In my previous post, I examined the historical performance of Johnson & Johnson using various fundamental analysis metrics. Based on these calculations, JNJ was awarded 3 of 3 stars in the fundamentals category for having an average RoE of greater than 20% over the last 10 years, a dividend yield and dividend growth rate that should provide more income than a comparable investment in long corporate bonds over 20 years, and for having a well covered dividend and strong balance sheet. Continuing with the analysis of JNJ, the following post looks at the various valuation metrics that I use to determine whether or not the stock is trading below my buy price.

Rate of Return:

The first valuation metric I use is a simplified discounted cash flow analysis. For any investment that I enter into, I want to have a minimum expected return of 15% per year. Thus, I am only interested in investing in stocks that that have earnings yields and growth rates in excess of this hurdle rate.

In general, earnings yield can be calculated using either the inverse of the P/E ratio, the Price to FCF ratio, or the EBIT/EV ratio. Based on data for the trailing twelve months (TTM) and the closing price as of October 25, 2010 ($63.98), these ratios are as follows:

Table 1: Earnings Yields

Of the three values, I have adopted the free cash flow yield (8.7%) as the current earnings yield. From yesterday’s analysis , forward looking growth in free cash flow is estimated at 6.5%. Therefore, the total return going forward should be 15.2% which is just above my cut-off rate of return. Using this analysis, JNJ’s price could increase to approximately $65.79 before the rate of return would be below my hurdle rate. As JNJ’s current stock price is below the price necessary to achieve a 15% rate of return, JNJ is awarded a star for this valuation metric.

Dividend Income:

The second metric that I look at is the price necessary to ensure that the dividend income stream over 20 years is greater than the income received by holding corporate bonds. From the fundamental analysis, the NPV of the difference between the dividend income stream and the interest on the corporate bonds is $650 over 20 years. To have the dividend income stream equal the corporate bond income, JNJ’s price would have to increase to $82.17 which is comfortably above the current stock price.

Additional Metrics:

Though I place most weight on the rate of return and dividend income metrics, I examine a variety of other metrics to ensure that a stock is trading below its fair value buy price. Based on a 10-year price and earnings history, the high and low values of the P/E ratio, EV/EBIT, Dividend Yield, and Price to Book can be determined as shown in Table 2 below.

Table 2: 10 Year Average Valuation Metrics

Using the TTM earnings data, the current price and dividend yield, the following buy prices can be obtained based on these various metrics. In addition, the Graham number is presented based on the total based on total book value (including intangibles).

Table 3: Select Valuation Metrics

Based on these metrics, JNJ is trading below its historical averages, but above its Graham number. Using an average of these valuation metrics, fair value for JNJ is approximately $68.37.

Summary

Based on the above metrics, JNJ is trading at a discount to its calculated fair value and is awarded a 4^th star. (out of 4 so far). Of the metrics discussed above, the most stringent valuation methodology produces a buy price of $65.79. Thus, I will look to add to my JNJ position so long as prices remain below this level depending on the outcome of a technical analysis of JNJ’s recent price action which will be the subject of my next post.

Until next time,
Nathan @ EngineeringIncome.com

Disclaimer:
The data and opinions presented above are for educational purposes only and should not be construed as individualized investment advice or as a recommendation to buy or sell the securities in question. The investing methodology outlined on this site assumes that a stock will perform in the future as it has in the past. This is generally not true. It is the responsibility of individuals to perform their own due diligence and/or consult their investment adviser to determine the suitability of any given investment product for their specific situation. For more information, please see my disclaimer.

Full Disclosure: Long JNJ at the time of this writing.