Company Description (Source: SEC 10-K)
Johnson & Johnson (JNJ) engages in the research and development, manufacture and sale of a range of products in the healthcare field. The company operates in three segments: Consumer, Pharmaceutical, and Medical Devices and Diagnostics.
Johnson & Johnson is a dividend aristocrat with 49 consecutive years of increasing dividends.
Vital Statistics (Source: Google Finance)
Recent Price: $64.60 (as of 03/02/2012)
52-Week Range: $57.50 - $68.05
Market Capitalization: $177.58 B
Shares Out.: 2.75 B
P/E Ratio: 18.57
A 10-year summary of Sales, Earnings Before Interest and Tax (EBIT), Earnings per share (EPS), yearly high and low stock price, corresponding high and low P/E (calculated by dividing the high and low price by the EPS for the year), and average P/E (average of high and low P/E) is shown below.
Key 10-year data for Johnson & Johnson
Sales (in Millions)
EBIT (in Millions)
Source: MSN Money; SEC 10-Ks.
From the above data, we can plot Sales, EBIT, and EPS versus Year, as shown in the chart below.
Sales (in Millions), EBIT (in Millions), and EPS versus Year for Johnson & Johnson, 2002-2011
As evident from the chart above, Johnson & Johnson has demonstrated reasonable predictable sales and earnings over the past 10 years, which allows us to project EPS in the near future, say in five years (i.e. Year 2016), using the logarithmic regression equation for EPS = 9.406E-66 * exp(0.07523*2016) = 6.92. This projection assumes 7.5% annual EPS growth. Johnson & Johnson's 2011 earnings were hurt by expenses related to litigation, product liability, and adjustment to the value of the currency option and deal costs related to the planned acquisition of Synthes, Inc., totaling $3.5 billion, or $1.27 per share.
A conservative average P/E estimate for the stock can be obtained as follows:
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 calculate this by averaging the Average P/E over the past 10 years, excluding any outliers (data points that fall significantly beyond the other data points). There are no significant outliers, so we average the Average P/Es from the past 10 years to arrive at a signature P/E of 17.9.
High P/E estimate: A conservative high P/E estimate can be calculated by averaging the five lowest High P/Es of the 10 High P/Es from the past 10 years. Averaging the 5 lowest High P/Es from the past 10 years gives 16.3.
Low P/E estimate: A conservative low P/E estimate can be calculated by averaging the five lowest Low P/Es of the 10 High P/Es from the past 10 years. Averaging the 5 lowest Low P/Es from the past 10 years gives 13.2.
Average P/E estimate: This takes the average of the High P/E estimate and the Low P/E estimate, as calculated above, to give a conservative estimate of an average P/E for the stock we can expect. Averaging 16.3 and 13.2 gives us 14.77.
Multiplying our EPS projection for 5 years hence by the average P/E estimate gives us a projected average price for the stock: $6.92 * 14.77 = $102.24, which represents an annual stock price return of 12.2% from the current price = $64.60. When we add in the 3.5% dividend yield, the total return expected is 15.7% a year, which means an investment in Johnson & Johnson today is expected to double in about 5 years.
Given a beta = 0.53 for Johnson & Johnson, a risk-free rate = 3% (using the yield on 30-year Treasury bond as a benchmark), and estimated risk premium of about 8% for the general stock market, we have a discount rate = 3% + 0.53*(8%) = 7.24%. Applying this discount rate of 7.24%, our projected price of $102.24 in 5 years translates to a target price = $72 in today's dollars. This is 11% margin of safety from the current price of $64.60, suggesting the stock is slightly undervalued right now. For a good margin of safety, investors are well-advised to buy only if the current price is at least 20% below the target price, which means a buy price of $57.66 and under.
The intrinsic value of Johnson & Johnson can be estimated using a discounted cash flow model. The company's operating cash flow, capital expenditure, and free cash flow (difference between operating cash flow and capital expenditure) for the past 10 years is shown below. All figures are in millions of dollars.
Operating Cash Flow
Free Cash Flow
These data are plotted below:
Note that the free cash flows over the past 10 years fit reasonably well a logarithmic regression, with R squared greater than 0.75. Thus, we can comfortably project operating cash flow over the next 5 years, using the logarithmic regression equation 6.505E-63 * exp(0.07598*Year). This assumes that operating cash flows grow at a rate of 7.6% a year over the next 5 years, a reasonable assumption.
