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Summary

  • In the latest instalment of our Head-To-Head series, we pitch two companies from the health care sector, Johnson & Johnson and Covidien, against one another.
  • The article focuses on the relative strengths and weaknesses of Johnson & Johnson and Covidien based on business performance and sustainability/dividends.
  • It concludes by discussing the current valuations of the two companies, and answers whether Johnson & Johnson represents good relative value at current price levels.

Johnson & Johnson Background

Johnson & Johnson (NYSE:JNJ) was founded in 1885 and is based in New Brunswick, New Jersey. It is engaged in the research and development, manufacture, and sale of various products in the health care field worldwide. The company operates in three segments: Consumer, Pharmaceutical, and Medical Devices and Diagnostics. The Consumer segment offers a range of products used in the baby care, skin care, oral care, wound care, and women's health fields. The Pharmaceutical segment provides various products in, among others, the areas of anti-infective, antipsychotic, cardiovascular, contraceptive and gastrointestinal medicine. The Medical Devices and Diagnostics segment offers various products to treat, among others, cardiovascular disease as well as orthopaedic and neurological products.

Team Money Research Rating

Our investment philosophy is to focus on company fundamentals and identify stocks that are displaying strong business performance, that operate sustainably and that pay a decent, well-covered dividend.

We score each company relative to the other on the following criteria within each of our two main buckets:

Business Performance

  1. Return on equity
  2. Return on assets
  3. Operating margins
  4. Quarterly revenue growth
  5. Quarterly earnings growth

Sustainability/Dividends

  1. Debt to equity ratio
  2. Interest cover
  3. Dividend payout ratio
  4. Yield
  5. 5-year average yield

Once we have scores for the two buckets, we can then assess whether a company represents good value based on the current prices of the two stocks. We use the following criteria to assess valuations on a relative basis.

Valuation

  1. Price to earnings ratio
  2. Price to book value ratio
  3. Enterprise value to EBITDA
  4. Price to sales ratio
  5. 5-year price to earnings growth ratio

So, for example, a company that scores well compared to its rival on the first two buckets (business performance and sustainability/dividends) and that is undervalued relative to its peer (based on the third bucket: valuation) could outperform its competitor going forward.

The table below highlights the data that we will use to score Johnson & Johnson and Covidien (COV) for the first two buckets.

Stock

Johnson & Johnson

Covidien

Business Performance

Return on equity

21.00%

15.57%

Return on assets

9.59%

6.40%

Operating margins

27.20%

21.39%

Quarterly rev. growth

3.50%

2.70%

Quarterly EPS growth

35.20%

0.50%

Sustainability/Dividends

Debt to equity ratio

22.58%

52.18%

Interest cover

40.88

12.13

Dividend payout ratio

50.00%

33.00%

Dividend yield

2.70%

1.40%

5-year average yield

3.30%

1.80%

We then score each company relative to its peer based on the above data, with points being awarded as follows:

1st place: 10 points

2nd place: 0 points

Below are the scores for Johnson & Johnson and Covidien:

Stock

Johnson & Johnson

Covidien

Business Performance

Return on equity

10

0

Return on assets

10

0

Operating margins

10

0

Quarterly rev. growth

10

0

Quarterly EPS growth

10

0

Sustainability/Dividends

Debt to equity ratio

10

0

Interest cover

10

0

Dividend payout ratio

0

10

Dividend yield

10

0

5-year average yield

10

0

Total Score

90

10

As you can see, Johnson & Johnson comprehensively beats Covidien in terms of business performance and also with regards to sustainability/dividends. Indeed, this is a highly dominant performance by Johnson & Johnson, with the company losing out on only one of the ten criteria, namely dividend payout ratio. However, while not as attractive as Covidien's low payout ratio of 33%, Johnson & Johnson's payout ratio of 50% is certainly not excessive and shows that there is considerable scope to increase dividends as a proportion of profit going forward.

What really impresses us about Johnson & Johnson is the sustainability of the business, coupled with very strong profitability. For example, while the debt to equity ratio stands at just 22.58% and interest cover is very high at 40.88 (which highlights how conservatively financed the company is) Johnson & Johnson is able to post return on equity of 21% and was able to grow quarterly earnings by over 35% last time around. This, combined with a dividend yield that is only just short of the key 3% level, shows that Johnson & Johnson is a formidable business that we think is considerably more attractive than Covidien.

Valuation

So, we feel that Johnson & Johnson is a higher quality stock than its sector peer, Covidien. Therefore, we believe it should trade at a premium to its rival. Let's see whether it does.

Stock

Johnson & Johnson

Covidien

Valuation

Price to earnings ratio

16.72

20.37

Price to book ratio

3.90

4.28

EV/EBITDA

12.14

16.07

PEG

2.55

2.43

Price to sales ratio

4.16

3.97

Despite being the higher quality company, Johnson & Johnson appears to offer good value relative to sector peer, Covidien. For example, it trades on a P/E that is 17.9% lower than that of Covidien, while its price to book ratio is 3.9 versus 4.28 for Covidien. In addition, Johnson & Johnson's EV/EBITDA ratio is just 12.14 (versus 16.07 for Covidien), which continues to highlight its great value when compared to its competitor. Sure, Covidien's price to sales and PEG ratios are slightly more attractive than those of Johnson & Johnson, but overall it seems as though Johnson & Johnson is attractively priced on a relative basis.

Conclusion

Johnson & Johnson is a great company that we believe offers good value at current levels. It scored highly on the Team Money Research rating system, beating its sector peer, Covidien, by a wide margin. It also appears to be relatively undervalued at current levels and, as such, could outperform its sector peer going forward.

Feedback Request: What do you think about Johnson & Johnson? Would you buy, sell or hold right now? Please comment below!

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.