Johnson and Johnson General Johnson & Johnson and its subsidiaries (the Company) have…

Johnson and Johnson

General

Johnson & Johnson and its subsidiaries (the Company) have approximately 117,900 employees worldwide engaged in the research and development, manufacture and sale of a broad range of products in the health care field. Johnson & Johnson is a holding company, which has more than 250 operating companies conducting business in virtually all countries of the world. Johnson & Johnson’s primary focus has been on products related to human health and well-being. Johnson & Johnson was incorporated in the State of New Jersey in 1887.

The Company’s structure is based on the principle of decentralized management. The Executive Committee of Johnson & Johnson is the principal management group responsible for the strategic operations and allocation of the resources of the Company. This Committee oversees and coordinates the activities of the Consumer, Pharmaceutical and Medical Devices and Diagnostics business segments. In line with the principle of decentralized management, senior management groups at U.S. and international operating companies are each responsible for their own strategic plans, as well as the day-to-day operations of those companies, and each subsidiary within the business segments is, with some exceptions, managed by citizens of the country where it is located.

Segments of Business

Johnson & Johnson’s operating companies are organized into three business segments: Consumer, Pharmaceutical and Medical Devices and Diagnostics. Additional information required by this item is incorporated herein by reference to the narrative and tabular (but not the graphic) descriptions of segments and operating results under the captions “Management’s Discussion and Analysis of Results of Operations and Financial Condition” on pages 26 through 36 and Note 18 “Segments of Business and Geographic Areas” under “Notes to Consolidated Financial Statements” on page 56 of the Annual Report, filed as Exhibit 13 to this Report on Form 10-K.

Consumer

The Consumer segment includes a broad range of products used in the baby care, skin care, oral care, wound care and women’s health fields, as well as nutritional and over-the-counter pharmaceutical products, and wellness and prevention platforms. The Baby Care franchise includes the JOHNSON’S ® Baby line of products. Major brands in the Skin Care franchise include the AVEENO ® ; CLEAN & CLEAR ® ; JOHNSON’S ® Adult; NEUTROGENA ® ; RoC ® ; LUBRIDERM ® ; DABAO™; and VENDÔME ™ product lines. The Oral Care franchise includes the LISTERINE ® and REACH ® oral care lines of products. The Wound Care franchise includes BAND-AID ® brand adhesive bandages and NEOSPORIN ® First Aid products. Major brands in the Women’s Health franchise are the CAREFREE ® Pantiliners; o.b. ® tampons and STAYFREE ® sanitary protection products. The nutritional and over-the-counter lines include SPLENDA ® No Calorie Sweetener; the broad family of TYLENOL ® acetaminophen products; SUDAFED ® cold, flu and allergy products; ZYRTEC ® allergy products; MOTRIN ® IB ibuprofen products; and PEPCID ® AC Acid Controller. These products are marketed to the general public and sold both to retail outlets and distributors throughout the world.

The valuation residual example

There are two valuations below. The required return for equity in both cases is the 8% we calculated using the CAPM in the Case for Chapter 3.

1. First we calculate the value based on only two years of analysts’ forecasts and then apply a growth rate of 4% after 2012.

Required Return

8.0%

 

2010

2011

2012

Eps

 

 

 

4.98

5.35

Dps

 

 

 

2.80

3.00

Bps

 

 

14.54

16.72

19.07

ROCE

 

 

 

34.3%

32.0%

RE

 

 

 

3.817

4.012

Discount factor

 

 

 

1.08

1.166

PV of RE

 

 

 

3.534

3.441

Total PV of RE

 

 

6.98

 

 

RE growth rate (g)

4.0%

 

 

 

 

Continuing value

 

 

 

 

104.312

PV of CV

 

 

89.46

 

 

Value per share

 

 

110.98

 

 

 

 

Continuing value (CV) = =104.312

(The dps for 2012 is calcualted by applying the payout ratio for 2001 to 2012 eps:

Dps = 5.35 × 0.56 = 3.00)

Note that RE is growing in 2012 at 5.1% over 2011. We have no information about the long-term growth rate for the continuing value (and analysts do not supply it), so we apply the average GDP growth rate of 4% — the average we would expect for all firms.  (Don’t confuse analysts’ 3-5 year growth rate with the long term growth rate. The latter applies to a growth rate in perpetuity.)

By these calculations, KMB is reasonably well underpriced at $65.24 and a “buy” is recommended. This differs from analysts’ recommendations: If you look back to Chapter 1, analysts’ average recommendation (on a scale of 1-5) was 2.6 at the time, indicating a “hold”.

