Why Buffett Loves Johnson & Johnson

As of March 31, 2007, Warren Buffett's company, Berkshire Hathaway (BRK.A), reportedly increased its holding in Johnson & Johnson (JNJ) to 48.7 million shares - an increase of 24 million shares in three months. And it's no surprise. Forget Wall Street's earnings; JNJ knows how to generate cash!

Buffett tells us we should look at 4- and 5-year histories to judge the performance of a company and that we should look primarily at the intrinsic value of a company and pay a fair or bargain price. Let's follow the lead of this investing genius:

You Need Data

You can not possibly analyze the health or value of a business without looking at ten years or more of financial history (though you can trade stocks on anything). In JNJ's case, we'll look at the growth of the business from 1997-2006. Looking at multi-year histories of the Free Cash Flow and Shareholder Equity (net worth) of JNJ, we find that Free Cash Flow had a median growth rate of 16.1% and that net worth grew at a median rate of 14.6%. We use median rates to analyze various multi-year timeframes from 1997-2006 to eliminate any erratic years.

Considering that, when buying a business (i.e., stock), you are buying the net worth of the company and any future cash that the company can produce, JNJ was a heck of a company from 1997 to 2006. Moving on:

You're Buying JNJ's Net Worth

At the end of 2006, JNJ had $39.3 billion in net worth—that is the basis for calculating the value. If you bought JNJ and it went out of business tomorrow, you would be entitled to you fair share of $39.3 billion.

But we don't expect JNJ to go out of business tomorrow. We expect it to be in business for twenty or more years. Because of that, we need to figure out how much cash we expect it to produce for the next twenty years. Though JNJ's year-to-year Free Cash Flow changed frequently, running up 45.1% one year, dropping 14.8% another, we need to look at JNJ as a business—a business that can survive or thrive over the long term.

You're Buying The Right To JNJ's Cash

JNJ's Free Cash Flow grew at a median rate of 16.1% in various timeframes—and that is the basis for our projection of its future cash. Because of JNJ's multi-year consistency in the past, we can reasonably expect JNJ to grow its Free Cash Flow 16.1% in the future—at least for ten years. Beyond that, we can expect growth to slow down—say, to 5% a year. (If we're wrong and JNJ grows 16.1% for twenty years, we end up making a lot more money.)

With $11.6 billion of Free Cash Flow in 2006, a 16.1% growth rate for ten years, and a 5% growth rate for years eleven to twenty, JNJ can reasonably expected to generate $966.9 billion of cash over the next twenty years. But we want to earn 15% or more on JNJ so we have to buy that cash at a discount today. After all, we are buying $39.3 billion of net worth and the right to $966.9 billion of cash—but we can't pay full price or we would have a 0% return.

Putting It Together

A quick spreadsheet calculation tells us that we can buy Johnson & Johnson's expected $966.9 over twenty years for $201.7 billion today. Doing so, we would earn 15% a year in each of the next twenty years. If we bought the entire company today, we could reasonably expect a 15% return if we paid $201.7 billion for the future cash and $39.3 billion for today's net worth: a total purchase of $241 billion.

Is Management Rational?

Johnson & Johnson is growing Free Cash Flow like gangbusters—but at what cost? The company has some $31 billion in debt. We need to know if management is using debt as an asset to fuel growth, or if they are borrowing to the point that our company is going to choke.

A quick look at the Cash Return On Invested Capital [CROIC] tells us that management is very rational—to the tune of 20.8%. For every dollar that the company has in assets and long-term borrowing, it creates an additional $0.21 of cash. Unless interest rates soar beyond 20%, JNJ appears to be doing a wonderful job of borrowing money, generating cash from those borrowings, repaying the loans, and rewarding shareholders with excess cash without putting up its own money.

But There Are Problems—For Me, At Least

Two problems—both easily remedied:

1. I don't have $241 billion;
2. I can't be 100% sure that JNJ will grow the way I hope.

Getting The Share Price

Johnson & Johnson is worth $241 billion. It has 2.9 billion shares of stock available for purchase. A quick division ($241/2.9) tells me that JNJ is worth $83.10 a share. I don't need $241 billion—I need $83.10 for each share I want to buy.

Problem 1 resolved.

Margin Of Safety

Though JNJ appears to be worth $83.10 a share, that number is only good if the company performs as I expect it to—continuing to grow Free Cash Flow at 16.1% for ten years. But there are no guarantees in business. In fact, just about anything can happen. Why should I lose money if it does?

