Why We're Big Fans Of Johnson & Johnson

| About: Johnson & (JNJ)

As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Johnson & Johnson's (NYSE:JNJ) case, we think the company is undervalued. We think it is fairly valued at $90 per share. Our report on Johnson & Johnson and hundreds of other companies can be found here.

For some background, we think a comprehensive analysis of a company's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index, our Valuentum Buying Index (click here for more info on our methodology), which ranks stocks on a scale from 1 to 10, with 10 being the best.

In the spirit of transparency, we show how the performance of our VBI has stacked up per underlying score:

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If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Johnson & Johnson posts a VBI score of 9 on our scale, reflecting our 'undervalued' DCF assessment, attractive relative valuation versus peers, and bullish technicals. Johnson & Johnson leads its peer group that includes Procter & Gamble Co. (NYSE:PG), Colgate-Palmolive Co. (NYSE:CL), Kimberly-Clark Corporation (NYSE:KMB), and Clorox Corporation (NYSE:CLX).

Our Report on Johnson & Johnson

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Investment Considerations

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Investment Highlights

Johnson & Johnson's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the companies in our coverage universe. The companyhas been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively.

The company's shares are trading at an attractive level at this time. Given the company's track record of solid business performance, we'd take a closer look at picking up some of the company's shares.

Johnson & Johnson has an excellent combination of strong free cash flow generation and low financial leverage. We expect the company's free cash flow margin to average about 21.2% in the coming years. Total debt-to-EBITDA was 1 last year, while debt-to-book capitalization stood at 25.6%.

Johnson & Johnson's relative stock price performance, undervaluation, and dividend yield of 3.6% may make it attractive to a variety of investors. Having more types of investors interested in its shares increases the potential for future stock price appreciation, in our opinion.

The company sports a very nice dividend yield of 3.6%. We expect it to pay out about 47% of next year's earnings to shareholders as dividends. We have included Johnson & Johnson in our Dividend Growth Newsletter. It is among a small group of companies with both a high VBI rating and a strong dividend yield.

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Economic Profit Analysis

The best measure of a company's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (WACC). The gap or difference between ROIC and WACC is called the company's economic profit spread. Johnson & Johnson's three-year historical return on invested capital (without goodwill) is 32.8%, which is above the estimate of its cost of capital of 9.3%.

As such, we assign the company a ValueCreation™ rating of Excellent. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome in our opinion, and represents the scenario that results in our fair value estimate.

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Cash Flow Analysis

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Companies that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Johnson & Johnson's free cash flow margin has averaged about 21.1% during the past three years. As such, we think the company's cash flow generation is relatively Strong. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company.

For more information on the differences between these two measures, please visit our website at Valuentum.com. At Johnson & Johnson, cash flow from operations decreased about 14% from levels registered two years ago, while capital expenditures expanded about 22% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Johnson & Johnson's shares are worth between $72.00 and $108.00 each. The stock is currently trading below the low end of our fair value range, suggesting significant upside potential. The margin of safety around our fair value estimate is driven by the company's Low ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $90 per share represents a price-to-earnings ((P/E)) ratio of about 25.8 times last year's earnings and an implied EV/EBITDA multiple of about 12.4 times last year's EBITDA.

Our model reflects a compounded annual revenue growth rate of 5.6% during the next five years, a pace that is higher than the company's three-year historical compounded annual growth rate of 0.7%. Our model reflects a five-year projected average operating margin of 27.1%, which is above Johnson & Johnson's trailing three-year average. Beyond year five, we assume free cash flow will grow at an annual rate of 2% for the next 15 years and 3% in perpetuity. For Johnson & Johnson, we use a 9.3% weighted average cost of capital to discount future free cash flows.

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Margin of Safety Analysis

Our discounted cash flow process values each company on the basis of the present value of all future free cash flows. Although we estimate the company's fair value at about $90 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.

Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Johnson & Johnson. We think the company is attractive below $72 per share (the green line), but quite expensive above $108 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the company, in our opinion.

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Future Path of Fair Value

We estimate Johnson & Johnson's fair value at this point in time to be about $90 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the company's current share price with the path of Johnson & Johnson's expected equity value per share over the next three years, assuming our long-term projections prove accurate.

The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the company's shares three years hence. This range of potential outcomes is also subject to change over time should our views on the company's future cash flow potential change. The expected fair value of $108 per share in Year 3 represents our existing fair value per share of $90 increased at an annual rate of the company's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

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Pro Forma Financial Statements

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Some of the companies mentioned in this article may be included in the portfolio of our Dividend Growth Newsletter.