As the stock market keeps rallying to set fresh all-time highs on a regular basis, this has resulted in bloated valuations for a few of the biggest stocks in the health care sector. One in particular that stands out as greatly overvalued is Bristol-Myers Squibb (BMY). Bristol-Myers Squibb is far too overpriced, when compared to both the broader market and the pharmaceutical sector. This is because its future growth potential is simply not going to be enough to justify its current and forward-looking valuations.
On the other hand, there is still a bastion of value among Big Pharma. That would be Johnson & Johnson (JNJ). J&J is a cheap stock by most valuation metrics, especially when compared to Bristol-Myers Squibb, and J&J will provide enough future earnings growth to justify multiple expansion. For these reasons, here's why investors would be far better off swapping Bristol-Myers Squibb for J&J in their portfolios.
Valuation is a major cause for concern
Bristol-Myers Squibb has seen its share price skyrocket in recent years. Over the past two years, Bristol-Myers Squibb is up more than 50%. This is a hugely impressive return. However, Bristol-Myers Squibb's fundamentals have been far less impressive. Its earnings growth hasn't kept up with its soaring share price. This has left the stock with a very high valuation, which is a big red flag for investors.
To that end, consider that right now, Bristol-Myers Squibb is valued at 30 times trailing twelve-month earnings per share. This is a huge premium to both the broader market and the company's direct peer group. According to Standard & Poor's, the S&P 500 Index trades for 18 times trailing earnings. In addition, the health care sector trades for just 19 times trailing earnings and 18 times forward EPS. This means that Bristol-Myers Squibb is valued at an approximately 67% premium to the S&P 500 on a trailing basis.
Earnings growth does not justify the valuation
Even more concerning is that analysts do not expect significant earnings growth going forward for Bristol-Myers Squibb. The stock's forward P/E multiple is 29, which implies little to no earnings growth in the near future. Indeed, Bristol-Myers Squibb's earnings reports bear this out. The company reported 7% revenue growth last quarter, but also a 37% drop in GAAP diluted earnings per share. The big drop in profits was due to a 49% spike in research and development expenses, and a $458 million impairment charge.
For the remainder of the year, management expects the company to generate $1.50-$1.60 per share in GAAP EPS. Even if you exclude one-time items like impairments that are currently weighing on GAAP earnings, Bristol-Myers Squibb's adjusted non-GAAP EPS is expected to be just $1.70-$1.80 per share in 2014. The midpoint of this guidance would actually represent a 3.8% decline in non-GAAP EPS year-over-year.
Why Johnson & Johnson is a much better pick
Bristol-Myers Squibb's earnings are expected to decline this year, after falling in 2013 as well. And yet, its stock price keeps soaring. This is a very troublesome scenario that sets up investors for poor future returns.
On the other hand, J&J is a highly profitable health care stock with a much more reasonable valuation. The trailing P/E ratio is 20, which is a much less aggressive valuation than Bristol-Myers Squibb. Even better, the stock trades for just 16 times forward earnings estimates, because the company is expected to produce strong underlying growth. That means that Bristol-Myers Squibb is 81% more expensive than J&J on a forward P/E basis.
Plus, J&J is putting up solid growth this year. Total sales are up 6.3% through the first half of the year. Organic sales are up an even better 7.4%, once you strip out the effects of foreign currency translation. Adjusted earnings are up 9.5% in this time. Going forward, J&J expects full-year EPS of $5.89 at the midpoint of its guidance. This would represent nearly 7% growth from the previous year. If J&J keeps growing in the future, there's no reason why its valuation multiple cannot expand.
The major takeaway here is that Bristol-Myers Squibb is far too richly valued for investors to jump in right now. It holds a very speculative valuation that sets up investors for poor returns going forward. On the other hand, Johnson & Johnson is much more modestly valued, meaning investors should expect much better returns. This is especially true since J&J expects earnings growth this year, while Bristol-Myers Squibb does not. Sell Bristol-Myers Squibb, and buy J&J.
