It May Not be Too Late for JNJ.

6 04 2010

Up 35% from its lows a little over a year ago, JNJ has already had quite a run. Yet, there may still be some value in this stock.

As Warren Buffett has explained before, the proper way to arrive at a company’s intrinsic value is by discounting its future cash flows back to the present. In the 1986 Berkshire letter to shareholders, Buffett defined his cash flows (or “owner earnings”) as “(a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges…less ( c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume.” Thus, owner earnings are nearly the same as free cash flows; the only difference is that owner earnings subtract an average maintenance capital expenditure rather than the capital expenditure of each specific year.

So what is JNJ’s maintenance capital expenditure? Over the last ten years, the capital expenditures have fluctuated from $1,646 million in 2000 to $3,310 million in 2007. I believe that maintenance cap ex is about $3,000. This may be a little high, but it’s better to be safe than sorry (especially when investing). Using this capital expenditures estimate, owner earnings were $11,510 million in 2006, $11,939 million in 2007, $11,907 million in 2008, and $14,206 million in 2009. For the base cash flow of our estimated intrinsic value, let’s use $12,000 million rather than $14,000 million just to be conservative. During the previous ten years, JNJ has averaged a 28-29% cash return on equity: one sign of a wonderful company. JNJ has also grown owner earnings at a rate of 14.8% of the last ten years. If we use a 9% discount rate and assume a growth rate of 8% for the next ten years, a growth rate of 3% for the next ten, and then a 0% growth rate for the company’s remaining life, we arrive at an intrinsic value of $250.6 billion dollars, or $91.00 per share. Is it possible that this intrinsic value is mistaken? Of course! Perhaps our growth rate is wrong. Perhaps disaster will strike the company. Perhaps the United States will sink into the ocean. But that’s exactly why value investors rely on a margin of safety! Selling at $65.50 today, JNJ is selling at a 28% discount from our estimated value. Since the valuation used conservative estimates too, 28% is a large enough discount for my tastes. $65.00 is also about the price that Buffett paid when he started acquiring JNJ back in 2007.

As a side note, I think it’s interesting to look at the chart of JNJ.

When the market price of a security remains flat for several years, there are three possible scenarios taking place:

1.) The company’s intrinsic value hasn’t changed in several years and isn’t expected to change.

2.) The company’s intrinsic value is catching up to an over inflated stock price.

3.) The company’s intrinsic value is rising and the price is not following.

JNJ first reached the $60 dollar range in early 2002, about 8 years ago. I believe JNJ was overvalued then, but the price hasn’t risen along with the underlying value of the company–possibly giving investors a great opportunity!

Disclaimer: This article should not be construed as investment advice. Investment decisions should be made according to an investor’s own evaluation and personal circumstances.

Disclosure: Author hasn’t purchased JNJ-but may soon!

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2 responses

8 04 2010
Ziv

hmm, again I need to run the calculations myself, but just a basic question – why 8% growth rate? why not ~14.8? (maybe a typo?)

8 04 2010
Adam

Hey Ziv,

I chose 8% because I was trying to be conservative. In the last 5 years, JNJ has grown cash at 10.8%. Undoubtedly, as the company gets bigger, it is going to have a hard time maintaining a growth rate as high as 14.8%. I chose the 3% growth rate for the second 10 year span because 3% is about our GDP growth.

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