Numbers can lie -- yet they're the best first step in determining whether a stock is a buy. In this series, we use some carefully chosen metrics to size up a stock's true value based on the following clues:

  • The current price multiples.
  • The consistency of past earnings and cash flow.
  • The amount of growth we can expect.

Let's see what those numbers can tell us about how cheap Johnson & Johnson (NYSE: JNJ) might be.

The current price multiples
First, we'll look at most investors' favorite metric: the price-to-earnings ratio. It divides the company's share price by its earnings per share (EPS). The lower the P/E, the better.

Then we'll take things up a notch with a more advanced metric: enterprise value to unlevered free cash flow. This tool divides the company's enterprise value (basically, its market cap plus its debt, minus its cash) by its unlevered free cash flow (its free cash flow, adding back the interest payments on its debt). As with the P/E, the lower this number is, the better.

Analysts argue about which is more important -- earnings or cash flow. Who cares? A good buy ideally has low multiples on both.

Johnson & Johnson has a P/E ratio of 12.2 and an EV/FCF ratio of 9.9 over the trailing 12 months. If we stretch and compare current valuations to the five-year averages for earnings and free cash flow, J&J has a P/E ratio of 13.9 and a five-year EV/FCF ratio of 12.6.

A one-year ratio of less than 10 for both metrics is ideal. For a five-year metric, less than 20 is ideal.

J&J has a mixed performance in hitting the ideal targets, but let's see how it compares against some of its competitors and industry mates. 

Company

1-Year P/E

1-Year EV/FCF

5-Year P/E

5-Year EV/FCF

Johnson & Johnson

12.2

9.9

13.9

12.6

Medtronic (NYSE: MDT)

10.1

10.4

13.2

13.3

Forest Laboratories (NYSE: FRX)

15.7

5.2

12.1

5.5

Abbott Laboratories (NYSE: ABT)

14.8

11.7

19.8

17.3

Source: Capital IQ, a division of Standard & Poor's.

Numerically, we've seen how cheap Johnson & Johnson is on both an absolute and relative basis. Next, let's examine …

The consistency of past earnings and cash flow
An ideal company will be consistently strong in its earnings and cash-flow generation.

In the past five years, Johnson & Johnson's net income margin has ranged from 18.5% to 21.6%. In that same time frame, its unlevered free cash flow margin has ranged from 18.2% to 25.4%.

How do those figures compare with those of the company's peers? See for yourself:


Source: Capital IQ, a division of Standard & Poor's; margin ranges are combined.

In addition, over the past five years, J&J has tallied up five years of positive earnings and five years of positive free cash flow.

Next, let's figure out …

How much growth we can expect
Analysts tend to comically overstate their five-year growth estimates. If you accept them at face value, you will overpay for stocks. But even though you should definitely take the analysts' prognostications with a grain of salt, they can provide a useful starting point compared with similar numbers from a company's closest rivals.

Let's start by seeing what this company's done over the past five years. Johnson & Johnson has put up past EPS growth rates of 10.1% in that time frame, while Wall Street's analysts expect future growth rates of 6.7%.

Here's how J&J compares with its peers for trailing-five-year growth:


Source: Capital IQ, a division of Standard & Poor's; EPS growth shown.

And here's how it measures up with regard to the growth analysts expect over the next five years:


Source: Capital IQ, a division of Standard & Poor's; estimates for EPS growth.

The bottom line
The pile of numbers we've plowed through has shown us how cheap shares of Johnson & Johnson are trading, how consistent its performance has been, and what kind of growth profile it has -- both on an absolute and a relative basis.

The more consistent a company's performance has been and the more growth we can expect, the more we should be willing to pay. We've gone well beyond looking at a 12.2 P/E ratio. Still, the numbers are just a start.

If you find Johnson & Johnson's numbers compelling, don't stop here. Continue your due-diligence process until you're confident that the initial numbers aren't lying to you.

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Anand Chokkavelu doesn't own shares in any company mentioned. Johnson & Johnson is a Motley Fool Income Investor recommendation. Motley Fool Options has recommended a diagonal call position on Johnson & Johnson. The Fool owns shares of Medtronic. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Fool has a disclosure policy.