Dividend Growth Investors: Focus On Valuation Rather Than Price

Jul.22.13 | About: Johnson & (JNJ)

This article is inspired by a series of comments on Bob Wells' recent excellent article about retirement investing strategies.

A comment thread developed around the idea of stock prices, specifically about the difficulties an investor can experience buying more of a stock that he or she purchased for a lower price in the past. The point I made in the comments, and that I want to expand on here, is that if you shift your focus from price to valuation, the decision becomes clearer and less emotional.

First, let's define price and valuation. This might seem too elementary, but my observations are that people get hung up on price sometimes, and that they don't fully appreciate the power of valuation as a tool to help them make buy, hold, and sell decisions. Valuation includes price, but price by itself tells you nothing about valuation.


Price is, in one sense, obvious. It is the amount in dollars and cents that a share of stock costs. As I write this, the price of Johnson & Johnson (NYSE:JNJ) is $92.33. Here is a 10-year price chart of JNJ:

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Someone focused on price might notice things like this:

  • If they were lucky enough to purchase JNJ at its low in 2009, the price has almost doubled since then.
  • If they bought it in the 2005-2007 or 2010-2012 time periods, its price hovered in the 60s. I remember it being described as "going nowhere" for quite a while. Its current price is now 35-40% higher since then.
  • JNJ's price hasn't has a meaningful dip since about mid-2012.
  • JNJ's price is about at its 52-week high.

With observations like these, someone might conclude that this is no time to buy JNJ. Its price has doubled in 4 years, it has gained 40% in 1-3 years, and it shows no signs of faltering. It is near its 52-week high, a correction must be coming, the whole stock market might correct and take JNJ with it, etc. If someone buys more of JNJ now, they would have to pay 35-40% more than it cost just a few years ago.

I would suggest that these sorts of focuses on price points can be misleading and lead to decisions that are not optimal for a long-term income investing strategy. Better insights come from valuations.


Valuing a stock - comparing it to its "fair" price - puts price into context. Valuation compares the price to some measure of the "fair" or "intrinsic" value of the stock. Investopedia defines intrinsic value as:

The actual value of a company or an asset based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors. This value may or may not be the same as the current market value.

One common way to value a stock is to assess its price-to-earnings (P/E) ratio. Other valuation ratios - such as P/B (price to book), or P/S (price to sales) - are also commonly used. The following screenshot shows Morningstar's computations of several valuation ratios for JNJ. Note that in the last column, you can find JNJ's 5-year averages for the various metrics. Note that a couple of them currently are below their 5-year averages.

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The granddaddy of valuation ratios is P/E. Here is how JNJ's P/E ratio has changed over the past 10 years:

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A common benchmark for the "fair" P/E ratio for moderate-growth stocks is 15. That is, investors are willing to pay 15 times a dollar of earnings for the stock. 15 is also the very long-run historical average P/E of the broad stock market, according to many studies.

As you can see, JNJ's P/E ratio has gone all over the map in the past 10 years, but its mean appears to be a fair amount above 15. That suggests that JNJ has been frequently "overvalued" if you are using 15 as a benchmark. An alternative way of looking at it is that JNJ is a high quality stock that investors have frequently awarded a premium valuation. Presumably, they have done this based on its track record, overall quality, and its expected performance and reliability going forward.

Note also in the YChart that the P/E ratios graphed there are based on TTM (trailing 12 months) earnings. Since most investors look forward, for a stock whose earnings are growing, the TTM P/E ratio will look a little high compared to the same ratio based on forward forecasts of earnings. If the forward forecasts are for, say, 8% earnings growth per year, the TTM P/Es would all be about 8% high.

FASTgraphs provide a visual representation of valuation and price. Here is a recent FASTgraph for JNJ:

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On the FASTgraph above, I selected diluted - that is, GAAP - earnings rather than the default setting of operating earnings, to make the graph more comparable to the YChart. Earnings are shown by the dark green area on the chart. The orange line represents "earnings justified" fair value using a P/E ratio of 15.

The black line represents price. As you can see, JNJ's price has hovered above the orange line for most of the past 10 years (suggesting overvaluation), but it did dip into undervalued territory during the recession and stock market crash in 2008, emerging back above the orange line in 2010.

The blue line shows JNJ's actual P/E ratio for the time of the chart (10 years), and as suggested earlier, it is not unusual for JNJ to be "overvalued" most of the time, that is, to carry a P/E higher than 15. The blue line is always above the orange line.

Chuck Carnevale, the creator of FASTgraphs, uses operating earnings (rather than diluted earnings) as the default setting for his displays. He has found over many years of working with thousands of charts that operating earnings more often lead to better assessments of valuation. Here is the same 10-year chart using operating earnings:

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There is not much difference between the two charts. In both, the black price line is above the orange fair value line, suggesting that the stock is currently overvalued. In both, the blue "normal" P/E line is above the orange line, suggesting that JNJ frequently trades at a P/E greater than 15.

In fact, we saw in the Morningstar table above that JNJ's 5-year average P/E ratio is 15.5, and FASTgraphs shows its 10-year "normal" P/E ratio as 17.5. If we plug that latter ratio into FASTgraphs to override the default ratio of 15, the graph looks like this.

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The pink line is the override P/E ratio of 17.5. By that measure of fair value, JNJ is not overvalued at all. In fact, it is a little under its historical P/E valuation ratio despite its recent price run-up.

