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Johnson & Johnson a Buy?

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By kelbon
December 17, 2008

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There's a simple way to ask yourself if JNJ is a buy - in a big picture sort of way.

$60.00 a share equates to a yield on free cash flow of just over 7% - very similar to the earnings yield.

The dividend is a healthy 3%, with a pay-out ratio of 39%. Baring something unforeseen the dividend is safe and it's reasonable to expect annual increases in line with earnings growth.

So you could look at it this way. You're getting a 7% return on cash flow, plus a 3% dividend in hand - a 10% return.

Value Line expects earnings to grow at around 8% annually to 2011-13. If this happens then you're getting a 10% return, compounding at 8% a year. The questions are: is this a satisfactory return, and how predictable is it? Whether it's a satisfactory return is an individual matter, but given negligible returns on 'safe investments,' it presumably holds some attraction.

So how safe is it? JNJ has a long history of increasing earnings, free cash flow, book value, and dividends almost every year. They're in an extremely strong financial position and Value Line gives them a Financial Rating of A++ (the highest). They also have a long history of stellar returns on equity and total capital which have consistently been in the mid to upper 20% range. On a risk/reward basis, even in todays unsettled world, there probably isn't much risk to permanent loss of your capital; provided you are prepared to hold the stock for a while. Meanwhile you can collect, or reinvest, the 3% dividend yield.

JNJ hasn't been this cheap (stock price to fundamentals) for a very long time, but it's come close. If you go by Benjamin Graham's rule of thumb then with a p/e of 13 it's fairly priced if they grow earnings at 2 1/2% a year. Hopefully, they will best that and if they do at some point down the line it's almost inevitable that the p/e ratio will expand. Value Line is guessing to 18 come 2011-13.

And there's always the old adage that it's better to buy a great company at a reasonable price, than a good company at a cheap price...