In this article, let´s consider Johnson & Johnson (JNJ, Financial), a $297.71 billion market cap that is the world's largest and most diverse healthcare company. It has a trailing P/E ratio that indicates that the stock is relatively undervalued (PE 19.4x vs Industry Median 42.0x).
Key drivers
The company is a leader across the healthcare industry. The business is divided in three divisions: Consumer, Pharmaceutical and Medical Devices & Diagnostics. The pharmaceutical division represents almost 40% of total sales. Due to patent losses and the Synthes acquisition, this proportion will be reduced to approximately 32% during the next decade.
Three drivers of the firm are its diverse revenue base, a robust research pipeline and good cash-flow generation. The leading positions of the company are in medical devices, in over-the-counter products as well as in various pharmaceutical markets. With more than a third of total revenue, the pharmaceutical division boasts several industry-leading drugs, including immunology drug Remicade and psoriasis drug Stelara.
We must say that, with the acquisition of Pfizer (PFE, Financial) Consumer Healthcare's global business of personal care and over-the-counter products, Johnson & Johnson gained a strong position in this market.
The free cash flow (operating cash flow less capital expenditures) is about 20% of sales, and it is very important to take advantage of acquisition opportunities like the previous one. Further, cash generation has enabled the firm to increase its dividend for more than 50 years. The current dividend yield is 2.65%, which can improve in the future allowing higher shareholder returns. So now, let's try to find the intrinsic value of the stock.
Valuation
In stock valuation models, dividend discount models (DDM) define cash flow as the dividends to be received by the shareholders. Extending the period indefinitely, the fundamental value of the stock is the present value of an infinite stream of dividends according to John Burr Williams.
Although this is theoretically correct, it requires forecasting dividends for many periods, so we can use some growth models like: Gordon (constant) growth model, the Two- or Three-Stage growth model or the H-Model (which is a special case of a two-stage model).With the appropriate model, we can forecast dividends up to the end of the investment horizon where we no longer have confidence in the forecasts and then forecast a terminal value based on some other method, such as a multiple of book value or earnings.
To start with, the Gordon Growth Model (GGM) assumes that dividends increase at a constant rate indefinitely.
This formula condenses to: V0=(D0 (1+g))/(r-g)=D1/(r-g)
where:
V0 = fundamental value
D0 = last year dividends per share of Exxon's common stock
r = required rate of return on the common stock
g = dividend growth rate
Let´s estimate the inputs for modeling:
Required Rate of Return (r)
The capital asset pricing model (CAPM) estimates the required return on equity using the following formula: required return on stockj = risk-free rate + beta of j x equity risk premium
Assumptions:
Risk-Free Rate: Rate of return on LT Government Debt: RF = 2.67%. This is a very low rate because of today´s context. Since 1900, yields have ranged from a little less than 2% to 15%; with an average rate of 4.9%. So I think it is more appropriate to use this rate.
Beta: β =0.61
GGM equity risk premium = (1-year forecasted dividend yield on market index) +(consensus long-term earnings growth rate) – (long-term government bond yield) = 2.13% + 11.97% - 2.67% = 11.43%[1]
rJNJ = RF + βJNJ [GGM ERP]
= 4.9% + 0.61 [11.43%]
= 11.87%
Dividend growth rate (g)
The sustainable growth rate is the rate at which earnings and dividends can grow indefinitely assuming that the firm´s debt-to-equity ratio is unchanged and it doesn´t issue new equity.