But remember, we have a growth rate that has not been subject to analysis: Can KMB maintain a growth rate at the same rate for the economy as a whole, or would we expect a lower growth rate for KMB? Given the analysts forecasts for two years ahead (and a required return of 8%), it is clear that the market is forecasting a growth rate considerably below the 4% rate used here.

2. Now we incorporate analysts’ five-year growth rate of 9.1% and apply a growth rate of 4% for years thereafter. We do this with some trepidation: Analysts’ growth rates for five years are notoriously inaccurate. The eps forecasts for 2013-2015 below are growing at 9.1% per year, the consensus growth estimate at the end of Exhibit 1.1 in Chapter 1. The dps are forecasted to grow at 9.1% per year to maintain the same payout ratio.

Required Return

8.0%

 

2010

2011

2012

2013

2014

2015

Eps

 

 

 

4.98

5.35

5.84

6.37

6.95

Dps

 

 

 

2.80

3.00

3.27

3.57

3.90

Bps

 

 

14.54

16.72

19.07

21.64

24.44

27.49

ROCE

 

 

 

34.3%

32.0%

30.6%

29.4%

28.4%

RE

 

 

 

3.817

4.012

4.314

4.638

4.995

Discount factor

 

 

 

1.080

1.166

1.260

1.360

1.469

PV of RE

 

 

 

3.534

3.441

3.424

3.410

3.400

Total PV of RE

 

 

17.21

 

 

RE growth rate (g)

4.0%

 

 

 

 

Continuing value

 

 

 

 

 

129.84

PV of CV

 

 

88.39

 

 

Value per share

 

 

120.14

 

 

The continuing value (CV) = = $129.84

Intrinsic P/B = 8.26

V/P = 120.14/65.24 = 1.84

This valuation also is above the market price. Either

The analysts’     forecasts are optimistic that those implicit in the market price

The long-term   growth rate of 4% is too high

The required     return should be higher than 8%

The market is    mispricing these expectations.

One can repeat the analysis with a higher required return: Does the stock still look overpriced if the required return in 10%? Use the engine at the end of this solution to test that.

One can also see if the price is better approximated with a lower long-term growth rate. If one forecasts the growth rate as zero (no-growth) for the valuation with two years of forecasts, the continuing value is $50.15 and the value is $64.53, almost the market price.  For the 5-year forecast with a zero growth rate, the continuing value is $62.44 and the value is $74.25.

Now we are getting a handle on things: Given the analysts’ forecasts are unbiased, the market is pricing this stock as if there is no growth, or even negative growth, expected. Yet we can see from the pro forma that residual income is growing. Perhaps this stock in underpriced?

We explore this more in the Chapter 7 continuing case. Note that the stock price by May 2012 was $79.50.

A SPREADSHEET ENGINE

Here is a spreadsheet to carry out the valuation with a two-year forecast horizon. Click on the frame to activate….that will put you in Excel.

X

Enter inputs in the yellow shaded areas. Thus you can observe the effect on the valuation from changing the required return, the long term growth rate, and alternative forecast scenarios for Year 1 and Year 2 ahead. For example, if your change the growth rate to 0%, the program will deliver you a valuation that is approximately the market price.

Example of Discounted cash flow valuation

Apply the discounted cash flow (DCF) model to the forecasted cash flows. There is a question of the appropriate growth rate for the continuing value. The valuation below uses 2% for the growth rate and a 8% CAPM required return.

2007

2008

2009

2010

FCF

1,726

2,367

1,942

Discount                   factor

1.080

1.166

1.260

PV                    of FCF

1,598

2,030

1,541

Total                         PV of FCF

5,169

FCF                   Growth rate

4.0%

Continuing                        value (CV)

33,014

PV                    of CV

26,202

Value                        of the firm

31,371

Book                         Value of Net debt

(5,294)

Value                        of Equity

26,077

Value                        of Equity per share

64.09

The continuing value is calculated as

= $33,014

The present value of the CV = $33,014/1.260 = $26,202

We are, of course, uncertain about the growth rate to apply in the continuing value. This is quite speculative, and notice that a sizable amount of the valuation comes from the continuing value. What justifies the 2% growth rate? Should it be 4%, more like the average GDP growth rate? Clearly, we have more work to do to get a feel for the appropriate growth rate. You might also ask whether the required return is the right one.

Are free cash flows a good base to apply growth to? Well, in KMB’s case it might work. This is a firm with positive free cash flows, growing somewhat steadily. At least the free cash flows are not negative!