Johnson & Johnson Is Not As Expensive As You Think

| About: Johnson & (JNJ)

If you pull up a stock screen for Johnson & Johnson (NYSE:JNJ), you will likely receive a quick indication that the stock is probably overvalued. Per the E-Trade website, Johnson & Johnson appears to trade at over 21x earnings, with the price of $81.53 seeming much larger than the displayed earnings per share of $3.86.

This is one of those circumstances where the earnings per share reported by many of the brokerage search engines and quick stock screeners understate the true earnings power of the firm. The healthcare giant had to report $1.24 per share in non-recurring items that may prevent some investors from realizing the true earnings power of the firm at current stock prices. Johnson & Johnson's earnings in 2012 (if you discount one-time events that understate the company's earnings power) actually turned out to be $5.10 per share. The 2013 analyst consensus of earnings estimates for the company are $5.43 per share.

That tells a slightly different story. If you remove one-time items, Johnson & Johnson's trailing P/E ratio is actually 15.99x earnings, rather than the 21x earnings that the present figure indicates. If you look, accept the guidance that the company will earn $5.43 this year, then the company is trading at 15x forward earnings. However, if you believe that Johnson & Johnson's problems with recalls over the past couple of years do not truly constitute "one-time items" and are likely to continue indefinitely, then the stock may not appear cheap to you.

However, if you do accept the company's classification of $1.24 worth of earnings impairment as non-recurring, then Johnson & Johnson is likely fairly valued right now (as opposed to overvalued). The last time that the company traded at over 20x earnings happened during the 1997-2002 bubble years, and investors only achieved 2-6% annual returns over the subsequent decade (depending on the price point at which they bought). However, if you accept the argument that company's true earnings power is in the low $5 range (by believing that the company's reports of one-time impairments turns out to be accurate), then the company is likely trading at the same P/E valuation that it did in 2006 (the company has delivered returns of roughly 6% annually since then, depending upon when you bought in 2006), and this is not bad considering the combination of recalls, unfavorable currency translation, and slow growth during the 2008-2010 financial crisis that accompanied the recent seven-year period.

Most likely, if you choose to buy shares of Johnson & Johnson at today's prices, your future returns will likely correlate with the overall earnings growth of the business. If Johnson & Johnson grows by 6% annually for the next decade, you'll probably get around 6%. If the company grows by 10% annually, you'll probably get around 10%. Accepting that the company's normalized earnings power is around $5 per share and the company is trading at 15-16x normalized earnings, it seems unlikely that current investors will either benefit from future P/E expansions or get hurt by P/E contractions over the long-term.

Those facts do not make Johnson & Johnson a screaming buy right now, but it makes the investment seem much more attractive than if followed the 21x earnings valuation indicated by most brokerage search engines right now. If that were the case, investors would likely experience total returns that lagged the earnings growth of the company going forward. Because the $5 per share in normalized earnings likely indicate fair valuation, the terms are much more attractive because your future success with Johnson & Johnson will likely mirror the company's business performance going forward. It is up to you to decide whether you want to buy an excellent company at a fair price, or insist on a margin of safety so that you can still do well if the company experiences the kind of difficulties over the next seven years that it has endured over the past seven.

Disclosure: I am long JNJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.