Company Background (sourced from Yahoo! Finance):
Johnson & Johnson, together with its subsidiaries, engages in the research and development, manufacture, and sale of various products in the health care field worldwide. The company operates in three segments: Consumer, Pharmaceutical, and Medical Devices and Diagnostics. The Consumer segment offers products used in the baby care, skin care, oral care, wound care, and womens health fields, as well as nutritional and over-the-counter pharmaceutical products, and wellness and prevention platforms under the JOHNSONS, AVEENO, CLEAN & CLEAR, NEUTROGENA, RoC, LUBRIDERM, DABAO, VENDÔME, LISTERINE, REMBRANDT, REACH, BAND-AID, NEOSPORIN, CAREFREE, STAYFREE, SPLENDA, TYLENOL, SUDAFED, ZYRTEC, MOTRIN IB, and PEPCID AC brand names. This segment markets its products to the general public, as well as to retail outlets and distributors. The Pharmaceutical segment provides various products in the areas of anti-infective, antipsychotic, contraceptive, gastrointestinal, hematology, immunology, infectious diseases, neurology, oncology, pain management, thrombosis, and vaccines. This segment distributes its products directly to retailers, wholesalers, and health care professionals for prescription use. The Medical Devices and Diagnostics segment offers products to treat cardiovascular disease; orthopaedic and neurological products; blood glucose monitoring and insulin delivery products; general surgery, biosurgical, and energy products; professional diagnostic products; infection prevention products; and disposable contact lenses. This segment distributes its products directly, as well as through surgical supply and other distributors to wholesalers, hospitals, and retailers.
Analysts expect Johnson and Johnson to grow earnings 6.58% per year for the next five years and I've assumed they can continue to grow at 3.50% per year thereafter. Running these numbers through a two stage DCF analysis with a 10% discount rate yields a fair value price of $93.35. This means the shares are trading at a 12.1% discount to the DCF.
With a current book value per share of $23.33 and TTM EPS of $3.86, the Graham Number is calculated to be $45.01. Currently JNJ is trading for a 82.3% premium to the Graham Number.
Average High Dividend Yield:
Johnson and Johnson's average high dividend yield for the past 5 years is 3.73% and for the past 10 years is 3.01%. This gives target prices of $65.47 and $81.00 respectively based on the current annual dividend of $2.44. The high yields are pretty different. I think it's going to be closer to around 3.25% going forward which gives a price of $75.08. Johnson and Johnson is currently trading at a 9.3% premium to my assumed average high dividend yield valuation.
Johnson and Johnson's average low PE ratio for the past 5 years is 13.59 and for the past 10 years is 15.51. This corresponds to a price per share of $73.53 and $83.93 respectively based off the analyst estimate of $5.41 per share for fiscal year 2013. If you exclude 2008 and 2009 from the calculations, the 10 year average is 16.50 so I'll use the 10 year average for my calculations and that is closer to what I'd expect given more normal times. A company as large and stable as JNJ, usually commands a premium in the market place. Currently JNJ is trading for a 11.6% premium to the 10 year P/E price target.
Average Low P/S Ratio:
Johnson and Johnson's average low PS ratio for the past 5 years is 2.43 and for the past 10 years is 2.82. This corresponds to a price per share of $61.90 and $71.83 respectively based off the analyst estimate for revenue growth from FY 2012 to FY 2013. Currently, their current PS ratio is 3.44 on a trailing twelve months basis. Excluding 2008 and 2009 the average low P/S ratio since 2001 is 2.95. I'll use the 5 year average in my calculations just to be conservative. JNJ is currently trading at a 32.6% premium to this price.
Dividend Discount Model:
For the DDM, I assumed that JNJ will be able to grow dividends for the next 5 years at the minimum of 15% or the lowest of the 1, 3, 5 or 10 year growth rates. In this case that would be 6.67%. After that I assumed they can continue to raise dividends for 3 years at 75% of 6.67% or 5.00% and in perpetuity at 3.50%. The dividend growth rates are based off fiscal year payouts and don't necessarily correspond to quarter over quarter increases. To calculate the value I used a discount rate of 10%. Based on the DDM, JNJ is worth $43.59 meaning it's overvalued by 88.3%.
Johnson and Johnson's trailing PE is 21.26 and it's forward PE is 14.25. The PE3 based on the average earnings for the last 3 years is 20.30. I like to see the PE3 be less than 15 which JNJ is currently well over. Compared to it's industry, JNJ seems to be overvalued versus COV (17.23) and NVS (18.38) but fairly valued against the industry overall (21.46). All industry comparisons are on a TTM EPS basis. JNJ's PEG for the next 5 years is currently at 2.28 while COV is at 1.69 and NVS is at 2.74. The industry as a whole carries a 2.74 PEG. Based on the PEG ratio you're paying about par with the industry for the growth of JNJ.
Johnson and Johnson's gross margins for FY 2011 and FY 2012 were 73.5% and 73.2% respectively. They have averaged a 75.2% gross profit margin since 2001 with a low of 73.2% in FY 2012. Their net income margin for the same years were 14.9% and 15.6%. Since 2001 their net income margin has averaged 18.5% with a low of 14.9% in FY 2011. I typically like to see gross margins greater than 60% and at least higher than 40% with net income margins being 10% and at least 7%. JNJ is killing it on both fronts. Since each industry is different and allows for different margins, we'll see where they stand against the industry. For FY 2012, Johnson and Johnson captured 94.2% of the gross margin for the industry and 84.8% of the net income margin. I'd like to see these numbers come back up to at least par with the industry.
