In this article, I'm going to show how much Johnson & Johnson stock (JNJ) is worth according to a Warren Buffett "owner earnings" style analysis.
I will be posting a link to the valuation model (in an excel file) that I used along with describing the assumptions that went in it. This file will contain all the cash flow data from JNJ going back to 1991. (The last year in which there is EDGAR data for the stock in the SEC website.)
I built an excel file with a valuation model using Buffett's measure of "owner's earnings." Warren Buffett is known for being skeptical for conventional valuation models that rely on GAAP such as price-to-earnings ratio and the like. He defined one of his methods in the 1986 Letter to Shareholders:
These represent (A) reported earnings plus (B) depreciation, depletion, amortization, and certain other non-cash charges...less (C) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume....Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since must be a guess - and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes...All of this points up the absurdity of the 'cash flow' numbers that are often set forth in Wall Street reports. These numbers routinely include plus - but do not subtract.
In order to make it consistent with his conservative approach, I will be using safe assumptions in order to make sure a buy or sell rating in the stock is not based on predictions that are difficult to make. Please note that this article is not a suggestion that Buffett would value the stock exactly like suggested or that he would agree with this article. I'm simply using a model that is similar to how he described his valuation method, I like to think of these Buffett style valuations as DCF analysis with significant margins of safety (trying to find the fish in the barrel).
The assumptions that went into the model were:
-I defined owner earnings as Operating Cash flow minus Capex minus "other assets" plus asset sales (when there is any). Why add back asset sales? They represent a recovery from old capex and M&A so in a way, its old operating cash flow coming back home. In the past I used to subtract M&A from owner earnings but that can be confusing for some people, as a result I will assess the risks of M&A through other means and leave the owner earnings more "pure" as it is.
-I assume JNJ will have another 10 years of above average owner earnings growth of 5% then normalize to 3% for the long-run. The compounded rate of growth over the last 10 years is 15% (13% since 91). Why I choose 5%? Growth seems to be slowing down:
They have been almost stagnant over the last few years.
In fact, Buffett himself has criticized the company and even started to decrease his stake in the stock. As a result I can't give high hopes for the company to growth too rapidly during the growth phase. I believe 5% is a conservative number.
-JNJ required return is 10% (the rate at which the future cash flows are discounted back to the present). I'm assigning a higher discount rate than CAPM would suggest due the risks of the amount of M&A the company engages in. It is a significant % of operating cash flow, 24% during the last 10 years up from 15.8% in the 10 years prior. Buffett has criticized some of the ways the company structured deals. M&A is a major way in which shareholder value gets destroyed (think Autonomy). Its hard to trust a management that has undelivered recently to the point that Buffett started to sell, if they are gambling which shareholder cash that is a concern.
-Long-term normalized growth is 3%. This is even lower of what World Nominal GDP is likely to be going forward. Earnings growth tends to be quite similar to Nominal GDP growth over long periods of time.
-As margin of safety at the start of the valuation, I took JNJ owner's earnings and decreased by 20%. This 20% decrease takes into account cash liabilities that are unexpected like lawsuits, government fines, patent violations, dumb M&A and other unexpected charges. This adds a margin of safety in estimating future cash flows and is consistent with Buffett's skepticism of people not subtracting enough from cash flow figures.
Plugging all these in the excel file, projecting the owner cash flows and discounting it back to the present at the chosen discount rate yields a fair value price of $66.71. With the stock currently trading at $85 or so, I would call the stock overvalued.
Does that mean the stock is a sell? Well, a conservative estimation of owner cash flows tells me that the stock is over valued but keep in mind that the assumptions I tend to use are very conservative, given the market run-up over the last few years not a lot of stocks will be buys according to this type of analysis. The stock could be a buy at these levels, its just not a safe one and depends in the investors having special insights on how high the company will grow going forward and if the M&A will be smart or not. Instead of trying to make these difficult guesses, I just try to find margin of safety and if there isn't, I move on to the next investment. I encourage readers to use their own numbers and come up with their own exact fair value if they disagree with my assumptions.
According to a safe set of assumptions and a Buffett like valuation model, JNJ stock is currently overvalued. I wouldn't be personally buying stock right now as I believe there are better opportunities out there currently. However, if the stock drifts down to the low $60s I might start to build up a position, especially if people start to get overly pessimistic in the stock.
Additional disclosure: I can't guarantee the accuracy of every data point included in this article, I encourage the reader to double check the data. This article does not constitute investment advice.