McDonald’s Stock Analysis – Technicals

In my previous two posts I examined various fundamental and valuation metrics for McDonald’s using historical data over a 10-year time span.  From these analyses, MCD was awarded 3 of 3 stars in the fundamentals section 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 an adequately covered dividend and moderately leveraged balance sheet.  Due to MCD trading above my calculated fair value, no stars were awarded for valuation.

Given that MCD has strong fundamentals, examining various technical analysis metrics can help to determine an appropriate entry (or exit) point for the stock.

52-Week Prices:

One of the simplest screens for an appropriate entry point is the price that a stock is currently trading at compared to its 52-week high and 52-week low.  For a graphical representation of prices and other technical indicators described below, the 52-week technical’s chart for MCD is presented below:

Figure 1:  MCD Technical Chart


From the chart it can be seen that the stock has been gradually increasing throughout the past year.  Relative to the closing price of $79.02 on November 19th, MCD is trading the following distance from its 52-week high and low:

Price % from value
52-Week High $79.90 1.1%
52-Week Low $60.04 31.6%

To conform to the ‘buy low, sell high’ adage, as MCD is trading within 2% of its 52-week high, and is greater than 10% from its 52-week low, no stars are awarded for this timing metric.

RSI

In addition to the simple screen based on 52-week highs and lows, I also track the 7-day, 7-week, and 7-month Relative Strength Indicator (RSI) values for each stock I follow.  RSI is a momentum indicator that shows when stocks are overbought or oversold.  When a stock is oversold on all three time frames (RSI < 30), that typically indicates a good time to buy.  Similarly, when a stock is oversold (RSI > 70), that can indicate a good time to sell.  The three RSI values for MCD are currently as follows:

Value
RSI-7d 55.3
RSI-7w 72.2
RSI-7m 85.7

With all RSI values relatively high on the index, and the 7-week and 7-month RSI values in overbought territory, no stars are awarded for this timing metric.  A plot of the 7-week RSI indicator for the last year is in the technical’s chart presented in Figure 1.  Examining the chart, it can be see that MCD has been in a strong uptrend the entire year with the lowest readings of near 40 in April.

MACD

To supplement the RSI calculation, I also examine the Moving Average Convergence Divergence (MACD) indictor.  The one year MACD(12,26,9) chart is again presented in Figure 1 above.  From this chart, it can be seen that MCD is currently treading water with its signal line and MACD approximately equal.  Given that the histogram recently has turned negative and the 7-day RSI has retreated from overbought territory, the technical’s indicate that it may be a good time to reduce holdings of MCD.

Based on oversold RSI indicators and a MACD chart that has recently had a signal line cross, MCD earns no stars in this technical analysis metric.

Summary

Overall, MCD earned a total of 3 stars (out of 6) which gives MCD a ‘Hold’ rating.  However, based on the technical analysis above, with MCD trading above its calculated fair value and technical indicators showing overbought, it may be a good time to start booking some profits and wait to re-enter the stock the next time it experiences a downturn.

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: No positions as of the time of this writing.

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McDonald’s Valuation

In my previous post, I examined the fundamental business performance of McDonald’s over the last 10 year time period.  Based on this analysis, MCD was awarded 3 of 3 stars in the fundamentals category for having an average RoE of greater than 20%, 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 an adequately covered dividend and moderately leveraged balance sheet.  Continuing with the analysis of MCD, 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:

For any investment that I enter into, I have a minimum expected return of 15% per year.  Thus, I am only interested in investing in stocks where the sum of the current earnings yield and the projected earnings growth rate in excess of this hurdle rate.

To calculate the earnings yield, I look at the inverse of the P/E ratio, the Price to FCF ratio, and the EBIT/EV ratio.  Based on data for the trailing twelve months (TTM) and the closing price as of November 19, 2010 ($79.64), these ratios are as follows:

Table 1:  Earnings Yields

EPS / Price: 5.5%
FCF / Price: 8.7%
EBIT / EV: 4.6%

Using these three metrics, the median value (5.5%) is adopted as the current earnings yield.

