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Play The Percentages With GlaxoSmithKline plc

GlaxoSmithKlineThe forward price-to-earnings (P/E) ratio — share price divided by the consensus of analysts’ forecasts for earnings per share (EPS) — is probably the single most popular valuation measure used by investors.

However, it can pay to look beyond the consensus to the spread between the most bullish and bearish EPS forecasts. The table below shows the effect of different spreads on a company with a consensus P/E of 14 (the long-term FTSE 100 average).

EPS spread Bull extreme
P/E
Consensus
P/E
Bear extreme
P/E
Narrow 10% (+ and – 5%) 13.3 14.0 14.7
Average 40% (+ and – 20%) 11.7 14.0 17.5
Wide 100% (+ and – 50%) 9.3 14.0 28.0

In the case of the narrow spread, you probably wouldn’t be too unhappy if the bear analyst’s EPS forecast panned out, and you found you’d bought on a P/E of 14.7, rather than the consensus 14. But how about if the bear analyst was on the button in the case of the wide spread? Not so happy, I’d imagine!

GlaxoSmithKline

Today, I’m analysing top Footsie pharma group GlaxoSmithKline (LSE: GSK) (NYSE: GSK.US), the data for which is summarised in the table below.

Share price 1,680p Forecast
EPS
+/-
consensus
P/E
Consensus 108.7p n/a 15.5
Bull extreme 119.5p +10% 14.1
Bear extreme 100.6p -7% 16.7

As you can see, the most bullish EPS forecast is 10% higher than the consensus, while the most bearish is 7% lower. This 17% spread is far narrower than 40% spread of the average blue-chip company, as well as being narrower than that of sector peer AstraZeneca (36%).

Analysts, then, see a relatively tight range of plausible earnings outcomes for GSK this year. Visibility has improved from a couple of years ago, when the uncertainties surrounding a clutch of patent expiries were at their height.

However, last week GSK announced a major deal with Swiss pharma giant Novartis. Under the deal, the UK firm will acquire Novartis’s vaccines business, the Swiss firm will acquire GSK’s oncology portfolio, and the two companies will pool their over-the-counter products to create a new world-leading consumer healthcare business.

The deal is expected to complete during the first half of 2015, subject to approvals, so analysts will now be re-assessing how GSK’s earnings might play out next year and beyond. More immediately, with 2014 earnings unaffected by the news, the market’s warm response to the announcement has pushed up the current forecast P/E.

While the narrow EPS spread gives us some confidence in this year’s earnings out-turn, the P/E range stretches away from a bull extreme in line with the long-term FTSE 100 average of 14 towards the expensive side, with the consensus at 15.5 and bear extreme at 16.7.

However, GSK is a quality business, and paying a premium price on current-year earnings could still pay off for long-term investors, with GSK’s management expecting the Novartis deal to accelerate earnings “particularly in 2017, as growth opportunities and projected cost savings are delivered”.

Finally, if you already have GSK tucked away in your portfolio and are in the market for more quality blue chips, I recommend you help yourself to this free Motley Fool report.

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G A Chester does not own any shares mentioned in this article. The Motley Fool has recommended GlaxoSmithKline.