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Ben Reynolds
Ben Reynolds
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Johnson & Johnson: An Excellent Business Selling at a Rational Price

Analyzing the investment prospects of this health care conglomerate

December 05, 2018 | About:

In Warren Buffett (Trades, Portfolio)’s 1996 Berkshire Hathaway Annual Letter (NYSE:BRK.A) (NYSE:BRK.B), he laid out what an investor ought to be looking for:

“Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now.”

When you read something like that, a company like Johnson & Johnson (NYSE:JNJ) comes to mind.

I’ll give you some examples to illustrate what I mean. Twenty years ago, the company was earning roughly $1.10 per share. Ten years ago, it was earning around $4.55 per share. Five years ago, the number was approximately $5.50 per share. The expectation is $8.15 or so for this year.

Johnson & Johnson has grown earnings per share by a compound annual rate of 10.5% per year over the last two decades, by 6% per annum in the last decade and 8.2% annualized over the last five years. More than that, you can’t find a single year-over-year period in the last 20 years where Johnson & Johnson failed to increase earnings per share.

The dividend has followed suit. Actually, it’s been even more impressive: Johnson & Johnson has not only paid, but also increased its dividend for 56 straight years. The company is a quintessential example of a “Steady Eddy” business whose earnings stand an exceptional shot at being higher, perhaps materially higher, five, 10 and 20 years from now.

Of course, finding a great business is only half of the answer. The second and equally important consideration is whether or not shares are trading at a rational price. While the underlying volatility of J&J may be less than your typical stock, this does not preclude the security from bouts of over- or undervaluation from time to time. Even the best business will not save an investor from a terribly overvalued security.

So let’s consider the current valuation. This year, as noted, the expectation is for J&J to earn $8.15 or so per share. Against a current share price of $146, this implies a multiple of about 18 times earnings. Moving forward, the midpoint of analysts’ estimates suggest that $8.66, $9.28 and something close to $10.30 are possible in the coming three years. For our purposes, let’s start with $8.15 per share and grow this number by 7% per annum – more or less in the middle of what Johnson & Johnson has achieved historically.

At that rate, Johnson & Johnson could be earning $11.40 or so per share in the next five years. Valuation can jump about significantly (even for a company this steady), but we do have some clues. Over the past couple of decades, a typical earnings multiple for Johnson & Johnson has been in the 15 to 19 range, with exceptions on both the lower and higher sides. For illustration, let’s use 17 times earnings as a “fair” valuation, considering the company’s growth prospects and overall quality.

At that valuation, shares have the potential of reaching $194 or so after half a decade.

In addition, you have to consider the dividend. If the dividend grew at the same rate as earnings (J&J pays out a little under half of its earnings as dividends), you might anticipate receiving $22 or so in cash payments over the next five years. When added to the share price, this results in the potential for a nominal value of about $216.

There are two important considerations in this number. First, regardless of how exact your final number appears or how reasonable you believe your assumptions might be, this is simply a baseline for valuation and not an absolute. It is a starting place for thinking about the value of the business; one possibility out of a wide range of likely outcomes.

Second, the attractiveness of the potential $216 in nominal future value depends on the current share price and your applicable investment alternatives.

If Johnson & Johnson were currently trading at $216, this would imply 0% annual returns and would not appear especially attractive. On the other hand, if shares were trading hands at $87, this would imply the potential for 20% annualized gains and would be quite compelling. Reality is usually somewhere in-between.

Johnson & Johnson’s current share price is $146. At this mark, this would imply the potential for 8.2% annualized gains. And it’s best to think about this in ranges, say the potential for 7% to 9% or 6% to 10% annualized gains instead of 8.2% precisely.

This is what I mean when I suggest that Johnson & Johnson is trading at a “rational” price. It’s not exceptionally compelling, but it’s also quite acceptable for the quality that is being offered. Annual returns of 8% per year (or 6% to 10%) offer a reasonable investing starting point. You can do just fine in the investing world by compounding your wealth in the high single digits.

In short, shares of Johnson & Johnson are not necessarily offering a “bargain” today, trading around 18 times earnings with the expectation of single-digit growth ahead. Yet there are two important takeaways.

First, the quality component should be taken into consideration. If you’re looking for a business with a high likelihood of growing earnings in the next five, 10 and 20 years, a business like Johnson & Johnson should be on your short list. And second, just because an exceptional value is not presented, this alone does not mean you should move on to the next opportunity. From here investors still stand a good shot at capturing their “fair share” of business results. Johnson & Johnson offers the rare combination of an excellent business trading at a rational price.

Disclosure: I am not long any of the stocks mentioned in this article.

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About the author:

Ben Reynolds
I run Sure Dividend, a website that finds high quality dividend stocks for long term investors using the 8 Rules of Dividend Investing.

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