Warren Buffett's recent exit of Johnson & Johnson (JNJ) might raise some questions about both its valuation and its future prospects. My previous article on JNJ looked at the price-to-book value, which compares book equity per share to the traded value per share. While Warren Buffett is very fond of book equity ratios, many investors consider price to earnings (PE) ratio to be the key valuation metric. While I believe more strongly in cash flow ratios, PE ratios offer a relatively simple, common calculation. The price to earnings ratio is a comparison of the stock's price to its earnings per share, often on a trailing twelve months basis but also on a forward basis. This valuation multiple should reflect both the risk of owning the stock (e.g., a required rate of return or hurdle rate) as well as its growth prospects.
The graph compares the two PE ratios and shows the downward trend that is more pronounced in the broader market especially since JNJ is trending upwards due to recent lower EPS.
Comparisons to S&P 500 ratio from late 2008 through 2009 are probably not useful due to substantial losses in the financial sector and weakened earnings in most sectors. These earnings created significant distortion in the multiple that renders comparisons less insightful. The following chart simplifies by taking the premium of JNJ to the broader market and charting it by itself:
Source: Yahoo!Finance with daily closing prices
What is immediately notable about this chart is the lack of price appreciation over long stretches. Even with the struggles in the broader market, the S&P 500 has appreciated significantly more. While dividends would explain some of the difference given the higher yield on JNJ, there is still a meaningful unexplained portion.
This chart shows that there might have been a little downward drift when the PE ratio premium reached a relative maximum around April 2005. However, it is not as pronounced as in other stock examples that I have researched. Holders of JNJ might be wise to re-examine their positions. The counterpoint is clearly JNJ has high expectations for this year with estimated earnings at $5.07 per share for 2012. These prospects are most likely keeping the stock buoyed up. At an EPS of $5.07, JNJ trades at a much more reasonable 13.4x. This would be aligned with the market and reflect a negligible premium. The caution to this is that recent earnings revisions from analysts have been negative.
Additional disclosure: Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.