JNJ's shares outstanding have been in an overall downtrend with an average decrease of 0.82% since FY 2002, save a few years of increasing shares. Over that time they've bought back 7.9% of their shares outstanding. By repurchasing shares, JNJ is able to increase EPS and management can return cash to shareholders this way by increasing the ownership stake of the company for all the outstanding shares. I would have liked to see management upping the buyback program during the "Great Recession", but it was actually lower in FY 2009-2011 than in FY 2006-FY 2008. The biggest issue I have with buybacks is when they aren't done on a strategic basis due to undervaluation. If they pay more than fair value for the shares, then they are destroying shareholder value because that money could have been spent in more productive ways. If the program was maintained or increased during and after the "Great Recession" they could have created a lot more value.
A negative number for the % change value means shares were bought back by the company and a positive value means the shares outstanding increased.
Johnson and Johnson is a dividend champion with 50 consecutive years of increases. Their current annual dividend sits at $2.44 for a yield of 2.97%. JNJ's annual increases for the last 1, 3, 5 and 10 years have been 6.67%, 7.54%, 8.18% and 11.61%. These numbers are different from the actual quarterly increases since they are based off the dividends paid out during each fiscal year. Their payout ratio has averaged 44.0% since 2001, peaking in 2011 with a 64.5% ratio. The payout ratio has increased the last two years due to the massive amounts of recalls they've had to make. I'd like to see it settle back down into the mid 40's area. Having a low payout ratio leaves more room for management to increase the dividend without overly burdening the underlying business.
Johnson and Johnson's free cash flow has been great since FY 2001 with every year having a positive cash flow. Their free cash flow payout ratio has averaged only 40.2% since FY 2001. This is lower than the payout based on earnings which is good to see. Annual total shareholder return when accounting for buybacks plus dividends has averaged 82.0% of FCF since FY 2001. In FY 2002 and 2012 the total payout was greater than 100% of FCF, if you back out those 2 years they've averaged 68.0%. Total yield, % shares bought back + dividend yield has averaged a pretty measly 3.52% since FY 2002, but has increased the last few years averaging 4.49% between FY 2007 and FY 2011. The increase was mainly due to the average yield increasing due to the undervaluation during the "Great Recession". This just goes to show how important it is to have cash available for special opportunities.
Return on Equity and Return on Capital Invested:
JNJ's ROE has averaged 26.0% since 2001 and has been in a pretty steady downtrend since then, but is still at a solid 18% for FY 2012. Their ROCI has averaged a very solid 23.2% since 2001 and like their ROE has been declining since the mid-2000's. It was still a strong 15.3% in FY 2012 but a far cry from the 28.1% in FY 2006. I don't necessarily look for any absolute values, rather I like to see stable to increasing levels over the long term. The trend should hopefully reverse with the recalls and "Great Recession" behind us.
Revenue and Net Income:
Since the basis of dividend growth is revenue and net income growth, we'll now look at how JNJ has done on that front. Their revenue growth since 2001 has been pretty solid with a 6.36% annual increase and their net income has been growing at a 4.77% rate. Since their net income has been growing slower than revenue, their net income margin has decreased from 18.2% to 15.6% between FY 2002 and FY 2012. Over that time, JNJ has only had 2 negative years of revenue growth, FY 2009 and FY 2010, with net income taking a big hit in FY 2011 due to the recalls. I feel that we'll start to see these metrics improve and the net income margin to rise going forward with the massive amounts of recalls done with.
The average of all the valuation models gives a target entry price of $65.41 which means that Johnson and Johnson is currently trading at a 25.5% premium to the average.. I've also calculated it with the highest and lowest valuation methods thrown out. In this case, the DCF and DDM valuations are removed and the new average is $63.88. JNJ is trading at a 28.5% premium to this price as well.
Assuming that JNJ can grow their earnings and dividends at the rates that I assumed, you're looking at pretty returns over the next 10 years. In 2023, EPS would be $7.84 and slapping an average PE of 16.03 gives a price of $136.69. Over the next 10 years you'd also receive $34.24 in dividends for a total return of 208.27% which is good for a 7.61% annualized rate. If you purchase at my target entry price of $65.41 your projected 10 year total return is 261.32% for an annualized return of 10.08%.
Overall, I would say that Johnson and Johnson is currently in the fair value range. I'd love to own some JNJ because their prospects going forward are still solid. While their payout ratio off earnings is a little high, it's still only about 50% of their FCF which leaves plenty of room to further increase the dividend. Based on the average of it's typical yield, P/E, and P/S ratios it should trade around $79.87 and the high valuation level would be around $87.55. With a dividend increase likely coming in late April, now could be a good time to pick up some shares. If there is a bit of a pullback to the sub-$80 level I'll be looking to initiate a position. It won't be the best price that's around but as Warren Buffet has said "it's better to buy a great company at a fair price, than a fair company for a great price."
With JNJ, the numbers for the last few years for both net income and earnings are skewed a little bit due to the recall issues. Management said that the recalls negatively effected earnings in 2012 by $1.24 per share. If you believe that they are a non-recurring item and won't come up again, then JNJ is trading at an undervalued or at least a better value price.
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What do you think about Johnson and Johnson as a DG investment at today's prices?