arrange the stocks in increasing Rank Sum order as below:

Pharma Stocks Analysis Using Magic Formula

What is the End Game?

So the endgame is finding 2 winners and sell 2 losers.

If it is in your portfolio, calibrate the portfolio after 1 year by repeating all 5 steps again. Period. The Magic Formula can be applied to any set of stocks.

The Building Blocks of Pharma Sector

The Regulatory Framework of Pharma Sector

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Amitabh Vatsya

Amitabh Vatsya

Amitabh Vatsya is an active Investment Vlogger (http://youtube.com/c/Sadhansimplified) | Loves to share his ideas at http://wealthsutra.wordpress.com | Follow him @amitabhvatsya
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