In part 1 of my valuation of Johnson & Johnson (JNJ), I looked at four different discounted cash flow scenarios. All four showed JNJ to be undervalued, one by as little as 15% and one by as much as 64%.
This is a wide range and skeptics of this approach may argue that this approach is entirely too imprecise. On the other hand, it may be useful to learn that JNJ is cheaper than even a conservative estimate of its discounted future free cash flows. After all, the most conservative model assumes no growth after year 8; this seems unlikely, even if we are talking about real growth after inflation.
Today, I’m going to look at how JNJ’s Value Line sheet might look in 2020 in order to ball park what an investors total return might be if he or she invested in the stock at around $60 per share, roughly where it is trading today. I was inspired to do this exercise because some years ago Buffett said that that’s what he tries to do when analyzing a business in Value Line. Both Buffett and Munger (and Li Lu, the seeming heir-apparent to at least part of Berkshire’s CIO position) are on record as singing the praises of Value Line as an analytical tool.
For most stocks/businesses, such a projection would be an exercise in self-delusion as their economic fundamentals are subject to too many unknown factors such as creative destruction, lack of growth and reinvestment opportunities, heavy debt loads that are subject to unknown future conditions in the credit markets, no current profits – the list could go on. Others argue that, more than ever, current macroeconomic uncertainties make such a long-range forecast impossible.
The contention here is that JNJ’s exceptional track record, current economics and future prospects make such an exercise both possible and useful. If nothing else, it is an exercise in inversion in that it allows you to test your assumptions and see what type of economic performance and action by management is required to achieve a given total-return hurdle rate.
The primary variable in the three Value Line scenarios is the Return on Equity (ROE). In the base case, I assume it will be 23.5%, which was its actual ROE in 2009. In this case, I also assume that the stock will trade at 15x earnings in 2020, which is an average historical multiple for the S&P 500. The argument here is that JNJ warrants at least an average market multiple.
In the pessimistic case, I assume an ROE of 20%, which is 2-3% lower than anything JNJ has produced in the past decade, and a 2020 P/E ratio of 10. Finally, in the optimistic case, I assume an ROE of 27%, which was approximately the average ROE over the past ten years and a 2020 P/E ratio of 18.
In all cases, I used Value Line’s actual numbers for 2010 to provide a common baseline.
The spreadsheets’ formats will be roughly familiar to those who follow Vale Line. I left out a lot of rows and data which are not material to the exercise. I also added some rows that do not appear in Value Line (the rows in gray shade at the bottom).
The first added row is “Profits Reinvested in Equity”. Although Value Line shows the percentage of net profit which is “retained to common equity”, it does not break out how the retained cash is used, i.e. dividends, share repurchases, maintenance cap-ex. In the case of JNJ, I assume that earnings are free cash flow because, historically, JNJ’s depreciation and cap-ex have been roughly equivalent. I further assume – somewhat over simplistically – that profits retained to common equity will be used for only one of two things: equity reinvestment in the business or share repurchases.
The “Profits for Share Repurchases” and “Avg. Price per share of Repurchases” allow me to calculate how many shares are repurchased annually. Obviously, this won’t happen in a linear fashion, if at all, although it is broadly consistent with JNJ’s use of cash over the prior five years.
2005 – $1.7 billion
2006 – $6.7 billion
2007 – $5.6 billion
2008 – $6.7 billion
2009 – $2.1 billion
Cash could also be used to do something else such as make an acquisition. The long-term outcome should be roughly the same if we assume that JNJ will do intelligent things with their capital and get a return commensurate with the company’s long-term returns.
I assume that future share repurchases will be done at 3.5x book value per share. This assumption cuts both ways. Historically, JNJ has traded at a higher multiple to book, so you could argue that shares will not be available at this price going forward. This would reduce the number of shares repurchased and lower future earnings per share. On the other hand, it would mean a higher multiple for the stock and potentially a higher total return, depending on when and if the stock was sold.
The Base Case
The base case results in the stock growing at a CAGR of 11.7%. Add in average dividends of 3% and the total return is close to 15%.
(click image to enlarge)
The Pessimistic Case
The pessimistic case results in the stock growing at a CAGR of 7%. Add in average dividends of 3% and the total return is still about 10%.
(click image to enlarge)
The Optimistic Case
The optimistic case results in the stock growing at a CAGR of 14%. Add in average dividends of 3% and the total return is approximately 17%.
(click image to enlarge)
As always, I invite and welcome your comments.
The author of this blog is NOT an investment, trading, legal, or tax advisor, and none of the information available through this blog is intended to provide tax, legal, investment or trading advice. Nothing provided through these posts constitutes a solicitation of the purchase or sale of securities/futures. The data and information presented in this blog entry is believed to be accurate but should not be relied upon by the user for any purpose. Any and all liability for the content or any omissions, including any inaccuracies, errors or misstatements in such data is expressly disclaimed.