3 Large Growth Stocks To Buy; 2 To Hold

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Includes: IBM, JNJ, MCD, MSFT, PEP
by: Difu Wu

In this article, we will analyze five large growth stocks that have fairly predictable earnings growth. Three are currently selling at good valuations, which should allow them to maintain at least 15% annual growth and double your investment in five years. Two are currently fully priced, and should be avoided until their lofty valuations come back down. The stocks we will analyze in this article are Johnson & Johnson (NYSE:JNJ), Microsoft (NASDAQ:MSFT), Pepsico (NYSE:PEP), McDonald’s (NYSE:MCD), and International Business Machines (NYSE:IBM).

Please note: the analysis used in this article works only for stocks with fairly predictable earnings; it will not work well for stocks with erratic earnings, such as Alcoa (NYSE:AA) and Ford (NYSE:F). Only full analysis for the first stock is detailed. Analyses for the other four stocks discussed here are very similar and therefore condensed for brevity.

Johnson & Johnson

Company Description: Johnson & Johnson is a holding company engaged in the research and development, manufacture and sale of a range of products in the healthcare field. The company’s operating companies are organized into three business segments: Consumer, Pharmaceutical and Medical Devices and Diagnostics.

The Sales, Earnings Before Interest and Taxes (EBIT), Earnings-Per-Share (EPS), High Price, Low Price, High P/E, Low P/E, and Average P/E over the past 10 years are tabulated below in Table 1. Stock prices are adjusted for stock splits.

Year

Sales

(in Millions)

EBIT

(in Millions)

EPS

High Price

Low Price

High P/E

Low P/E

Average P/E

2010

61587

16947

4.78

66

57

13.8

11.9

12.9

2009

61897

15755

4.4

65

47

14.8

10.7

12.7

2008

63747

16929

4.57

72

55

15.8

12.0

13.9

2007

61095

13283

3.63

68

59

18.7

16.3

17.5

2006

53324

14587

3.73

69

57

18.5

15.3

16.9

2005

50514

13116

3.35

70

60

20.9

17.9

19.4

2004

47348

12331

2.74

64

50

23.4

18.2

20.8

2003

41862

10308

2.4

59

48

24.6

20.0

22.3

2002

36298

9291

2.16

65

41

30.1

19.0

24.5

2001

32317

7898

1.84

61

43

33.2

23.4

28.3

Click to enlarge

Table 1. Key 10-year data for Johnson & Johnson

The Sales, EBIT, and EPS data are taken from money.msn.com. The High and Low stock prices for the past 10 years are obtained from stock price charts from google.com/finance. High P/E is calculated by dividing High Price by EPS, and Low P/E is calculated by dividing Low Price by EPS. Average P/E is calculated by adding High Price and Low Price, then dividing by 2.

Sales, EBIT, and EPS versus Year are plotted in a semi-log plot and linear regression fit with R squared is obtained (see Chart 1). For JNJ, the linear fit for EPS versus Year is given by 0.3396 (Year) – 677.78, with an R squared of 0.9683. Sales, EBIT and EPS all demonstrate predictable growth, fitting linear regression well with R squared above 0.9 (R squared = 1 implies a perfect fit). This enables us to project EPS for the near future, over the next 5 years.

Chart 1. Sales (in Million), EBIT (in Million), and EPS versus Year for Johnson & Johnson (<a href='http://seekingalpha.com/symbol/JNJ' title='Johnson & Johnson'>JNJ</a>).

Chart 1. Sales (in Millions), EBIT (in Millions), and EPS versus Year for JNJ.

The following key values are computed for our analysis.

Signature P/E: A well established stock has a signature P/E, an average P/E it commands in the market based on its business. We can calculate this by averaging the Average P/E over the past 10 years, excluding any outliers (values that fall significantly beyond the other data points). From Table 1, we see that the Average P/E of 28.3 for Year 2001 is an outlier, as it significantly exceeds the other 9 data points, so we average the Average P/E’s from Year 2002-2010 to arrive at a signature P/E of 17.9.

Historic Value Ratio: This is a ratio of the current P/E to the signature P/E. If below 100%, it means the stock is currently selling at a valuation below its historic average valuation; if over 100%, it means the stock is currently selling at a valuation above its historic average valuation. For margin of safety, it is preferable to buy at a historic value ratio below 80%, or at least below 90%.

Average half of lowest High P/E: this takes the average of five lowest High P/Es of the 10 High P/Es from the past 10 years. It gives us a conservative estimate of a high P/E for the stock we can expect.

Average half of lowest Low P/E: this takes the average of five lowest Low P/Es of the 10 Low P/Es from the past 10 years. It gives us a conservative estimate of a low P/E for the stock we can expect.

Forecast Avg P/E: this takes the average of Average half of lowest High P/E and Average half of lowest Low P/E, thereby giving us a conservative estimate of an average P/E for the stock we can expect.