From the fundamental analysis, the forward looking growth rate in free cash flow is estimated at 6.8%.  Therefore, the total return going forward should be 12.3% which is below my cut-off rate of return.  Using this analysis, MCD’s price would have to fall to approximately $58.53 (near its 52-week low) before the rate of return would be above my hurdle rate.  As MCD’s current stock price is above the price necessary to achieve a 15% rate of return, MCD is awarded no stars 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 $522 over 20 years.  To have the dividend income stream equal the corporate bond income, MCD’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

Metric High Low
Price / Earnings: 24.3 15.4
EV / EBIT: 16.6 11.6
Dividend Yield: 2.56% 1.72%
Price / Book: 4.34 2.88

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 book value (including intangibles).

Table 2:  Select Valuation Metrics

Price Based on: Average Fair Valued:
Average Price / Earnings: $65.65 No
Average EV / EBIT: $46.73 No
Average High Yield: $69.13 No
Average Price / Book: $64.75 No
Graham Number $30.60 No

Based on these metrics, MCD is trading above its historical averages in all categories.  Using an average of these valuation metrics, fair value for MCD is approximately $59.04.

Summary:

Based on the above metrics, MCD is trading at a premium to its calculated fair value and as such no stars are awarded for valuation (3 out of 4 so far).  Of the metrics discussed above, the most stringent valuation methodology produces a buy price of $58.53.  Thus, I will look to initiate a MCD position only after the stock price declines in the future.

For my next post, I will take a look at some of MCD’s technical indicators.

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: No positions as of the time of this writing.

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McDonald’s Stock Analysis – Fundamentals

Though I will eventually get around to analyzing Canadian dividend growth stocks, I am presently involved in screening my current U.S. stocks.  Though I performed in-depth reviews of each of my holding prior to investing, I am interested in keeping track of the current valuation and technical signals of stocks in my portfolio to identify appropriate accumulation and divestment points as they occur.  To continue with this portfolio evaluation, the following presents an analysis of McDonald’s Corp – the world’ largest fast-food company.

10 Year Company Performance

Examining historical financial statements for MCD, select 10-year compounded annual growth rates (CAGR) are as follows:

  • Revenue:  6.2%
  • Earnings:  16.7%
  • Book Value:  7.6%
  • Free Cash Flow:  23.6%
  • Dividends:  30.6%

A plot of the historical earnings, free cash flow, and dividends paid is presented below. Note how earnings and free cash flow track each other and remain consistently above the dividends paid.

From the above results, it can be seen that McDonald’s has produced exceptional results over the past 10 years with earnings, free cash flow, and dividends all growing at rates in excess of 15%.

Future Projections:

Though MCD has a very strong 10-year growth record, it is unlikely that they will be able to produce the same type of growth into the future.  To provide a margin of safety for the investment, the following projections from have been used for continuing business growth:

  • Revenue:  6.0%
  • Earnings:  9.0%
  • Book Value:  7.5%
  • Free Cash Flow:  7.5%
  • Dividends:  9.5%

As can be seen, consensus estimates for future growth are less than the historical growth rates, but still high enough to provide the opportunity for significant returns in the future.

Screening Criteria:

Return on Equity:

Looking at MCD’s return on equity (ROE) for the last 10 years (see Table 1 below), we can see that it has averaged 19.6% which is approximately equal to the 20% average that I am looking for.  However, in 2002 the ROE decreased to 8.7% which is below my 15% minimum.  At this time, McDonalds entered into a corporate restructuring with the appointment of a new chairman and CEO and a renewed corporate focus.  Since this restructuring, MCD’s operating results have improved with an average ROE of 22% and a minimum above 15%.  Though MCD does not meet my strict criteria for ROE, their performance since restructuring has been exceptional and as such MCD is awarded a star in this metric.

Dividend Income vs. Fixed Income:

To determine the relative attractiveness of MCD’s dividends to the income from long corporate bonds, a Net Present Value (NPV) calculation of the difference between the two income streams has been completed.  For this calculation, MCD’s current yield of 2.8% was adopted along with the assumed dividend growth rate of 9.5% per year.  The interest on comparable long corporate bonds was set to 5.2% per annum.

Using this data, over a 20-year investing horizon the NPV of the dividend stream in excess of the interest on the long corporate bonds is calculated to be $533.  As the income received from dividends is greater than the interest received from a comparable fixed income investment, MCD is awarded a star for this income metric.

