Defining Intrinsic Value Estimation: Johnson & Johnson

| About: Johnson & (JNJ)

Johnson & Johnson (NYSE:JNJ) is one of our favorite dividend growth gems. Let's take a deep dive into its valuation while acknowledging both its dividend growth track record and solid Valuentum Dividend Cushion score, a cash-flow measure of dividend strength.

Investment Considerations

Investment Highlights

  • Johnson & Johnson's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively.
  • J&J has built one of the most comprehensive bases of health care businesses, generating approximately 70% of revenue from top positions in its respective markets. The firm remains focused on innovation and generating incremental revenue from new products while broadening its geographic presence.
  • Johnson & Johnson has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 23.1% in coming years. Total debt-to-EBITDA was 0.8 last year, while debt-to-book capitalization stood at 20%.
  • The firm's pharmaceutical portfolio remains impressive. The company's REMICADE has 16 indications and 75% share of the US market for IV immunology products. Plus, it has exclusivity through 2018 in the US. STELARA and SIMPONI are other key profit drivers.
  • J&J's dividend track record has been very impressive. The firm's annual dividend payout has advanced from just $0.43 per share in 1997 to its current payout of $2.44 per share. J&J's Dividend Cushion score currently sits at 2.2, indicating the firm's ability to maintain or even increase its dividend payout.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital - ROIC - with its weighted average cost of capital - WACC. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Johnson & Johnson's 3-year historical return on invested capital (without goodwill) is 32.1%, which is above the estimate of its cost of capital of 9.5%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Johnson & Johnson's free cash flow margin has averaged about 19% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at At Johnson & Johnson, cash flow from operations decreased about 13% from levels registered two years ago, while capital expenditures expanded about 23% over the same time period.

Valuation Analysis

The estimated fair value of $97 per share represents a price-to-earnings (P/E) ratio of about 28.2 times last year's earnings and an implied EV/EBITDA multiple of about 13.1 times last year's EBITDA. A firm's valuation is a key component of the Valuentum Buying Index, our stock selection methodology. The valuation model reflects a compound annual revenue growth rate of 4.8% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 2.8%. Our model reflects a 5-year projected average operating margin of 29.7%, which is above Johnson & Johnson's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.6% for the next 15 years and 3% in perpetuity. For Johnson & Johnson, we use a 9.5% weighted average cost of capital to discount future free cash flows.

Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $97 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Johnson & Johnson. We think the firm is attractive below $78 per share (the green line), but quite expensive above $116 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Johnson & Johnson's fair value at this point in time to be about $97 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Johnson & Johnson's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $119 per share in Year 3 represents our existing fair value per share of $97 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

Disclosure: JNJ is included in the portfolio of our Dividend Growth Newsletter. I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.