Forecast High EPS: this applies the EPS projection from the EPS versus Year using the linear fit equation for EPS. We forecast the high EPS as the EPS for year 2016 (five years from now) if the earnings growth continues. For JNJ, it is 0.3396 (2016) – 677.78 = 6.8536.

Potential High Price: this is calculated by multiplying the Average half of lowest High P/E by the Forecast High EPS, giving us a price target in 5 years if the stock should command a high P/E.

Projected Avg Price: this is calculated by multiplying the Forecast Avg P/E by the Forecast High EPS, giving us a price target in 5 years if the stock should command an average P/E.

Potential Return: this is calculated by computing the annualized return in the stock price, assuming the potential high price is reached, and then adding the dividend yield. It is calculated as (Potential High price/Current price)^(1/4) – 1 + Dividend Yield.

Projective Avg Return: this is calculated by computing the annualized return in the stock price, assuming the projected average price is reached, and then adding the dividend yield. It is calculated as (Projective avg price/Current price)^(1/4) – 1 + Dividend Yield.

Forecast Low EPS: this is calculated by averaging EPS over the past 5 years, to give an estimate of low EPS expected in 5 years. Because we are interested in only growth stocks with predictable earnings growth, EPS in 5 years should not be any lower than this conservative estimate.

Forecast Low Price: this is calculated by multiplying the Average half of lowest Low P/E by the Forecast Low EPS, giving us a conservative estimate of low price for the stock in 5 years, assuming zero EPS growth and low valuation.

Risk Index: This is calculated by (Current Price – Forecast Low Price)/ (Potential High Price - Forecast Low Price), giving us an estimate of the risk: reward ratio. Risk index less than 20% is desired, which gives us +200% potential returns for every risk of 50% loss we assume.

The relevant data as calculated for JNJ are listed below. The Current Price, current EPS, and latest dividend are obtained from google.com/finance.

Signature P/E=

17.9

Current Price=

65

Current EPS=

4.1

Current P/E=

15.85366

Historic Value Ratio=

0.886746

Avg half of lowest High P/E=

16.3

Avg half of lowest Low P/E=

13.2

Forecast Avg P/E=

14.77431

Latest dividend=

2.28

Yield=

0.035077

Forecast High EPS=

6.8536

Potential High Price=

111.805

Projected Avg Price=

101.2572

Potential Return=

0.180292

Projected Avg Return=

0.15227

Forecast Low EPS=

4.222

Forecast Low Price=

55.8794

Risk Index=

0.163084

Click to enlarge

Given a projected average annualized return of 15.2%, with a target price of $101 and dividend yield of 3.51%, we can expect to double our investment in JNJ in 5 years. The risk index of 16.3%, which is below 20%, is acceptable.

Microsoft

Company Description: Microsoft Corporation is engaged in developing, licensing and supporting a range of software products and services. It also designs and sells hardware, and delivers online advertising to the customers.

The relevant 10-year data with stock prices adjusted for splits are tabulated in Table 2.

Year

Sales

(in Millions)

EBIT

(in Millions)

EPS

High Price

Low Price

High P/E

Low P/E

Average P/E

2011

69943

28071

2.69

28.6

23.9

10.6

8.9

9.8

2010

62484

25013

2.1

31

23.2

14.8

11.0

12.9

2009

58437

19821

1.62

31

15.2

19.1

9.4

14.3

2008

60420

23814

1.87

36.1

19.1

19.3

10.2

14.8

2007

51122

20101

1.42

37

27

26.1

19.0

22.5

2006

44282

18262

1.2

30.2

21.9

25.2

18.3

21.7

2005

39788

16628

1.12

28

24

25.0

21.4

23.2

2004

36835

12196

0.75

30

24.6

40.0

32.8

36.4

2003

32187

11054

0.69

30

23.2

43.5

33.6

38.6

2002

28365

7875

0.48

34.4

21.8

71.7

45.4

58.5

Click to enlarge

Table 2. Key 10-year data for Microsoft

Sales, EBIT, and EPS versus Year are plotted in a semi-log plot and linear regression fit with R squared is obtained. For MSFT, the linear fit for EPS versus Year is given by 0.2217 (Year) – 443.44, with an R squared of 0.9397. Sales, EBIT and EPS are all demonstrate predictable growth, fitting linear regression well with R squared above 0.9 (R squared = 1 implies a perfect fit). This enables us to make EPS projections.

The relevant analytical data are shown below. Note that the high average P/Es for Years 2002-2004 are considered outliers and excluded from calculation of signature P/E.

