Johnson & Johnson´s Dividend Discount Model Suggests Value of $139.6 Per Share

In this article, let´s take a look at Johnson & Johnson (JNJ, Financial), which has reported better-than-expected earnings but a decline in revenues. The EPS for the third quarter was $1.49, beating estimates by $0.04. However, revenue of $17.1 billion misses by $350 million.

Relative valuation and dividend yield

As of June, the three-year dividend growth rate is at 7%. Since 2000, the company has raised dividends by 11% per year.

Johnson & Johnson is trading at a P/E ratio of 16.88x and is close to three-year low of $15.99. In the next graph, we can see the price evolution. On a year-to-date basis, the stock lost more than 8%.

Over the last 10 years, Johnson & Johnson has averaged a valuation of 16.9 times trailing earnings:

In my opinion, a temporary valuation with a price decline indicates a buying opportunity. Despite this, the company earns much of its revenue from outside the U.S., which means that earnings, when translated to dollars, are lower. This should be important because the dollar keeps rising.

Now, we are going to turn our attention to competitors. By dividend yield, Pfizer (PFE, Financial)'s dividend looks attractive and cheaper than Colgate-Palmolive (CL, Financial).

Intrinsic value

The Yahoo! (YHOO, Financial) Finance consensus price target is $107.77, so now let´s try to estimate the fair value of the firm; for that purpose I will use the Dividend Discount Model (DDM). In stock valuation models, DDM define cash flow as the dividends to be received by the shareholders. The model requires forecasting dividends for many periods so we can use some growth models like: Gordon (constant) growth model, the Two- or Three-stage growth model or the H-Model (which is a special case of a two-stage model).

Once we select the appropriate model, we can forecast dividends up to the end of the investment horizon where we no longer have confidence in the forecasts and then forecast a terminal value based on some other method, such as a multiple of book value or earnings.

Let´s estimate the inputs for modeling:

First, we need to calculate the different discount rates, i.e. the cost of equity (from CAPM). The capital asset pricing model (CAPM) estimates the required return on equity using the following formula: required return on stock j = risk-free rate + beta of j x equity risk premium

Risk-Free Rate: Rate of return on LT Government Debt: RF = 3.03%[1]. I think this is a very low rate. Since 1900, yields have ranged from a little less than 2% to 15%; with an average rate of 4.9%. So, I believe it is more appropriate to use this rate.

Gordon Growth Model Equity Risk Premium = (1-year forecasted dividend yield on market index) + (consensus long-term earnings growth rate) – (long-term government bond yield) = 2.13% + 11.97% - 2.67% = 11.43%[2]

Beta: From Yahoo! Finance we obtain a β = 0.989993.

The result given by the CAPM is a cost of equity of: rJNJ = RF + βJNJ [GGM ERP] = 4.9% + 0.989993 [11.43%] = 16.21%.

Dividend growth rate (g)

The sustainable growth rate is the rate at which earnings and dividends can grow indefinitely assuming that the firm´s debt-to-equity ratio is unchanged, and it doesn´t issue new equity.

g = b x ROE

b = retention rate

ROE = (Net Income)/Equity= ((Net Income)/Sales).(Sales/(Total Assets)).((Total Assets)/Equity)

The “PRAT” Model:

g= ((Net Income-Dividends)/(Net Income)).((Net Income)/Sales).(Sales/(Total Assets)).((Total Assets)/Equity)

Collecting the financial information for the last three years, each ratio was calculated, and then to have a better approximation I proceeded to find the three-year average:

Now, is easy to find the g = Retention rate × Profit margin × Asset turnover × Financial leverage = 31.08%

Because for most companies, the GGM is unrealistic, let´s consider the H-Model which assumes a growth rate that starts high and then declines linearly over the high growth stage, until it reverts to the long-run rate. In other words, a smoother transition to the mature phase growth rate that is more realistic.

Dividend growth rate (g) implied by Gordon growth model (long-run rate)

With the GGM formula and simple math:

g = (P0.r - D0)/(P0+D0)

= ($95.99 × 16.21% – $3.0) ÷ ($95.99 + $3.0) = 12.69%.

The growth rates are:

G(2), g(3) and g(4) are calculated using linear interpolation between g(1) and g(5).

Now that we have all the inputs, let´s discount the cash flows to find the intrinsic value:

Final comment

The dividend discount model suggests a value of $139.57 per share. Intrinsic value is above the trading price by 45%, so according to the model and assumptions, the stock is undervalued. Also considering a margin of safety (usually a 20%) we arrive at the same conclusion.

The company´s dividend yield is around 3%, which is an attractive yield for a well-diversified business. Further, the firm has solid prospects that should result in a reliable dividend in the future.

However, we must keep in mind that the model is a valuation method, and investors should not be relied on alone to determine a fair (over/under) value for a potential investment.

Hedge fund gurus like Jeff Auxier (Trades, Portfolio), Sarah Ketterer (Trades, Portfolio), and John Rogers (Trades, Portfolio) have upped their stakes in the second quarter by 122.2%, 41.3% and 19%. Others betting on the stock were Manning & Napier Advisors, Inc and Paul Tudor Jones (Trades, Portfolio). Further, David Dreman (Trades, Portfolio) has initiated a new position with 6,648 shares.

[1] This value was obtained from the U.S. Department of the Treasury

[2] These values were obtained from Bloomberg´s CRP function.