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Summary

  • JNJ offers huge margins on its sales and high return on money invested.
  • JNJ's multiples are comparatively low.
  • According to the DCF method, JNJ is trading beneath fair value right now.

Johnson & Johnson (NYSE:JNJ) is one of the biggest healthcare companies in the world, with revenues of $74 billion and earnings of $15.6 billion in the last twelve months. Right now the company has a market capitalization of $291 billion.

The company operates in three divisions:

- pharmaceutical (40% of sales in 2013)

- medical devices and diagnostics (40% of sales in 2013)

- consumer goods (20% of sales in 2013)

Profitability

JNJ Profit Margin (<a href=

JNJ Profit Margin (TTM) data by YCharts

The company offers huge margins on its sales. With net profits being 21% of sales and an operating margin of 27%, the company vastly caps the broad market, represented by the SPY, which offers a profit margin of 9.3% and an operating margin of 10.2%.

JNJ Return on Equity Chart

JNJ Return on Equity (TTM) data by YCharts

JNJ also reports superior return rates on capital employed (ROCE) and on equity (ROE) than the main competitors (as seen in the panels above) and the broad market (ROE: 14.9%). This shows that Johnson & Johnson's management allocates capital more effectively and at a higher return rate than the management of most other companies.

Valuation

Johnson & Johnson trades at a P/E of 19.06, slightly below the market average of 19.72, and a forward P/E of 16.25. The dividend yield is 2.72% for JNJ and 1.88% for the SPY. JNJ offers multiples slightly below the broad market and a dividend yield about 50% higher than the S&P 500 index.

JNJ Price to Book Value Chart

JNJ Price to Book Value data by YCharts

Johnson & Johnson's P/E and price to book ratio are also around the average over the last ten years.

Is Johnson & Johnson undervalued?

To assess the fair value of JNJ's shares, I will use the DCF method. In this approach, all future earnings are discounted with a desired return rate, and the present values of those future earnings are added up the get the fair value.

The EPS over the last twelve months were reported to be $5.41. The average estimated EPS growth rate over the next 5 years is 7.11%.

Depending on the assumptions we make for the long-term EPS growth rate after year 5 and the annual return we aim for, we receive different fair values. I will lay this out in a couple of examples.

If we desire an average annual return of 8%, and we assume a long-term EPS growth rate of 5%, fair value is $208.

If we desire an average annual return of 8%, and we assume a long-term EPS growth rate of 6%, fair value is $301.

If we aim for an average annual return of 8%, and we assume a long-term EPS growth rate of 7%, fair value is $581.

Even if we assume there would be no EPS growth from year 6 on, an investor aiming for 8% annual return wouldn't overpay by a lot right now, fair value would be 91%.

For investors aiming for a higher average annual return, things are a little bit different:

If we aim for an average annual return of 10%, and we assume a long-term EPS growth rate of 5%, fair value is $124.

If we aim for an average annual return of 10%, and we assume a long-term EPS growth rate of 6%, fair value is $150.

If we aim for an average annual return of 10%, and we assume a long-term EPS growth rate of 7%, fair value is $194.

In a hypothetical no-growth-after-year-5 scenario, the fair value for an investor looking for a 10% annual return would be $72.

The long-term growth rate required for the fair value to be equal with today's price is 1% if investors are looking for an 8% annual return and 4% if investors are looking for a 10% annual return.

Several reasons for compelling growth assumptions come to mind:

In the past ten years, JNJ managed to grow EPS (diluted) at an annual rate of 7% - the company's management showed they are able to allocate capital in a way that rewards shareholders by increasing the bottom line continuously.

JNJ also has a strong position in emerging markets, more than 20% of revenues come from Brazil, Russia, India and China. Due to the economic growth in these countries, that enables a growing amount of people to spend money on consumer goods and healthcare products, it is very likely that JNJ will be able to benefit from the growing market significantly and report strong gains in revenues and profits from these emerging nations.

Johnson & Johnson showed growth in all of their operations (pharmaceutical sales, medical devices and diagnostics as well as consumer goods) in recent years, a trend that is likely to continue.

Especially the pharmaceutical operations are rewarding, JNJ is the fastest growing top 10 pharmaceutical company in the U.S., Europe and Japan. According to the company's management, JNJ's growing pipeline will provide a lot of future growth opportunities in this segment.

Possible risks

Like every investment in equities, an investment in Johnson & Johnson bears risks. Due to JNJ's outstanding financial stability with $30 billion in cash, a Debt/Equity of just 0.22 and an AAA rating the possibility of bankruptcy is almost non-existent. Nevertheless, if future growth is lower than expected, it would be adverse to buy JNJ at current valuations.

Reasons for possible lower growth could be:

- a declining macroeconomic situation in growth markets like Brazil, Russia, India and China

or

- decreasing profits in JNJ's operations due to the availability of a better product by one of JNJ's competitors

Summary

Due to a growing human population, which gets older and more dependent on medical care each year, I think a conservative EPS growth rate of 5% should be very achievable for the company. Share buybacks will be beneficial for EPS growth as well.

Since JNJ is undervalued in most scenarios from above, among them the (in my mind) most likely one of a long-term EPS growth rate of 5%, I think the company is slightly undervalued right now. There is not a huge margin of safety for investors seeking a 10% annual return, but a pretty solid margin of safety for investors seeking an 8% annual return.

The size of the company, the financial stability (huge cash position, low debt, AAA rating), the low beta and the above average dividend yield of 2.7%, along with regular dividend increases, should give the stock some downside protection.

It definitely would not be a mistake to buy right now if an investor seeks steady returns of 8-10% with a low risk profile.

Source: Johnson & Johnson: High Profitability, Trading Below Fair Value