After the first two articles (here and here) of this series attracted a lot of attention from Seeking Alpha readers, we've picked another popular stock, Johnson & Johnson (NYSE:JNJ) to continue this series. But this time, the conclusion about the stock is not as positive as it were for AT&T (NYSE:T) and Altria Group (NYSE:MO). Let us get into the details.
- Like many stocks, Johnson & Johnson is also trading near its 52 week highs at $105.
- As a result, the yield right now is very close to the 5 year minimum of 2.55%.
- How wise is it to buy the stock now?
Yield on Cost Extrapolation:
The table below shows the yield on cost for an investor buying JNJ at this high-level. The assumed dividend growth rate [DGR] is 7%/yr for the first five years and 5%/yr for the next five years. Keep in mind that the 5 year average DGR stands at 7.40% based on 2014's dividend increase.
The yield on cost does not look as appealing as it did with Altria or AT&T. But is that enough reason to pass on JNJ here? Let us find out.
Capital Gains Extrapolation/Future Earnings:
While JNJ is primarily a dividend play, are there are enough reasons to be optimistic about for capital gains going forward?.
- Earnings are expected to grow at 7%/yr over the next 5 years. If that does hold true (JNJ beats estimates more often than not), we will be looking at an EPS of $7.40 in 5 years. Assigning JNJ's average 5 year PE of 17, we get a share price of $125. That represents only a gain of 3.5%/yr. Adding the yield, we are looking at roughly 6%/yr if things go as per expectations.
- With a multiple of 20 and an expected growth rate of 7%, JNJ is trading with a PEG of almost 3. This multiple is well above the 5 year average PE of 17. With mature companies, this usually is a recipe for a pullback in price.
- JNJ's biggest drug, Remicade will start losing its patent in Europe soon and will meet the same fate in 2018 in the United States. Before you brush that off as too far away, keep in mind that Remicade accounted for almost 10% of the company's revenue in 2013. Velcade, an oncology drug, is set to lose its patent in 2017. While these issues will never go away for pharma companies, it does take a lot of R&D expenses and time to replace a blockbuster like Remicade.
Conclusion: Johnson & Johnson certainly is perhaps one of the best stocks to own for the long term. That said, we are not currently looking at buying this stock and recommend that investors wait at least for a moderate pullback in price.
Readers might ask why is it that AT&T and Altria are buys even here but Johnson & Johnson is not. The answer is the fact that those two stocks have a combination of high yield and at least two of these characteristics: a) Capital appreciation potential through promising new initiatives (AT&T) b) an upcoming dividend increase in the next quarter that will immediately increase your yield. (Altria) c) combination of high yield and moderate dividend growth rate (Altria) d) a recent pullback in price (AT&T).
Morningstar has a fair value estimate of $99 for Johnson & Johnson and we agree that the stock would be more appealing in the mid $90s where the yield will be close to 3%. Please note that this is not a recommendation to sell the stock but to think twice about buying now or reinvesting dividends. Coincidentally, SA contributor Parsimony Investment Research recommends the same as you can read here.
Final takeaways: With the 3 exercises we've done so far, we've seen two things: a) Even great stocks can be overpriced and look unattractive for the time being b) Value can be found in an overvalued market if we look in the right place. Let us find them together as we continue this series.
Disclosure: The author is long T, MO. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.