The AstraZeneca (LSE:AZN) share price is approaching July’s all-time high following last week’s earnings announcement. It pushes the firm’s heady valuation even higher to a P/E ratio of 68. This certainly makes the stock look expensive on paper, but let’s take a closer look to see what’s going on.
The rich AstraZeneca share price
As a quick reminder, AstraZeneca is a pharmaceutical company. Through extensive research and development, it discovers, develops, and sells a wide range of drugs, focusing primarily on immunology and oncology.
In 2020, much like many other pharma giants, the firm has been pursuing a Covid-19 vaccine. This is likely a contributing factor to the rich valuation. However, management has committed to a non-profit vaccine launch. Therefore it’s unclear as to how much value the vaccine will actually add.
But there’s more to AZN than just a Covid vaccine. In the latest earnings report, the business appeared to be doing exceptionally well, despite the pandemic. Total revenue was up 10%, primarily driven by new medicines.
Seeing revenue originating from new drugs is an excellent sign. On average, it costs around $1.3bn to bring a medicine to market – an expensive investment that doesn’t always pay off. As of October, an additional $2.6bn in revenue has originated from new products this year.
The portfolio continues to expand, with four new regulatory approvals in 2020, a further six submissions yet to be reviewed, and four more drugs in phase-three trials.
The potential revenue from these new drugs, in combination with continued growth in older segments around the world, has analysts predicting $30bn total revenues at the end of 2021. Assuming the company maintains its most recent 19% operating profit margin, this forecast would lead to an estimated $5.7bn in profits (before taxes).
Based on today’s share price, that would put the forecast pre-tax P/E ratio at approximately 26 times (adjusting for exchange rates).
This certainly makes the current AstraZeneca share price more palatable, but only if it can meet shareholder expectations.
A problem with financials
The immense cost of drug development requires continual funding that the firm’s cash flow hasn’t been able to cover.
As such, AstraZeneca is heavily reliant on debt financing. Debt currently represents 58% of the capital structure which adds additional pressure. However, this level of debt is quite common in the industry and not what I’m concerned about.
My concerns surround the dividend policy. The stock has consistently paid out more in dividends than it makes in profits, using reserves and debt to make up the difference. This behaviour is unsustainable and is likely the primary reason why dividends have been cut numerous times in the past.
The bottom line
Overall, I think the business is doing very well and will continue to thrive in the future. The new drugs entering the market present many opportunities to grow. Also, operations continued to be streamlined, eliminating expenses leading to higher margins.
However, based on current and predicted performance, I believe the share price is simply too high.
Zaven Boyrazian does not own shares in AstraZeneca. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.