Signature P/E=

17.0

Current Price=

27

Current EPS=

2.75

Current P/E=

9.818182

Historic Value Ratio=

0.576864

Avg half of lowest High P/E=

17.8

Avg half of lowest Low P/E=

11.6

Forecast Avg P/E=

14.66135

Latest dividend=

0.8

Yield=

0.02963

Forecast High EPS=

3.5072

Potential High Price=

62.31206

Projected Avg Price=

51.42028

Potential Return=

0.262173

Projected Avg Return=

0.204372

Forecast Low EPS=

1.94

Forecast Low Price=

22.41825

Risk Index=

0.114849

Click to enlarge

Given a projected average annualized return of 20.4%, with a target price of $51 and dividend yield of 2.96%, we can expect to double our investment in MSFT in 5 years. The risk index of 11.5%, well below 20%, is acceptable.

Pepsico

Company Description: PepsiCo, Inc. is a global food, snack and beverage company. The company’s brands include Quaker Oats, Tropicana, Gatorade, Lay’s, Pepsi, Walkers, Gamesa and Sabritas.

The relevant 10-year data with stock prices adjusted for splits are tabulated in Table 3.

Year

Sales

(in Billions)

EBIT

(in Billions)

EPS

High Price

Low Price

High P/E

Low P/E

Average P/E

2010

57.84

8.23

3.92

66.7

60.7

17.0

15.5

16.3

2009

43.23

8.08

3.77

64

48.5

17.0

12.9

14.9

2008

43.25

7.05

3.21

77.8

51.7

24.2

16.1

20.2

2007

39.47

7.64

3.43

78.5

62.5

22.9

18.2

20.6

2006

35.14

6.99

3.34

65.4

57.2

19.6

17.1

18.4

2005

32.56

6.38

2.39

60

51.9

25.1

21.7

23.4

2004

29.26

5.55

2.41

55

45

22.8

18.7

20.7

2003

26.97

4.99

2.04

48.5

38.3

23.8

18.8

21.3

2002

25.11

4.43

1.67

53.1

36.2

31.8

21.7

26.7

2001

23.51

3.64

1.33

50

41.2

37.6

31.0

34.3

Click to enlarge

Table 3. Key 10-year data for Pepsico

Sales, EBIT, and EPS versus Year are plotted in a semi-log plot and linear regression fit with R squared is obtained. For PEP, the linear fit for EPS versus Year is given by 0.2901 (Year) – 579.09, with an R squared of 0.943. Sales, EBIT and EPS are all demonstrate predictable growth, fitting linear regression well with R squared above 0.9. This enables us to make EPS projections.

The relevant analytical data are shown below. Note that the high average P/E for Year 2001 is considered an outlier and excluded from calculation of signature P/E.

Signature P/E=

20.3

Buy Price=

66

Current EPS=

3.93

Current P/E=

16.79389

Historic Value Ratio=

0.828569

Avg half of lowest High P/E=

19.9

Avg half of lowest Low P/E=

16.0

Forecast Avg P/E=

17.90828

Latest dividend=

2.04

Yield=

0.030909

Forecast High EPS=

5.7516

Potential High Price=

114.2039

Projected Avg Price=

103.0013

Potential Return=

0.177832

Projected Avg Return=

0.148608

Forecast Low EPS=

3.534

Forecast Low Price=

56.40452

Risk Index=

0.166013

Click to enlarge

Given a projected average annualized return of 14.8%, with a target price of $103 and dividend yield of 3.09%, we can expect to double our investment in PEP in 5 years. The risk index of 16.6%, which is below 20%, is acceptable.

4. McDonald’s

Company Description: McDonald’s Corporation franchises and operates McDonald’s restaurants in the global restaurant industry. The Company and its franchisees purchase food, packaging, equipment and other goods from various independent suppliers, and offer a range of products.

The relevant 10-year data with stock prices adjusted for splits are tabulated in Table 4.

Year

Sales

(in Millions)

EBIT

(in Millions)

EPS

High Price

Low Price

High P/E

Low P/E

Average P/E

2010

24074.6

7000.3

4.58

80

61.8

17.5

13.5

15.5

2009

22744.7

6487

4.11

64

52.2

15.6

12.7

14.1

2008

23522.4

6158

3.76

65.7

53

17.5

14.1

15.8

2007

22786.6

3572.1

1.93

61

43

31.6

22.3

26.9

2006

20895.2

4154.4

2.29

44

32.6

19.2

14.2

16.7

2005

19117.3

3660.2

2.02

38

28

18.8

13.9

16.3

2004

18594

3200.7

1.79

32.5

25.4

18.2

14.2

16.2

2003

17140.5

2346.4

1.18

26

12.8

22.0

10.8

16.4

2002

15405.7

1662.1

0.77

30.3

15.5

39.4

20.1

29.7

2001

14870

2329.7

1.25

33.6

25

26.9

20.0

23.4

Click to enlarge

Table 4. Key 10-year data for McDonald’s

Sales, EBIT, and EPS versus Year are plotted in a semi-log plot and linear regression fit with R squared is obtained. For MCD, the linear fit for EPS versus Year is given by 0.4057 (Year) – 811.26, with an R squared of 0.8631, which is fairly good and enables us to make EPS projections.

