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Johnson & Johnson (NYSE:JNJ) has delivered strong returns to its shareholders over the past 1 year. The stock is up 38% compared to the 26% increase in the S&P 500. Currently trading at $86 a share, the stock is valued at 23 times its trailing twelve month earnings; a multiple not seen in almost a decade. Trading at high multiples is very uncommon for safety stocks such as JNJ. In this article, we will examine the company's fundamentals and perform a valuation analysis to determine if the stock is still a worthy investment candidate.

Growth:

JNJ's historical growth rates are a mixed bag. While the revenues in the most recent quarter were up 8% compared to the corresponding quarter last year, the net income was down 11% and EPS was barely up 1%. Over the last 3 years, income declined by an annual rate of 5% while EPS was flat. Going forward, analysts expect a long-term growth rate of 6.3% below the projected growth rate of the industry. My predicted growth rate of 7% is on par with the analyst expectations and is derived by using a fundamentals-based growth approach.

The growth rates are presented in the table below:

Growth Rates

3 Year

YOY

QOQ

Revenue

3%

3%

8%

Income

-5%

12%

-11%

EPS

0%

30%

1%

Growth Estimates

JNJ

Industry

S&P500

Next Year

7.00%

64.60%

12.10%

Next 5 Years

6.33%

13.48%

9.42%

Profitability and Operations:

JNJ has maintained its gross margins in the tight range of 67 to 69%. The operating margins and net margins have declined over the last 3 years falling from an average of 22% and 18% to 19% and 15%, respectively. Additionally, return on equity and return on assets declined from 20% to 16%, and from 11% to 9%, respectively over the last 3 years. The profitability and operational metrics are shown below:

Profitability & Operations

3 Year

1 Year

TTM

Gross Margin

69%

68%

67%

Operating Margin

22%

20%

19%

Net Margin

18%

16%

15%

Return on Equity

20%

18%

16%

Return on Assets

11%

9%

9%

Competition:

To compare JNJ to its competitors, key operational and valuation metrics for its peers were obtained. The peer group selected for analysis included Pfizer (NYSE:PFE), Eli Lilly (NYSE:LLY), Medtronic (NYSE:MDT), Amgen (NASDAQ:AMGN) and Sanofi (NYSE:SNY) and Roche (OTCQX:RHHBY). The table below presents the peer analysis results.

Ticker

Mkt Cap

Price

P/E

P/S

Lt D/E

ROA

ROI

GM

OM

PFE

200.45B

28.26

20.03

3.4

38.19

5.09

6.04

81.29

20.48

LLY

61.24B

54.36

13.03

2.68

37.38

12.01

16.12

78.78

23.93

MDT

52.83B

52

15.4

3.16

55.12

10.27

11.88

75.13

25.62

AMGN

78.84B

105.12

17.78

4.53

126.1

8.42

9.74

82.53

32.3

SNY

145.45B

54.96

22.67

3.08

18.69

4.72

5.47

68.19

17.54

RHHBY

218.88B

63.42

21.89

4.54

123.22

15.47

22.9

73.69

30.99

JNJ

241.45B

85.97

23.38

3.58

17.72

8.95

11.19

67.78

20.49

As shown above, JNJ appears expensive compared to its peer group.

Valuation:

Valuation analysis was performed using residual income analysis and three scenarios identified below:

  • Optimistic Scenario: In this scenario, I assumed that JNJ would report 2013 and 2014 EPS meeting the high end of analyst expectations. A growth rate of 8% was assumed for the next 5 years beating market expectations.

  • Realistic Scenario: This scenario is based on my expectations. I started my analysis in this scenario employing the average 2013 and 2014 EPS estimates. A long-term growth rate of 7% was used as part of this analysis.

  • Pessimistic Scenario: In this scenario, I assumed that the company would miss average forecasts for 2013 and 2014 and report an EPS matching the low end of analyst expectations. A long-term growth rate of 6% was assumed as part of this analysis.

A cost of equity of 10% and a stable growth rate of 3% was applied in the case of all three scenarios. The analysis results are presented below:

Optimistic Scenario:

EPS 2013 - $5.5

EPS 2017 - $7.2

PV of Residual Income = $25.6

PV of Terminal Value = $30.9

Existing Book Value = $23.8

Intrinsic Value = $80

Realistic Scenario:

EPS 2013 - $5.4

EPS 2017 - $7.1

PV of Residual Income = $24.7

PV of Terminal Value = $30.2

Existing Book Value = $23.8

Intrinsic Value = $79

Pessimistic Scenario:

EPS 2012 - $5.4

EPS 2021 - $6.7

PV of Residual Income = $22.9

PV of Terminal Value = $27.5

Existing Book Value = $23.8

Intrinsic Value = $74

As shown in the above, JNJ's fair value is in the range of $74 to $80. At current levels, the stock appears modestly overvalued. I would book profits at current levels and avoid the stock.

Disclaimer: Kindly use this article for information purposes only. Please consult your investment advisor before making any investment decision

Source: Johnson & Johnson - Avoid This Safety Stock