To protect myself, I need to buy companies at a discount. Because JNJ is an industry leader, 25% is more than enough for me to comfortably and confidently invest in JNJ.

Determining The Buy Price

A 25% discount on a value of $83.10 a share results in a target buy price of $62.33 a share. Problem 2 resolved.

And hey, isn't that right about where Buffett was buying JNJ earlier this year?

Disclosure: Author has a long position in JNJ

JNJ 1-yr chart

Comments

[weiwentg:]

JNJ is one of those companies where, if you hear that they're going out of business, look out the window: you'll probably see a few mushroom clouds. I think the stock, as priced today, is a very good defensive investment even if the economy has a downturn.

2007 Jul 09 04:17 PM

[turleymuller:]

JNJ should always perform solidly in any economic environment. It has a consistent historical operating record which should translate into visibility going forward. The past 10 years DPS have grown close to 15% annually with a standard deviation of 2%. JNJ has a very strong competitive position that will provide future operating stability. My DCF model suggests JNJ is work at least $80/share. For my detailed commentary on Buffet take a look here- financial-alchemist.bl...

2007 Jul 09 10:23 PM

[hungwahcheung:]

You analysis is very interesting. Where would your analysis place his other large investment in 857 HK? I dont claim to be an analyst but a quick back of the envelope scribble gave an implied share price far higher than the current market price. Surely Buffet would lay more money on the table for this name?

2007 Jul 10 09:12 AM

[Joe Ponzio:]

I like when my investments are easy. Petrochina (857HK) is one of those companies that generates a ton a cash which means that it has the <i>opportunity&l... to grow. In the case of Petrochina, it has shown that it can grow.

The only problem with determining a value of Petrochina at this point is that I don't have access to the company's 1997 &amp; 1998 financial statements. The SEC only has the numbers from 1999 on. Without ten years of history, I do not feel comfortable trying to predict the next twenty years of the business.

Buffett was able to make this purchase, I assume, because he had access to the company's reports as filed in China. Armed with enough information, he was able to value Petrochina and move in. Not having access to that information, I have to be patient for another two years until I have ten full years of data.

Will Buffett load up on Petrochina? I would assume so. It depends on whether or not the stock market gamblers give him the opportunity to buy it at a fair price.

That's a long way of saying, "I don't know the value of Petrochina so I can't comfortably and confidently invest today." I'll just have to find another wonderful opportunity.

2007 Jul 10 11:22 AM

[sridhar.swa...:]

Joe,

A great analysis; using your growth rates of 16.1% for 10 years and 5% for the next 10 years, I get 970 billion vs $ 966 billion. Also, I am unable to get the PV of 201.7 bn using a 15% return-could you pls share the formula? I need to refresh my math but if you could share the calculation it would be a great help.

Thanks

2007 Jul 10 02:12 PM

[sridhar.swa...:]

Joe,

Thanks-I arrived at the $ 966 bn..

If I buy this $ 966 bn over 20 years to earn a 15% return every year, I get an amount of $ 241.5 bn; working backwrads ( 241.5+ (241.5*15%*20))=966 bn. If I add the current net worth of 39 bn, the total is $ 280 bn.. obviously, I am missing something, where am I going wrong?

Regards

Sridhar

2007 Jul 12 12:05 AM

[sridhar.swa...:]

Joe,

I figured it out finally.. pls ignore my earlier posting..once again, great analysis..

Any ideas on how to value growth stocks with great brand names e.g Starbucks; what would be your MOS; also CROIC for these companies should be lower than companies like J&amp;J because their cost of borrowing could be higher than companies like J&J; are there any other parameters you would use? wouldbe interested in your thoughts

Regards

2007 Jul 12 12:22 AM

[Joe Ponzio:]

Hi Sridhar,

To me, there is no such thing as a "growth" stock or a "value" stock - they are joined at the hip. I understand that Wall Street likes to separate the two, but don't we expect all of our investments to <i>grow</i>... in </i>value</i&... Why would you invest in any business that didn't?