The relevant analytical data are shown below. Note that the high average P/Es for Years 2002 and 2007 are considered outliers and excluded from calculation of signature P/E.

Signature P/E=

16.8

Current Price=

99

Current EPS=

5.1

Current P/E=

19.41176

Historic Value Ratio=

1.154461

Avg half of lowest High P/E=

17.5

Avg half of lowest Low P/E=

13.0

Forecast Avg P/E=

15.24795

Latest dividend=

2.8

Yield=

0.028283

Forecast High EPS=

6.6312

Potential High Price=

116.0205

Projected Avg Price=

101.1122

Potential Return=

0.068742

Projected Avg Return=

0.033575

Forecast Low EPS=

3.334

Forecast Low Price=

43.34118

Risk Index=

0.765814

Click to enlarge

Given a projected average annualized return of only 3.35%, with a target price of $101 and dividend yield of 2.83%, MCD is fully priced and the expected return is not high enough to double our investment in 5 years. By the rule of 72, it would take 22 years to double our investment if we buy MCD at the current price with an expected annualized return of only 3.35%/year. The risk index is 76.6%, which is prohibitively high. The historic value ratio of 115% is also too high. Therefore, this stock is a hold. Wait for a pullback to $68 to buy, which would provide 15% annualized return to allow doubling of investment in 5 years.

International Business Machines

Company Description: International Business Machines Corporation (IBM) is an information technology (NYSE:IT) company. The Company operates under five segments: Global Technology Services (NYSE:GTS), Global Business Services (GBS), Software, Systems and Technology, and Global Financing.

The relevant 10-year data with stock prices adjusted for splits are tabulated in Table 5.

Year

Sales

(in Millions)

EBIT

(in Millions)

EPS

High Price

Low Price

High P/E

Low P/E

Average P/E

2010

99871

19723

11.52

147

122

12.8

10.6

11.7

2009

95759

18138

10.01

131

81

13.1

8.1

10.6

2008

103630

16715

8.89

130

74

14.6

8.3

11.5

2007

98785

14489

7.15

118

91

16.5

12.7

14.6

2006

91423

13316

6.06

97

73

16.0

12.0

14.0

2005

91134

12226

4.91

96

73

19.6

14.9

17.2

2004

96225

10669

4.39

100

83

22.8

18.9

20.8

2003

89131

9417

3.75

93

77

24.8

20.5

22.7

2002

81186

7524

3.07

126

56

41.0

18.2

29.6

2001

83067

11450

4.59

123

90

26.8

19.6

23.2

Click to enlarge

Table 5. Key 10-year data for International Business Machines

Sales, EBIT, and EPS versus Year are plotted in a semi-log plot and linear regression fit with R squared is obtained. For IBM, the linear fit for EPS versus Year is given by 0.8853 (Year) – 1769.1, with an R squared of 0.8767, which is fairly good and enables us to make EPS projections.

The relevant analytical data are shown below. Note that the high average P/E for Years 2002 is considered an outlier and excluded from calculation of signature P/E.

Signature P/E=

16.3

Buy Price=

183

Current EPS=

12.64

Current P/E=

14.47785

Historic Value Ratio=

0.890628

Avg half of lowest High P/E=

14.6

Avg half of lowest Low P/E=

10.4

Forecast Avg P/E=

12.47602

Latest dividend=

3

Yield=

0.016393

Forecast High EPS=

15.6648

Potential High Price=

228.6453

Projected Avg Price=

195.4344

Potential Return=

0.073644

Projected Avg Return=

0.032964

Forecast Low EPS=

8.726

Forecast Low Price=

90.3658

Risk Index=

0.669906

Click to enlarge

Given a projected average annualized return of only 3.3%, with a target price of $195 and dividend yield of 1.64%, IBM is fully priced, and the expected return is not high enough to double our investment in 5 years. By the rule of 72, it would take 22 years to double our investment if we buy IBM at the current price with an expected annualized return of only 3.3%/year. The risk index is 67%, which is prohibitively high. Therefore, this stock is a hold. Wait for a pullback to $123 to buy, which would provide 15% annualized return to allow doubling of investment in 5 years.

Conclusion

Johnson & Johnson, Microsoft and PepsiCo, with target prices of $101, $51, and $103, respectively, all have expected annualized returns over 15 percent, allowing doubling of investment in five years. They are Buys at current market prices.

McDonald’s and International Business Machines, with target prices of $101 and $195, respectively, are good companies but have expected annualized returns only around 3 percent. They are fully priced and are Holds at current market prices.



Disclosure: I am long JNJ, MSFT, PEP.