J&J's Valuation (Drip Port) June 30, 1999

<THE DRIP PORTFOLIO>
J&J's Valuation
The thumbs up?

by Jeff Fischer (TMFJeff)

PARIS, FRANCE (June 30, 1999) -- Over one week ago, we looked at the price of fallen Pfizer (NYSE: PFE) and declared that "there's gold in them there hills." Maybe.

Using a discounted cash flow model and reasonable growth rate projections, Pfizer shares looked interesting at $97 apiece, or $32.30 following the 3-for-1 split arriving tomorrow.

It now makes sense to run some numbahs on Drip Port darlin' Johnson & Johnson (NYSE: JNJ) to see where this puppy might land. Unlike Pfizer, which was 36% below its high when we considered it, Johnson & Johnson's stock has risen more than fallen of late. It was only 9% below its all-time high as of yesterday when it closed at $94.

Crank out the calculator, Ma. Here we go again. If you need a mathematical refresher, please visit the recent Pfizer column, because today we're diving straight into the numbahs. (If you haven't, also see that column for how we valued Pfizer.)

The most important number in a discounted cash flow model, which we're about to run, is arguably the discount rate. You should usually use the rate that you hope to return. In our case, that is 15.5%. For J&J, we will bring it down to 15%. That's still aggressive for the old boy. Now, we need to find a reasonable growth rate for the company. You can determine this based on what you know and assume is acceptable, or you can use math to calculate it. Either way, it is an estimate.

Published estimates predict more than 12% earnings per share (EPS) growth at Johnson & Johnson each of the next two years, and about 11.8% annual growth in the three years following. The company grew EPS 13.7% annually the past five years, so 12% future growth seems reasonable -- especially given Johnson & Johnson's long history of at least this rate of growth.

We could also use the company's Return on Equity (ROE) history and its average dividend payout ratio to calculate potential growth. The back of the company's 1998 annual report has an excellent ten-year snapshot of J&J's financial performance. ROE has been impressively steady and has averaged 27.62% since 1989. The dividend payout ratio has averaged 38%. We calculate 1 minus the dividend payout ratio, multiplied by ROE, to approximate a future rate of growth. Our ROE is 27.62% and the dividend payout ratio is 38%, so we have: 1 - 0.38 = 0.62 x 27.62 = 17.12%. According to this, we can hope for EPS growth of 17%. Although J&J may come fairly close to that type of growth this year, bouncing from last year's results, it could never sustain it.

We'll assume 12% indefinitely. Some years J&J will underperform this, other years it will exceed it, but over the next twenty years, if management's goals are met, it could grow at this rate.

Last year, J&J achieved net earnings of $3.05 billion. In 1997, it achieved $3.3 billion. The decline last year was largely due to currency translations and a pummeling of the company's stent business. Given that currencies are beyond one's control and that 1998's lower performance might unfairly lower our results, we'll average the last two years together for an approximate starting point. This gives us $3.175 billion. We'll now begin to discount the future value of projected net earnings at 15%. Each year we assume growth of 12%.

Year      Income       Discounted Value

1          $3.55b          $3.08
2           3.98            3.00
3           4.46            2.93
4           4.99            2.85
5           5.59            2.77
6           6.26            2.70
7           7.01            2.63
8           7.86            2.56
9           8.80            2.50
10          9.86            2.43
11         11.04            2.37
12         12.36            2.31
13         13.85            2.25
14         15.51            2.19
15         17.37            2.13
16         19.46            2.07
17         21.79            2.02
18         24.41            1.97
19         27.34            1.92
20         30.62            1.87
         ---------       ----------
sum         N/A         $48.55 billion

Now, consider what this is saying: it is saying that if we wish to achieve a 15% return on an investment in J&J, a business that is disappearing after 20 years -- that is the important assumption being made here -- then we shouldn't pay more than $36 per share now. Of course, J&J won't disappear after 20 years and the market won't ever value it as though it would. Instead, the market is always trying to find a "terminal value," and the longer that a company thrives, the larger that terminal value can become.

So, we need to add a continuing value to the company, because that is what the market is always trying to do and that is how shares are valued. Twenty years from now, the value of the shares will be determined on past income and on the perceived continuing, or terminal, value of the company.

Arriving at a terminal value is easy. In this case, we multiply year 20 earnings by 12% growth again to get $34.29 billion in year 21 income. We then divide that by the difference between our discount rate and our assumed growth rate (0.15 - 0.12, which equals 0.03). After dividing, we arrive at a monstrous 1,143. We discount that number back at 15% from year 20 to achieve $69.83 billion in continuing value. We now must add the continuing value to our year 20 value. $69.83 plus $48.55 year 20 value = $118.38 billion total. Divide that by J&J's 1.345 billion shares outstanding and we arrive at $88 per share.

If we assume J&J can grow 12% annually forever and we want a 15% annualized return, $88 is the maximum price this model tells us to pay. The stock was only 7% above that yesterday.

Is 12% EPS growth too high? Let's assume 11% is the terminal growth rate after 20 years. This gives us $51.90 billion in terminal value. Added to $48.55 billion in year 20 value, we arrive at $100.4 billion in total value, or $74.64 per share. To meet our 15% return hurdle under these assumptions, that is the most we should pay per share. Incidentally, thanks to dollar-cost-averaging, we have paid $74.90 per share, on average, for Johnson & Johnson. 12% annual growth followed by ongoing 11% growth, indefinitely, will give us our 15% return according to this model.

This simple model shows -- somewhat surprisingly to me -- that Johnson & Johnson is quite possibly valued very rationally. Investors are apparently assuming that J&J can continue its long-term, steady, consistent EPS growth rate, and they are then discounting that growth somewhere around 14% and allowing J&J a slight premium over its rate of growth.

Running a discounted cash flow model like this is most practical when considering a company as consistent as Johnson & Johnson. Although J&J may not be able to grow net earnings 12% or 11% organically (via pure sales growth) every single year, we know that management does want to maintain EPS growth at this level and that it has many tools to do so. A company this size can tweak a few levers to keep EPS growth consistent, as J&J did in 1998 during slow sales growth. Management can buy back more shares of stock, continue to increase the dividend payout (as J&J has done for decades) and mess with billions in cash investments -- doing everything in its power, essentially -- to squeeze out total annual growth of 11% to 12%.

A criticism of Intel (Nasdaq: INTC), by the way, has been that interest on its multi-billion-dollar cash position is adding unfairly to earnings. There is nothing unfair about this, however. Cash drives growth and growth results in more cash. Good companies earn extra cash. Extra cash can add incremental value via interest. Great. That's a bonus. You shouldn't penalize a company for having interest-earning cash. You do, however, need to be aware of what is pure EPS growth and what is interest-derived "growth."

To close, assuming that any company can grow 11% or 12% forever entails obvious risk. All companies experience hiccups (regulation-prone pharmaceuticals included), and stocks often overreact to each hiccup. We hope to see such opportunities in J&J, but even at these prices (and especially at prices at least 7% or more lower) we will not be leery to continue averaging into our investment with the hope of a lifelong (or twenty year) market-beating return. Caveat emptor.

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