We have previously calculated a discount rate of 7.24%. The caveat is that this might be temporarily low due to low interest rates. For this analysis, let us apply a more conservative discount rate of 10%. Think of discount rate as the minimal annual rate of return you require to invest in the stock. Since the stock market has generated 10% returns a year historically, a discount rate of 10% seems reasonable. Let us assume, further, that the company will grow at a terminal growth rate of 2% a year after 5 years. From the fiscal 2011 balance sheet, Johnson & Johnson had $32261 million cash, $12969 million debt, and 2.75 billion common shares outstanding. With these inputs, we get an intrinsic value of $104 per share. The results are shown below.
Note that total DFCF is sum of discounted free cash flow from years 2012-2016. Residual value = (DFCF from Year 2016) * 1.02 / (1.1 - 1.02). Total EV (enterprise value) is the sum of the total DFCF and residual value. Adding back cash and subtracting debt, we get equity value. Dividing by shares outstanding gives us intrinsic value per share.
Free Cash Flow
This suggests Johnson & Johnson is undervalued at $64.60, with 38% margin of safety. The caveat is that discounted cash flow analysis is very sensitive to the inputs. If we merely change our discount rate from 10% to 12%, for example, the intrinsic value would drop to $85, in which case the stock is still undervalued, but the margin of safety would narrow to 24%.
Current P/E Compared with Signature P/E
The stock's current P/E should be compared with its signature P/E, since established stocks tend to revert back to their respective signature P/Es over the long term. The current P/E of 18.57 is 104% of the stock's signature P/E of 17.9, suggesting the stock is overvalued right now. Ideally, we should look to buy when the current P/E is 80% or less of the stock's signature P/E, so Johnson & Johnson is currently expensive compared to its historic P/E. However, the current EPS is at a 6-year low, temporarily depressed due to one-time litigation and product liability charges; as earnings go up, the P/E should fall accordingly.
Johnson & Johnson's P/E Compared with Competitors' P/Es
It is helpful also to compare Johnson & Johnson's valuations with those of its competitors. Current P/E and Forward P/E are tabulated below for the company and its main competitors.
Johnson & Johnson (JNJ)
Source: Yahoo! Finance; MSN Money.
Johnson & Johnson appears fairly priced compared to its competitors. Covidien and Novartis trade at a discount, while the rest have similar valuations.
Historically, for the past 10 years, Johnson & Johnson has underperformed the S&P 500 and Novartis, but outperformed Abbott, Pfizer, and Merck (10-year data is unavailable for Covidien).
Click to enlarge:
Lastly, we calculate the Risk Index, calculated as (Current Price - Forecast Low Price)/ (Potential High Price - Forecast Low Price) to give 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 Forecast Low Price is calculated by multiplying the Low P/E estimate by the Forecast Low EPS, to give a conservative estimate of low price for the stock in 5 years, assuming zero EPS growth and low valuation. Forecast Low EPS is estimated by averaging the EPS over the past 5 years. For growth stocks with predictable earnings growth, EPS in 5 years should not be any lower than this conservative estimate. For Johnson & Johnson, the forecast low EPS is equal to 4.174, so the Forecast Low Price = 13.2 * 4.174 = $55.24.
The Potential High Price is calculated by multiplying the High P/E estimate by the projected EPS in 5 years, giving us a price in 5 years, should the stock command a high P/E. For Johnson & Johnson, this equals 16.3 * 6.92 = $133.81.
Thus, the Risk Index = ($64.60 - $55.24) / ($112.89 - $55.24) = 16%. Since this is below 20%, the stock has a favorable reward to risk ratio at the current price.
Johnson & Johnson, currently selling around $64.60, has a target price = $72 and estimated intrinsic value = $104. While the current price provides only 11% margin of safety from the target price, and the current P/E is at a premium over the stock's historic P/E, the current stock price has a low risk index, provides 38% margin of safety from its intrinsic value, and apparently already reflects most of the bad news. An investment in Johnson & Johnson is expected to double in 5 years. Therefore, I rate the stock a BUY at the current price. More cautious investors may wait for a pullback to $57 to buy as a long-term investment.
Disclaimer: Use this information as a starting point for your own due diligence, before buying any stock. If you do buy, be sure to read any annual reports (10-K) and quarterly reports (10-Q) to ensure that the fundamentals remain good and the stock is on target to reach its projected price. After holding for five years, repeat the analysis detailed in the article to decide whether to continue to hold, add, or reduce your position. While I rate Johnson & Johnson a buy, please see my other articles for other stocks I would consider buying now, such as Becton-Dickinson , Walgreen (WAG), Wal-Mart (WMT), Target (TGT), and Procter & Gamble (PG). Adequate diversification, with no single stock or sector comprising more than 10%-20% of one's portfolio, is essential.