Dividend Payout Ratio:

As dividends are paid out of free cash flow, it is important to ensure that companies generate enough free cash flow to allow them to continue to pay their quarterly dividend while reinvesting in the business.  Over the trailing 12 months (TTM), MCD has generated $3.74 in free cash flow per share (fully diluted) while paying out $2.20 in common dividends.  This results in a free cash flow payout ratio of 59% which is near the high end of my acceptable range.  Over the last 10 years, the free cash flow payout ratio has averaged 41.5% and has generally remained close to the 50-60% level over the last 4 years.

Over the last 10 years, MCD’s rate of earnings reinvestment has averaged 18.8%.  Even with the relatively high payout ratio, this rate of reinvestment leaves a margin of approximately 20% for future dividend increases (an 11% increase has been announced for Q4) and share buyback programs discounting any projected growth in free cash flow.

Table 1:  Select Historic Data:  ROE & Free Cash Flow Payout

Year Return on Equity Free Cash Flow Dividends Paid Payout Ratio
2009 32.4% $3.43 $2.05 59.8%
2008 32.2% $3.30 $1.625 49.2%
2007 15.7% $2.42 $1.50 62.0%
2006 22.9% $2.08 $1.00 48.1%
2005 17.2% $2.14 $0.67 31.3%
2004 16.0% $1.95 $0.55 28.2%
2003 12.3% $1.54 $0.40 26.0%
2002 8.7% $0.69 $0.24 34.7%
2001 17.2% $0.60 $0.23 38.5%
2000 21.5% $0.59 $0.22 37.0%

Balance Sheet Leverage:

The use of leverage (debt) by corporations can be a good way to increase their rate of return.  However, taking on too much debt can be hazardous and can result in significant losses over time if not managed properly.  As a measure of the leverage of the balance sheet, the debt-to-total capital ratio indicates the ratio between the debt and the debt and shareholder’s equity on the balance sheet.  MCD’s debt to total-capital is 45.6% which indicates a moderately leveraged balance sheet.

Corporations with leveraged balance sheets tend to have a high return on equity.  By examining the return on assets ratio, a measure of the leverage employed can be gained.  Over the past 10 years, MCD has averaged a 9.3% return on assets (ROA) which I consider average.

Based on the analysis of these free cash flow payout and the balance sheet leverage, MCD is considered to have sufficient coverage for their dividend and a moderately leveraged balance sheet.  Though both of these metrics are near the upper end of what I consider to be acceptable ranges, MCD is awarded a star for their performance in these metrics.

Summary of Fundamental Metrics

Based on the Return on Equity since their corporate restructuring in 2003, a dividend payout that should outpace the interest income from corporate long bonds, and a sufficiently covered dividend payout and moderately leveraged balance sheet, McDonalds has been awarded 3 out of 3 stars in the fundamental analysis metrics that I track.

In my next post, I will look at McDonald’s valuation metrics compared to the current price.

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 MCD at the time of this writing.

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Dividend Growth Stocks

As a dividend growth investor, I am looking to invest in companies that have increased their annual dividend for a number of years.  Luckily, lists of dividend growth stocks are maintained by various organizations for both the Canadian and U.S. markets.

For stocks listed in the United States, by far the most comprehensive list of Dividend Growth Stocks is the Dividend Champions list maintained by David Fish at the DRiP Investing Resource Center.  This list is divided into companies that have raised dividends for more than 25 years (Champions), between 10 & 25 years (Contenders), and between 5 & 10 years (Challengers).  In addition, dividend histories, growth rates, and ex-dividend dates are provided for all of the stocks.  Best of all, it is updated monthly and free to download.  If you’re interested at all in dividend growth investing in the US markets, this is the place to start your research.

In Canada, two separate lists are maintained by Mergent, through their Dividend Achievers Index, and by Standard and Poors, through their S&P/TSX Canadian Dividend Aristocrats Index Canadian Dividend Aristocrats Index).  These lists are both available for free, though the S&P site requires registration.  There is considerable overlap between the two lists; however each one does have a few unique entries.

Now, just because a company has raised its dividend for a number of years, does not automatically make it a good investment.  In order to have a chance to generate exceptional returns, further analysis on the companies presented in these lists should be completed to determine their degree of risk and their potential for future return.

Over the coming weeks and months, I’ll be sharing the various analysis metrics that I use to screen these companies in order to better understand their historical performance, their operations, and their competitive position.  Only after a thorough analysis to determine the possible risks to your investment capital should an investment in any company be considered.

