Monsanto Upgraded Ahead of Buyout: 3 Things You Need to Know

By now you've heard the news: German chemicals-and-aspirin giant Bayer (NASDAQOTH: BAYRY) has offered to buy out Franken-seed maker Monsanto (NYSE: MON) in a deal valued at $128 per share -- and Monsanto has agreed.

Sounds like an open-and-shut case, right? Monsanto stock, valued at about $90 before rumors of Bayer's buyout began, should now be trading at $128 or thereabouts, and stick like glue to that stock price until the deal is finalized.

Except that's not what happened.

Instead, Monsanto stock currently costs just $104 and change, 18.5% below the buyout price, as investors hedge their bets, and worry over whether regulators will spray weed-killer all over this deal in an attempt to prevent Bayer from growing too powerful in the agricultural market.

In this, JPMorgan sees an opportunity for profit.

What happens if we pour Monsanto stock into Bayer stock? Image source: Getty Images.

1. Risk and reward

One of the best-rated investors on Motley Fool CAPS, investment banker JPMorgan boasts a record of outperforming the market by nearly 5 percentage points per pick on its stock recommendations. Today, the banking giant is going out on a limb to argue that everyone else in the stock market is wrong -- not just about the risk of Bayer not being allowed to buy Monsanto, but on the value of Monsanto itself.

As explained in a write-up on StreetInsider.com this morning, JPMorgan looks at the price Bayer is offering to pay (relative to Monsanto stock's price today), and at the price of Monsanto stock today (relative to Monsanto stock's price a few months ago), and concludes: "The reward and risk is then $25 up and ($13) down or a 66% probability the deal is frustrated and a 34% chance that it succeeds."

That's what JPMorgan thinks other investors are calculating as the odds of this deal going through. But JPMorgan disagrees -- and believes Monsanto really is worth $128, and that Monsanto stock is a buy.

2. If the merger happens

JPMorgan thinks this merger will happen. JP's new buy rating, and its $128 price target, confirm that despite other investors gauging success as only a 34% probability, JPMorgan thinks the merger will go through at the $128 offer price.

Part of the reason for this belief could be that mergers are in the air in the chemicals industry this year. Dow Chemical (NYSE: DOW) and DuPont (NYSE: DD) are merging in a $130 billion deal. ChemChina is buying Syngenta (NYSE: SYT) in another deal valued at $43 billion.

Assuming regulators would let these other mergers proceed, but scotch the Bayer-Monsanto deal, is simply illogical.

3. If the merger doesn't

$133 billion, $43 billion -- these big numbers bracket the $66 billion that Bayer is bidding to buy Monsanto. Looked at another way, ChemChina is offering to pay 36 times earnings for Syngenta. DuPont stock currently costs more than 26 times earnings, while a combined Dow-DuPont appears to be valued at nearly 13 times the company's combined earnings.

Crunching all these numbers, with a few more from chemicals companies Air Products, Praxair, and PPG Industries (valued at 55, 21, and 19 times earnings, respectively) besides, JPMorgan concludes that even if the Bayer-Monsanto merger doesn't happen, Monsanto should be worth at least 20 times earnings all on its lonesome.

Moreover, JPMorgan believes that in 2018, Monsanto will earn "roughly $5.00 per share ... in 2017." Times 20 per share, that works out to a "$100/sh" valuation on the stock. Accordingly, JP sees the downside risk as Monsanto stock falling to $100 a share (4% downside), not $90 (14%). At the same time, JP sees the potential for $128 a share if Bayer succeeds in buying Monsanto -- a potential 23% gain.

The most important thing: Valuation

Is JPMorgan right about that? Is Monsanto really worth 20 times earnings, just because that is in the range of the valuations that investors are paying for its peers?

I'm not so sure. According to data from S&P Global Market Intelligence, most analysts who follow Monsanto stock expect it to grow its earnings at no more than 8% annually over the next five years, exclusive of any boost from Bayer. Even with a 2.1% dividend yield tossed in, paying 20 times earnings for 8% growth doesn't seem like a very good deal to me.

Moreover, Monsanto isn't currently earning anywhere near "$5 per share," but only $2.27 over the past 12 months. If you pay the price that JPMorgan says Monsanto is worth, you're paying a high price today for earnings that you only hope will materialize two years in the future -- again, a risky bet, in my opinion. Valued on its earnings today, Monsanto stock costs closer to 46 times earnings, and is an even worse-looking deal.

So what's my advice? If Bayer wants to pay 46 times earnings for Monsanto, let them. New investors, however, should stay away.

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Fool contributorRich Smithdoes not own shares of, nor is he short, any company named above. You can find him onMotley Fool CAPS, publicly pontificating under the handleTMFDitty, where he currently ranks No. 280 out of more than 75,000 rated members.

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