Shares of Johnson & Johnson (NYSE:JNJ) have returned 18.5% since they reached the 52-week low of $61.71 in May 2012. At $73.10, the stock is trading near its 52-week high and offers an attractive dividend yield of 3.3%. Given the solid price appreciation, should you buy the stock at the current price level? In this article, I will elaborate on my stock valuation analysis which may assist you in formulating the investment decision.
From a relative valuation standpoint, JNJ's valuation appears to be somewhat attractive based on the firm's solid financial performance relative to its peers' (see comparable analysis chart below). Sell-side analysts on average predict JNJ's revenue, EBITDA, and EPS to grow at CAGRs of 5.1%, 6.9%, and 20.5%, respectively, over the current and next year. Those consensus estimates are considerably above the averages of -0.7%, -2.7%, and 10.7%, respectively, for a peer group consisting of JNJ's primary competitors listed in the US market. Similarly, the firm's EBITDA margin is forecasted to expand by 1.1% over the same period, outperforming the peer-average estimate of just -1.7%. On the profit side, JNJ's various margin metrics are fairly comparable to the group averages, and its capital return measures including ROE and ROIC are slightly above the par. The company carries a relatively low level of debt as reflected by its below-average debt to capitalization and debt to EBITDA ratios. In terms of liquidity, JNJ's free cash flow margin is below the par, but it remains healthy on an absolute basis. Due to the lower leverage, the firm was able to maintain a healthy interest coverage ratio. Both the firm's current and quick ratios are fairly in line with the peer averages, reflecting a healthy balance sheet performance.
To summarize the financial comparisons, JNJ's superior growth potential would likely be the primary support to the stock valuation. Given the company's solid profitability and liquidity position, I believe the stock's fair value should deserve a premium over the peer-average level. Nevertheless, JNJ's current valuations at 8.5x forward EV/EBITDA and 13.2x forward P/E are almost in line with the peer averages at 8.1x and 13.2x, respectively, and the stock's 2.0x PEG ratio is 40.9% below the peer average at 3.3x, suggesting JNJ may be somewhat undervalued (see chart above).
Moreover, JNJ's forward P/E multiple of 13.2x is currently trading at 6.8% discount to the same multiple of the S&P 500 Index, which stands at 14.3x now (see chart below). I believe the multiple discount is unwarranted and the stock should trade at least on par with the market level provided that 1) JNJ's long-term estimated earnings growth rate of 6.5% is not substantially below the average estimate of 8.6% for the S&P 500 companies; 2) the company has been able to maintain a stable and robust free cash flow margin; 3) the stock offers a dividend yield at 3.3%, which is higher than the market average; and 4) JNJ has an industry-leading market position with significant international diversification.
To support my view, I also performed a DCF analysis which incorporates the market's consensus revenue and EBITDA estimates from fiscal 2013 to fiscal 2017 (see DCF chart below). The revenue growth rates in fiscal 2018 and the terminal year are assumed to be 1.5% and 1.0%, respectively. The EBITDA margins over the same period are set to be equal to the market's estimated margin for fiscal 2017. Other free cash flow related items including depreciation and amortization, tax expense, capital expenditure, and net working capital investment are projected based on their historical ratios relative to the total revenue as those ratios have been trending steadily over time.
A company-specific risk premium of 3.5% is applied in the cost of equity calculation to account for the financial projection risk. Instead of using the currently depressed 10-year US Treasury Bond yield, a normalized 10-year risk-free rate of 2.5% is used. As such, based on a WACC of 9.0%, a terminal growth rate of 1.0%, and an implied EV/EBITDA multiple of 8.3x, the model yields a stock value of $79.34, which is 8.5% above the current share price at $73.10. To test the sensitivity of the model price, an assumption combination of 0.0% terminal growth rate and 10.5% WACC would drag down the stock value to $63.31, and a mix of 0.0% terminal growth rate and 28.2% terminal EBITDA margin will result in a value of $66.93. Both scenarios represent an average downside of just 10.9% from the current price level even without considering the 3.3% dividend income. Given the relatively conservative assumptions used in the model and the limited valuation downside, the DCF analysis suggests a tempting valuation level.
JNJ has a track record of raising dividend. Since 2010, the company has raised the dividend 3 times by 10.2%, 5.6%, and 7.0%, consecutively. According to a chart shown below, JNJ's free cash flow has demonstrated a stable performance over the past few years, and the company's annual dividend payment only represented less than a half of the annual free cash flow generated, indicating that there remains an ample capacity to sustain the current pace of the dividend growth (see chart below). Moreover, under the current low-interest market environment, I believe the strong investor demand for high-yield quality assets would weigh on the upside for JNJ's dividend yield, implying a floor for the stock price. Assuming a target dividend yield range from 3.0% to 4.0% (JNJ's dividend yield has never reached this level), and supposing that the annualized dividend per share would be raised by 7.0% from the current level at $2.44 to $2.61 in May 2013 payment period, this conservative scenario would suggest a stock value range from $65.25 to $87.00, or an attractive price return range from -10.7% to 19.0% without accounting for the 3.3% dividend income.
On the qualitative side, Deutsche Bank's research analyst, Kristen Stewart, has recently upgraded stock rating to buy based on the following view (sourced from Thomson One, Equity Research):
"For the past several years, JNJ has weathered through patent expirations, a general slowdown in utilization trends, and challenges with its OTC businesses. As we look ahead to 2013, we believe JNJ will see improving trends. We expect recent and new drugs to continue to drive pharma sales. A slight improvement in utilization and new products should benefit MD&D. For Consumer, J&J should continue to work through the McNeil Consent Decree and return products to market. Given these improving trends and the benefits of diversification, we believe JNJ deserves a premium to its peers."
Bottom line, in the light of the company's solid growth prospects as well as the stock's attractive valuation level and sustainable dividend yield, JNJ should deserve a buy rating.
The comparable analysis and DCF charts are created by the author, all other charts are sourced from Capital IQ, and all historical and consensus estimated financial data in the article and the charts is sourced from Capital IQ unless otherwise noted.