g = b x ROE
b = retention rate
ROE = (Net Income)/Equity= ((Net Income)/Sales).(Sales/(Total Assets)).((Total Assets)/Equity)
The “PRAT” Model:
g= ((Net Income-Dividends)/(Net Income)).((Net Income)/Sales).(Sales/(Total Assets)).((Total Assets)/Equity)
Let´s collect the information we need to get the dividend growth rate:
| Financial Data (USD $ in millions) | 31-Dec-13 | 31-Dec-12 | 31-Dec-11 |
| Cash dividends declared | 7,286,000 | 6,614,000 | 6,156,000 |
| Net income applicable to common shares | 13,831,000 | 10,853,000 | 9,672,000 |
| Net sales | 71,312,000 | 67,244,000 | 65,030,000 |
| Total assets | 132,683,000 | 121,347,000 | 113,644,000 |
| Total Shareholders' equity | 74,053,000 | 64,826,000 | 57,080,000 |
| Ratios | Â | Â | Â |
| Retention rate | 0.47 | 0.39 | 0.36 |
| Profit margin | 0.19 | 0.16 | 0.15 |
| Asset turnover | 0.54 | 0.55 | 0.57 |
| Financial leverage | 1.91 | 1.99 | 2.00 |
| Â | Â | Â | Â |
| Retention rate = (Net Income – Cash dividends declared) ÷ Net Income = | 0.47 | ||
| Â | Â | Â | Â |
| Profit margin = Net Income ÷ Net sales = | 0.19 | Â | Â |
| Â | Â | Â | Â |
| Asset turnover = Net sales ÷ Total assets = | 0.54 | Â | Â |
| Â | Â | Â | Â |
| Financial leverage = Total assets ÷ Total Shareholders' equity = | 1.79 | Â | |
| Â | Â | Â | Â |
| Averages | Â | Â | Â |
| Retention rate | 0.41 | Â | Â |
| Profit margin | 0.17 | Â | Â |
| Asset turnover | 0.55 | Â | Â |
| Financial leverage | 1.97 | Â | Â |
| Â | Â | Â | Â |
| g = Retention rate × Profit margin × Asset turnover × Financial leverage | Â | ||
| Â | Â | Â | Â |
| Dividend growth rate | 7.50% | Â | Â |
| Â | Â | Â | Â |
Because for most companies, the GGM is unrealistic, let´s consider the H-Model which assumes a growth rate that starts high and then declines linearly over the high growth stage, until it reverts to the long-run rate. A smoother transition to the mature phase growth rate that is more realistic.
Dividend growth rate (g) implied by Gordon growth model (long-run rate)
With the GGM formula and simple math:
g = (P0.r - D0)/(P0+D0)
= ($104.79 ×11.87% – $2.8) ÷ ($104.79 + $2.8) = 8.96%.
The growth rates are:
| Year | Value | g(t) |
| 1 | g(1) | 7.50% |
| 2 | g(2) | 7.86% |
| 3 | g(3) | 8.23% |
| 4 | g(4) | 8.60% |
| 5 | g(5) | 8.96% |
G(2), g(3) and g(4) are calculated using linear interpolation between g(1) and g(5).
Calculation of Intrinsic Value
| Year | Value | Cash Flow | Present value |
| 0 | Div 0 | 2.80 | Â |
| 1 | Div 1 | 3.01 | 2.69 |
| 2 | Div 2 | 3.25 | 2.59 |
| 3 | Div 3 | 3.51 | 2.51 |
| 4 | Div 4 | 3.82 | 2.44 |
| 5 | Div 5 | 4.16 | 2.37 |
| 5 | Terminal Value | 155.61 | 88.80 |
| Intrinsic value | Â | Â | 101.41 |
| Current share price | Â | Â | 104.79 |
Final comment
Using a margin of safety, one should buy a stock when it is worth more than its price on the market (plus a margin: I recommend 20%). We found that intrinsic value is approximately equal to the trading price, so we can conclude that the stock is fairly valued if you trust in the model and assumptions. However, due to its drivers I feel bullish on this stock.
We have covered just one valuation method and investors should not be relied on alone in order to determine a fair (over/under) value for a potential investment.
Hedge fund gurus like Paul Tudor Jones (Trades, Portfolio), John Rogers (Trades, Portfolio), Richard Pzena (Trades, Portfolio), Sarah Ketterer (Trades, Portfolio), Jim Simons (Trades, Portfolio), Ken Fisher (Trades, Portfolio), John Buckingham (Trades, Portfolio), James Barrow (Trades, Portfolio), Jean-Marie Eveillard (Trades, Portfolio) and Ruane Cunniff (Trades, Portfolio) added the stock in the second quarter of 2014, as well as Pioneer Investments (Trades, Portfolio), RS Investment Management (Trades, Portfolio) and Manning & Napier Advisors, Inc.
Disclosure: Omar Venerio holds no position in any stocks mentioned.
[1] These values were obtained from Bloomberg´s CRP function.
