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As part of our process at Valuentum, 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 firm is undervalued. We think it is fairly valued at $90 per share, indicating substantial upside from today's levels. Plus, we just love its dividend-growth potential, which we outline here.

If a company is undervalued both on a discounted cash-flow basis and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our stock-selection scale (the VBI). Johnson & Johnson posts a VBI score of 9 (out of 10, with 10 being the best), reflecting our 'undervalued' DCF assessment of the firm, its attractive relative valuation versus peers, and bullish techinicals (see investment considerations below). We compare Johnson & Johnson to peers Procter & Gamble (NYSE:PG), Clorox (NYSE:CLX), and Colgate-Palmolive (NYSE:CL). In the spirit of transparency, please click here to learn how the VBI has stacked up per score.

Our Report on Johnson & Johnson

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Investment Considerations

Investment Highlights

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

• The firm'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 firm's shares.

• Johnson & Johnson has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 21.5% in coming years. Total debt-to- EBITDA was 1 last year, while debt-to-book capitalization stood at 25.6%.

• The firm sports a very nice dividend yield of 3.4%. We expect the firm to pay out about 48% of next year's earnings to shareholders as dividends. The company has an excellent score on our Valuentum Dividend Cushion, as we outline in this article here.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Johnson & Johnson's 3-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 firm a ValueCreation™ rating of EXCELLENT. In the chart to the right, 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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Firms 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 3 years. As such, we think the firm'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. 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 - $108.00 each. The margin of safety around our fair value estimate is driven by the firm'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 12.3 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 5.2% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 0.7%. Our model reflects a 5-year projected average operating margin of 27.5%, which is above Johnson & Johnson's trailing 3-year average. Beyond year 5, 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. For more fair value estimates, please visit our website at Valuentum.com.

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Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm'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 above, we show this probable range of fair values for Johnson & Johnson. We think the firm 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 firm, 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 to the right compares the firm'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 firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $109 per share in Year 3 represents our existing fair value per share of $90 increased at an annual rate of the firm'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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Source: Johnson & Johnson Is En Route To $90

Additional disclosure: JNJ and PG are included in our Dividend Growth Newsletter.