The upshot of this discussion is that introducing valuation brings an entirely different perspective to JNJ's price. Whereas when we were only talking about price, we tended to make comparisons among prices at different times - such as comparing JNJ's price to what it was a few years ago or to its 52-week high - now we are led to compare JNJ's price to the fair or intrinsic value of the company.

Before leaving the subject of valuation, I would like to note that Morningstar computes fair values in a different way. They analyze each stock and mathematically project future earnings based on everything they can discover about JNJ, its products, markets, and competitive situation. Then they then discount those future earnings back to the present.

Under Morningstar's approach, JNJ is currently fairly valued.

Morningstar uses a 5-star system to evaluate stocks. Three stars indicate fair valuation on the 5-star scale, based on the analytics just described.

So Is Now the Time to Buy JNJ?

A brief summary of the article to this point would be that if you look only at price, now is definitely not a good time to buy JNJ, but if you look at valuation and expect to hold JNJ for a long time, it may be OK. It is hard to make an argument that now is an outstanding time to buy the stock.

Investing in individual stocks is all about probabilities. You won't get them all right, no one ever does. But no matter what your strategy, you want to tilt the odds in your favor. The odds that you are trying to tilt are the odds that your decisions will help you meet your goals.

In dividend growth investing, most investors are trying to optimize their income streams while minimizing the possibility of permanent loss of capital. Some investors use the strategy to maximize total returns. Let's look at each of those goals for a purchase of JNJ right now.

First, optimizing income streams. Here is a chart of JNJ's current yield over the past 10 years.

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As you can see, JNJ's recent price run-up has caused its current yield to slide down, even though it has been increasing its dividend every year. Even with its recent yield slide, JNJ's yield is higher than in the several years before the Great Recession in 2008. On the one hand, one may view a 2.9% yield from a great company like JNJ to be a good opportunity. On the other hand, one might bet that it is likely that before too long, JNJ will become available with a better yield than it has right now. Indeed, for some dividend growth investors, 2.9% would fail to meet a benchmark that many require of getting 3% minimum yield.

Second, minimizing the chances of realizing a loss in capital. A decent assessment of this comes from FASTgraphs.

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The above is one of my favorite tools in FASTgraphs, the Estimated Earnings and Returns Calculator. It projects JNJ's earnings growth - and therefore its increase in fair value - forward for 5 years, using consensus earnings growth forecasts. (To the right, you can see that estimates from 25 analysts are used for JNJ, and that collectively, they project 5-year earnings growth of 6.2% per year.)

Viewed this way, you can see that JNJ's price has gotten "ahead of itself." If you scan horizontally across from the end of the black current price line, you can see that the orange fair-value line would rise up to meet JNJ's current price around the end of 2015. That suggests that JNJ's price is about 2½ years ahead of itself.

With a long-term strategy such as dividend growth, you might say that this should not dissuade you from buying JNJ right now. You plan to hold it for many years, even for decades, by which time it is far more likely than not that JNJ's price will have gone up and stayed up from today's purchase price. Not only that, the company is of unarguably high quality, and you are willing to "pay up for quality."

On the other hand, you might look at the same data and conclude that even given the long-term probable good results, you would just as soon try to give yourself better odds of success by waiting to purchase JNJ when its price is more in line with or even under fair valuation. You are pretty confident that sooner or later, Mr. Market will give you that opportunity.

Finally, total return. Looking at the same graph above, notice at the top where it says, 5-Year Estimated Total Return = 6.4%. Think about that. If the company's earnings grow at the estimated 6.2% per year, and the stock's dividend yield holds at just under 3%, you would expect its total return to be a little over 9% per year for the next few years. Instead, the estimate is a little over 6% per year.

Where is the difference? It is in the stock's current overvaluation. If we assume that the stock's price is going to revert to fair value over time that means that the stock's price cannot be predicted to rise in step with its earnings growth. While Mr. Market may do anything with the price, the odds suggest that JNJ's price will flatten out, or fall, until it returns at some point to fair valuation (or fair valuation catches up to the price).

That's what holds the total return estimate down: The likelihood of not seeing earnings growth fully reflected in price growth over the next few years. Again we are talking about probabilities here. Nothing in the future is knowable now, and Mr. Market often springs surprises.

What Would I Do?

I would not purchase JNJ at this time, either in bulk or through a drip program. While a long-term case can be made that after a long time, you won't care that you overpaid a little for the shares, my experience is that at any given time, some highly desirable dividend growth stocks can be found at fair or favorable valuations. My practice is to go with those whenever I have this kind of choice.

I faced that decision earlier today, as I had enough accumulated dividends in my wife's and my Perpetual Dividend Portfolio to trigger a purchase. JNJ was on the candidate list, but I selected Chevron (NYSE:CVX) instead.

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For a company with about the same estimated earnings growth rate, I got a better yield (3.2%), significant under-valuation, and a much better projected 5-year total return (15%).

The only thing I didn't get was a better price. I could have gotten JNJ for about $92 a share. CVX cost me $127. Does JNJ's lower price per share make it a better deal? No.

In a different portfolio, I bought CVX for $94 a few years ago. See why I don't care that I had to pay 35% more today?

Disclosure: I am long JNJ, CVX. 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.