It is difficult to argue that Johnson & Johnson (NYSE:JNJ) is not a high quality company: 50+ years of consecutive dividend increases, consistent profitability and debt that is rated AAA by S&P. However, its shares are currently priced at multiples that are well above historical averages. This article outlines a simple DCF model that analyzes shares of Johnson & Johnson and shows the reader 35 different scenarios using a range of growth and discount rates. Is this dividend growth champion currently trading at overvalued levels? That really depends on your view of an appropriate discount rate.
Note: I invite you to read my original article that outlines the DCF sensitivity analysis methodology. The basic idea is that since the results of a DCF analysis can be heavily skewed by making minor changes to the terminal (long term) growth rate or WACC (weighted average cost of capital), I have used a range of long-term growth rates and discount [WACC] rates in my analysis below. By using one's own estimate of long-term growth and an appropriate WACC (discount) rate, each individual investor can come up with their own target price for the security in question.
For Johnson & Johnson, we can look back at the following sales, operating cash flow and capital expenditure data from the past five years:
This allows us to find the average Operating Cash Flow/Revenue (25.16%) and average Capital Expenditures/Revenue (4.77%). The fact that both of these ratios remain fairly consistent over the past half decade years gives additional confidence that future free cash flows can be modeled with reasonable accuracy.
Using the analyst consensus revenue forecasts for 2017 and 2018 (Source: Yahoo Finance) leads to the following pro forma free cash flow [FCF] projection (this particular iteration uses a 2.5% long-term growth rate, but remember, the model was also run at 2%, 3%, 3.5% and 4%):
These free cash flows (along with a terminal free cash flow estimate) are then discounted back to the present time using the WACC, which is usually estimated to be 8-9%. However, with Johnson & Johnson, a lower discount rate is likely justified. As previously mentioned, JNJ is rated AAA by S&P, making its cost of debt very low (less than 3.5% before tax according to this website). In addition, thanks in part to its solid dividend yield and strong dividend growth history, its shares have a beta of well below average (Yahoo Finance shows 0.68). Therefore, a discount rate of 7% (the lowest in the model) may well be warranted. In the end, I decided to be slightly more conservative with my base case and settled on 7.5%.
After adjusting for Johnson & Johnson's negative net debt (cash balance) of nearly $42 billion and its number of shares outstanding, the model spits out a target price of $139.15, nearly 10% above the current share price:
However, Johnson & Johnson's current share price may not provide a significant margin of safety. As a fairly slow growth company, using a growth rate of greater than 3% seems overly ambitious. Therefore, the only way to justify JNJ's current share price appears to be by using a discount rate of below 8%. For the reasons discussed above, Johnson & Johnson is one of the few companies in the world that might realistically deserve such a low discount rate (even if interest rates continue to rise modestly).
Below, I have summarized the results of 35 different simulations of the model using a range of long-term growth estimates and discount rates. The target prices range from $95.31 to $213.90 - those highlighted in red are more than 10% below the current share price, while those highlighted in green are more than 10% above the current share price:
Readers are encouraged to use the comment section below to explain what growth and discount rates they deem to be appropriate.
My view: as a long-term investor in Johnson & Johnson, the above table contains a comforting balance of green and red and demonstrates that further upside in its share price is certainly plausible. Interestingly enough, just a few weeks ago, when the share price was in the $115 range, there would have been only one or two red squares in the table. Investors in Johnson & Johnson should be pleased about the recent strong performance of its shares, but recognize that a low discount rate will likely need to persist for many years to come if they expect to continue to receive positive returns.
Disclosure: I am/we are long JNJ.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.