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: The author has long positions in a number of stocks listed as Dividend Champions.

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Why Dividend Growth Stocks?

Initially I was going to write a post about using options with JNJ, but based on its current valuation and the relatively poor options yields I’ve decided that it wouldn’t be that interesting of an article as I’m not interested in writing covered calls or in writing cash-secured puts at this point in time.  Instead, I’m going to elaborate on my preference to invest in companies that have shown a commitment to increasing their dividend for a number of years.  Though I do not restrict my stock selection to this universe, the bulk of my portfolio is allocated to these types of positions.  The reason for this is two-fold.

1.)  Dividends provide a margin of safety on my investment

First and foremost, I see dividend payments by the companies I invest in as providing a margin of safety (and immediate return) on my investment.  As I am looking to invest in companies with a reasonable expectation of a double digit annual return (over an appropriate time frame), by receiving a few percentage points in dividends, it helps to compensate for any unforeseen difficulties that the company may experience.

2.)  I eventually want to live off the income generated by my portfolio

The long-term goal of my portfolio is to finance retirement based solely on the income generated by my investments.  This is to ensure that I am not forced to liquidate portions of my holdings during significant bear markets (low valuations) which can adversely affect the longevity of a retirement portfolio.  Furthermore, to combat the effects of inflation, I want to be invested in assets that increase their annual payout at or above the rate of inflation.  Of all the investment options available, dividend growth stocks are one of the few asset classes that fulfill this requirement.  As a bonus, in the current market (and interest rate) environment, I consider them to be the most attractively priced option.

Summary:

The steady performance of well established dividend growth companies lets me sleep easy at night without worrying about short term swings in valuation (except for getting excited about good entry points for additional positions).  Paraphrasing Warren Buffett, ‘buy on the assumption that they could close the market the next day and not reopen it for five years.’  With a portfolio of high quality dividend growth companies providing an ever increasing annual income stream, this isn’t nearly as frightening a proposition as it could be.

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.

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JNJ Technical Analysis

In my previous posts I have examined various fundamental and valuation metrics for Johnson & Johnson using historical data over a 10-year time span. From these analyses, JNJ was awarded 3 of 3 stars in the fundamentals section 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. JNJ was also awarded 1 star in the valuation section for currently trading below my entry price.

As the stock is trading below my buy price, has performed well in the past (based on fundamentals) and has an adequate expectation of return in the future, I am interested in determining an appropriate entry time for the stock.

52-Week Prices:

One of the simplest screens for an appropriate entry point is the price that a stock is currently trading at when compared to their 52-week high and 52-week low. For reference, the 52-week prices for JNJ are presented below (click to enlarge).

From the chart it can be seen that the stock has fluctuated from a low of approximately $57 to a high of approximately $66 throughout the past year. Relative to the closing price of $63.84 on October 26th, JNJ is trading the following distance from its 52-week high and low:

Price % from value
52-Week High $66.20 3.6%
52-Week Low $56.86 12.2%

To conform to the ‘buy low, sell high’ adage, as JNJ is trading within 5% of its 52-week high, and is greater than 10% from its 52-week low, no stars are awarded for this timing metric.

RSI

In addition to the simple screen based on 52-week highs and lows, I also track the 7-day, 7-week, and 7-month Relative Strength Indicator (RSI) values for each stock I follow. RSI is a momentum indicator that shows when stocks are overbought or oversold. When a stock is oversold on all three time frames (RSI < 30), that typically indicates a good time to buy. Similarly, when a stock is overbought (RSI > 70), that can indicate a good time to sell. The three RSI values for JNJ are currently as follows:

Value
RSI-7d 61.1
RSI-7w 79.1
RSI-7m 66.1

With all RSI values relatively high on the index, and the 7-week RSI value in overbought territory, no stars are awarded for this timing metric. A plot of the 7-week RSI indicator for the last year is shown below (lower chart) along with the price movement (upper chart) and a MACD chart (middle chart). Note how the indicator forecast the last good entry point earlier this year as it was flashing oversold at that time.

