Firm Evaluation Johnson & Johnson Thesis

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JNJ's flows over the past three years have been $16,055, $4,083 and $7,770 million respectively. Operating cash flows are higher still. JNJ has clearly demonstrated the ability to generate cash flow internally. In addition, JNJ has more debt than many of its peers. While JNJ is liquid, their liquidity ratios are inferior to the industry average. Their debt-to-equity ratio is higher than the average ratio of their peers as well. This indicates that for the industry, JNJ already holds a sufficiently high debt level. They could in theory handle more, but it would be unwise for them to issue more debt if they have other options. For JNJ, the use of cash flow from operations is a much better option. They have been able to generate cash flow consistently from operations, and in the past few years have used this to pay down some of their debt.

The NASDAQ site puts analyst earnings calls at $4.53 for 2008 and $4.67 for 2009. At a 12% discount rate, the present value of these are $4.044 and $3.7208 respectively. To calculate using the residual income valuation approach we then add these to the book value of the equity today.

The book value per share is the book value of the equity divided by the number of shares outstanding. According to the 2007 annual report number of shares outstanding is 3120 million.

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There have been more shares issued, but the outstanding at the end of the 2007 fiscal year is clearly indicated in the report. The book value of the equity is $43,319 million, including share value and retained earnings so the book value per share is $13.88. When added to the present value of the future earnings this gives us a value per share of JNJ of $21.64.

The 12% discount rate is entirely unreasonable for JNJ. The company has a beta of 0.49, so its risk is half of the market risk. An appropriate discount rate would be the cost of equity for JNJ, which if derived using CAPM would be approximately 4.47%. Therefore, 12% is far too high a discount rate for JNJ.

The fiscal year for JNJ ended December 30th, 2007. That was a Sunday. The close price on December 31st was $66.70. Therefore the market to book value was $66.70 / $13.88 = 4.805.

The number of years is will take for the economic value to reach the market value is as follows: $66.70 - $13.88 - $4.04 - $3.72 / $3.88 = 11.61 years. Therefore investors are assuming that the earnings for JNJ will grow faster than the earnings for the group as a whole. They are assuming that the present value of residual income will grow more.....

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