The MOS depends on the moat of the business. A wide moat, industry leader like JNJ can be purchased with a 25% MOS. A weak- or no-moat business should be purchased with a 50% or more MOS, if at all. So, what do you think of Starbucks' moat? I'd say it is good, but hardly impenetrable. McDonald's is already trying to encroach on it, offering Premium Coffees. I'd want a 50% MOS on Starbucks. If I can't get it, there are plenty of other companies that might be worth my investment dollars. Remember, your goal is not to own Starbucks - it is to grow your money. <strong>Put your dollars where you'll get the best value</strong>.

CROIC is not a function of the size of a company, it tells us how well management is employing the capital it has. It is essentially a function of interest rates. If businesses have to borrow at 8% and CROIC is at 6%, our company had bad debt that is eating up cash. On the other hand, a 15% CROIC would indicate that management is using debt as an asset.

2007 Jul 12 03:46 AM

[neonbeam04:]

Hi sridhar, I've assumed that the growth rates are compounded annually, hence this calculation: (11.6+39.3)bil * 16.1% ^10 * 5%^10 = $368.92 bil, not even close to the $966 bil that you managed to get. Whats the mistake?

2007 Jul 12 07:24 AM

[sridhar.swa...:]

Hi,

for 2007 to 2016 use a 16.07% growth rate compunded and for 2017 to 2026 use 5% compounded; year wise no's will be as follows :

2006 11.6
2007 13.4
2008 15.6
2009 18.1
2010 21.0
2111 24.4
2112 28.3
2113 32.9
2114 38.2
2115 44.3
2116 51.4
2117 54.0
2118 56.7
2119 59.5
2120 62.5
2121 65.6
2122 68.9
2123 72.3
2124 75.9
2125 79.7
2126 83.7

total
966.47

2007 Jul 12 10:47 AM

[Ogradius:]

Joe;

I recently read that Buffett would prefer to invest in small companies if he were just starting out and had only a relatively small amount to invest. How would your analysis change if it were a small cap instead of a mega cap?

Thanks.

2007 Jul 11 10:18 AM

[Joe Ponzio:]

Sridhar,

I got an email from a visitor to F Wall Street that asked the same thing. For the calculation, I don't round the numbers. On the blog, for simplicity, I round. The 16.1% is actually 16.0754315618% - and even that is rounded a bit. Try the longer "16%" figure and you'll get the $966B.

--

S O,

The valuation methods are the same - shareholder equity plus the future free cash flow. The only difference is in the Margin of Safety (MOS, the discount to its intrinsic value). When investing in large, brand name, industry leaders, I am comfortable with a 25% MOS. It is tough to become an industry leader; it is easy to remain one. If JNJ feels threatened by a mid-size or small competitor, it can price them out of the market or buy them up - helping protect its status in the process.

With smaller companies, I like a 50% MOS. My rationale is two-fold:

1) The smaller companies have a tough battle against the leaders (as stated above). Anything can happen to their business - especially the inability to gain market share leading to slowed growth.

2) Smaller companies tend to grow much faster that large ones (on a percentage basis). If you project the value based on 25% growth in free cash flow, and the actual free cash flow grows at 15%, you'll have overvalued and overpaid for your business.

The 50% MOS reduces the risk of both. If you expect your company to grow at 20%, but it only grows at 12%, the 50% MOS still gives you a very nice, double digit return.

Why not go for a 50% MOS on companies like JNJ? I don't think you'd have the opportunity to buy it. The goal, according to Buffett, is to pay a "fair" or "bargain" price. Companies like JNJ have additional value as an industry leader - their "safer" than their smaller competitors. As such, a 25% MOS on JNJ provides roughly the same protection as a 50% MOS on its smaller competitor.

<strong>Why smaller companies?</strong&... Smaller companies can grow faster on a percentage basis and are often beat around by traders - offering us the opportunity to acquire a ton of shares of a rapidly growing business on a regular basis. Their businesses are also usually much more simple than those of the mega caps. Simple business = easy investing decisions. Sounds good to me.

2007 Jul 11 10:40 AM

[Creative In...:]

I've actually done my own analysis prior to reading your article and found it very interesting to read your take on JNJ. I've actually used a much lower expected growth rate of 10%, my premise being that last 10 years don't really predict the next 10, especially with the economy for which everybody has his own forecast. At the same time I used a lower discount rate, 10%, since this company is a relatively low risk.

So, my intrinsic value is much higher at $98.64. At the same time, I look for 30-50% in MOS to account for my inexperience. Thanks much for your great analysis.

Here is my full analysis if anybody is interested:

creativeinvestor.blogs...

2007 Oct 08 10:33 PM