MACD

To supplement the RSI calculation, I also examine the Moving Average Convergence Divergence (MACD) indictor. From the above chart of the one year MACD(12,26,9) it can be seen that JNJ is currently in an uptrend with the short-term moving average above the long term moving average. Additionally, JNJ is currently above the signal line. However, as can be seen from the histogram, the uptrend is slowing and a signal line cross may occur shortly. If this cross is confirmed with the RSI-7w indicator and holds for a few days, it would indicate a good time to reduce holdings or to become aggressive in selling covered calls.

Examining the MACD chart, a good entry point was signaled earlier this year first with a signal line cross (blue line crossing the red line) and then by a zero crossing. This would have confirmed the buy signal from the RSI indicators as they were recovering from oversold conditions during this time.

At the current time, based on both an oversold RSI indicator and a MACD chart showing a decelerating uptrend, JNJ earns no stars for timing based on these technical charts.

Summary

Overall, JNJ earned a total of 4 stars (out of 6) which gives JNJ a ‘Buy’ rating. However, based on the technical analysis above, even though JNJ is trading at a discount to its calculated fair value and has good fundamentals, it may not be a good time to add to or initiate a position in this stock. Instead, by patiently waiting for a better entry signal (close near 52-week low, oversold conditions, etc.) investors may be able to obtain a lower price which will increase the investment’s margin of safety.

In my next post, I will outline some options strategies that can be employed with JNJ to generate additional income from the stock and take advantage of the various technical indicators outlined above.

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.



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JNJ Valuation

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

EPS / Price: 7.5%
FCF / Price: 8.7%
EBIT / EV: 10%

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

Metric High Low
Price / Earnings: 23.3 17.0
EV / EBIT: 16.6 12.1
Dividend Yield: 2.47% 1.85%
Price / Book: 6.13 4.48

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

Price Based on: Average Fair Valued:
Average Price / Earnings: $65.41 Yes
Average EV / EBIT: $71.52 Yes
Average High Yield: $71.83 Yes
Average Price / Book: $68.17 Yes
Graham Number $41.40 No

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 4th 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.

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Down to Business – JNJ Fundamental Analysis

To get this blog started on the right foot, I’m going to postpone some planned discussion and get right to the heart of the matter; analyzing potential stocks for investment. As I am interested primarily in dividend growth stocks in the U.S. and Canada, I thought I would start with one of the most well-known dividend growth stocks, Johnson & Johnson Inc. (JNJ).

10 Year Company Performance

Before performing any detailed analysis, it is useful to examine a company’s historic growth rates and performance. Examining previous financial statements for JNJ, select 10-year compounded annual growth rates (CAGR) can be calculated as follows:

  • Revenue: 9.5%
  • Earnings: 11.7%
  • Book Value: 12.1%
  • Tangible Book Value: 3.2%
  • Free Cash Flow: 12.2%
  • Dividends: 13.6%

In addition to the above growth rates, a plot of historical earnings, free cash flow, and dividends paid is presented below. Note how earnings and free cash flow track each other closely and remain consistently above the dividends paid.

Examining the 10-year growth rates, with the exception of tangible book value all other metrics grew at or above 10% year-over-year. Regarding the tangible asset growth, as a health care company, JNJ relies on intangible assets (patents and trademarks) to generate a significant amount of their revenue. Due to Johnson & Johnson’s strong brand recognition and product pipeline, I feel that valuing JNJ based on their total assets instead of tangible assets is appropriate. However, the risks in this approach are that any unforeseen impairment charges could adversely affect returns in the future.

Future Projections:

Though JNJ has a very strong 10-year growth record, it is unlikely that they will be able to maintain the same type of business growth into the future. To provide a margin of safety for the investment, the following projections have been used for continuing business growth:

  • Revenue: 4.5%
  • Earnings: 7.0%
  • Book Value: 12.0%
  • Free Cash Flow: 6.5%
  • Dividends: 8.0%

In determining these values, the lesser of 60% of the 10-year growth rate, or the 5-year growth predictions from JNJ’s ValueLine report have been used.

Screening Criteria:

Return on Equity:

Looking at JNJ’s return on equity (ROE) for the last 10 years (See Table 1 below), we can see that it has averaged 26.4% which is above the 20% average that I am looking for. In addition, the minimum ROE during this 10 year period was greater than 15%. By fulfilling both criteria, JNJ was awarded a star for the Good Business metric.

