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Johnson & Johnson
Figuring Out Johnson & Johnson

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By WCMinor
March 1, 2002

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I am trying to figure out what to look for when it comes to balance/income/cash sheets for Johnson & Johnson. Every time I try to educate myself, I get totally confused in the process. On another discussion board somebody said it is important to measure cash from operating expenses less capital expenditures with reported net income. And these numbers should be fairly close or somebody is cooking the balance sheet -- is this true? If so where do I find that info? JNJ has a current P/E of 32...  how do you know if the company is overvalued or not?

We could probably spend a few days discussing how to figure out if J&J is over-valued or not. Let me try a little comparison instead. Let's look at Johnson & Johnson (JNJ), Pfizer (PFE), and Merck (MRK). All three are big, they're all pharma companies that also have non-prescription drug sidelines and -best of all- they are all companies I own small pieces of.

How much are you paying for a dollar of earnings? Their P/E ratios are as follows:

Price-to-earnings
PFE: 33.6
MRK: 19.3
JNJ: 32.6

Which makes JNJ and PFE look a little pricey, at least compared to MRK and even more so compared to the historical average for the market which is something south of 15. But this isn't quite fair because pharmaceutical companies spend a lot on R&D, which lowers earnings today. One way to adjust the P/E for a pharmaceutical company is to add back in the after-tax value of whatever was spent on R&D. That way you make up for companies that are spending more on R&D (which reduces earnings this year). I can get a quick-and-dirty estimate by looking at R&D expenses in comparison to pre-tax income, and dividing the above P/E by the fraction (R&D expense + pretax income)/(pre-tax income)). I'll use the 2001 Q3 figures for the companies and all figures are in millions:

PFE
R&D: $1188
Pre-tax income: $2754
Relative increase in earnings: 1.43
Adjusted P/E: 23

MRK
R&D: $590
Pre-tax income: $2783
Relative increase in earnings: 1.21
Adjusted P/E: 16

JNJ
R&D: $899
Pre-tax income: $2108
Relative increase in earnings: 1.43
Adjusted P/E: 23


Another adjustment we can make is to look at their PEG ratios (P/E ratio divided by growth rate in percentage):

PEG ratios
PFE: 1.39
MRK: 1.76
JNJ: 2.07

Here again JNJ looks a bit expensive, in fact all three stocks are trading at higher ratios than 1 (some folks think of a PEG ratio of 1 as the upper limit of what you should pay).

How about price-to-sales? This is a nice ratio to look at because there is less fudging companies can do in reporting sales than in reporting earnings.

Price-to-sales
PFE: 7.96
MRK: 2.90
JNJ: 5.55

Now Pfizer looks really bad, but we've overlooked some important distortions. Both MRK and JNJ have significant non-pharma businesses that should get a lower P/S than their pharma bits, while Pfizer's non-pharma business is relatively smaller. If I remove the Medco (a pharmacy benefit manager currently owned by MRK) sales of about $30 billion from the denominator and $15 billion (a fair P/S ratio for a pharmacy benefits manager) from the numerator of MRK's ratio I get (138-15)/(47.7-30) = 6.9 as its ratio. I can't do as clean a calculation for the consumer products divisions of JNJ and PFE, but note that JNJ's consumer product sales are about 27% of its total (medical devices and pharmaceutical sales both deserve high multiples, in my opinion), whereas for PFE they are about 20%. Bottom line: on a P/S basis JNJ is not quite as expensive as PFE or MRK.

How about price to book value? Book value is the accounting value of each of these companies. If you were a classic Graham-Dodd investor, you would be reluctant to ever pay more than the value of the assets of a company (i.e. you would want P/B to be less than one):

Price-to-book
PFE: 13.58
MRK: 9.0
JNJ: 7.8

Here all three companies look very expensive, but this again is deceptive. Book value does not account very well for intellectual property or trademarks -vital assets of all pharma companies- and it can lose its meaning for companies like JNJ that make a large number of acquisitions.

That is a (long) list of ways of looking at JNJ but I hope one message is emerging: J&J is not "cheap" but its current market value is not out-of-line with its large peers and any measure that you use will come with some significant limitations.

WCMinor


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