Dividend Income vs. Fixed Income:

To determine the relative attractiveness of JNJ’s dividends to the income from long corporate bonds, a Net Present Value (NPV) calculation of the difference between the two income streams has been completed. For this calculation, JNJ’s current yield of 3.4% was adopted along with the assumed dividend growth rate of 8.0% per year. The interest on comparable long corporate bonds was set to 5.2% per annum.

Using this data, over a 20-year investing horizon the NPV of the dividend stream in excess of the interest on the long corporate bonds is calculated to be $650. As the income received from dividends is greater than the interest received from a comparable fixed income investment, JNJ is awarded a star for this income metric.

Dividend Payout Ratio:

As dividends are paid out of free cash flow, it is important to ensure that companies generate enough free cash flow to allow them to continue to pay their quarterly dividend while reinvesting in the business. Over the trailing 12 months (TTM), JNJ has generated $5.59 in free cash flow per share (fully diluted) while paying out $2.01 in common dividends. This results in a free cash flow payout ratio of 36% which indicates that the dividend is well covered. Examining the past 10 years, we can see that the free cash flow payout ratio has averaged 37.5% while remaining below 50% in all cases. Furthermore, as JNJ’s rate of earnings reinvestment is approximately 34% per year, this leaves a margin of 28% for additional dividend increases or share buyback programs in the future discounting the projected growth in free cash flow of 6.5% per year.

Table 1:  Select Historic Data:  RoE & Free Cash Flow Payout

Year Return on Equity Free Cash Flow Dividends Paid Payout Ratio
2009 24.2% $5.09 $1.930 37.9%
2008 30.5% $4.20 $1.795 42.8%
2007 24.4% $4.19 $1.620 38.7%
2006 28.1% $3.91 $1.455 37.2%
2005 26.0% $3.05 $1.275 41.8%
2004 26.7% $2.98 $1.095 36.7%
2003 26.8% $2.77 $0.925 33.4%
2002 29.1% $1.99 $0.795 40.0%
2001 23.4% $2.30 $0.700 30.4%
2000 25.0% $1.68 $0.620 36.9%

Balance Sheet Leverage:

The use of leverage (debt) by corporations can be a good way to increase their rate of return. However, taking on too much debt can be hazardous and can result in significant losses over time if not managed properly. As a measure of the leverage of the balance sheet, the debt-to-total capital ratio indicates the ratio between the debt and shareholder’s equity on the balance sheet. JNJ’s current debt to total-capital is 18% with a 10-year average of 15%. Both of these measures indicate a strong balance sheet.

Corporations with highly leveraged balance sheets tend to have high return on equity due to the use of leverage. By examining the return on assets in addition to the debt to total-capital, an approximation of the return due to leverage can be ascertained. Over the past 10 years, JNJ has averaged a 15% return on assets which is very good.

Based on the analysis of the free cash flow coverage and balance sheet leverage, JNJ is awarded a third star.

Summary of Fundamental Metrics

Based on their Return on Equity over the last 10 years, a dividend payment that should outpace the interest income from corporate long bonds, and a well covered dividend payout and strong balance sheet, Johnson and Johnson has earned 3 out of 3 stars in the fundamental analysis metrics that I track.

Tomorrow I will look at Johnson & Johnson’s valuation and examine some technical indicators for appropriate entry points.

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.

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Welcome!

Welcome to EngineeringIncome.com! This site will be a place where I will be discussing my long-term investing strategies, all of which will hopefully generate exceptional long-term results and a significant annual income stream. Most of the time, I will be focused on discussing and analyzing dividend growth stocks; however, other topics such as value investing, fixed income investing, and options investing strategies will be covered from time to time.

Before getting started on discussing investments, a bit of history about myself. I am recently married, in my late twenties, live in Canada, and work full-time as a mechanical engineer.  As a Canadian, my domestic stock exchange is the TSX. However, as many good companies are listed only on U.S. exchanges, I will be looking at both Canadian and U.S. Stocks. For reference, I do not hedge any of my U.S. dollar holdings and have no plans to into the future, though that is a post for another time.

To end my first post, I’ll leave you with my investing goals which will guide the discussion on this site: To generate a long-term annual rate of return greater than the TSX Composite Index through investing primarily in undervalued dividend growth companies while using options strategies to reduce volatility and increase my annual income stream.

Until next time,
Nathan @ EngineeringIncome.com

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