As of March 31, 2007, Warren Buffett’s company, Berkshire Hathaway, reportedly increased its holding in Johnson & Johnson (ticker: JNJ) to 48.7 million shares-an increase of 24 million shares in three months. And it’s no surprise. Forget Wall Street’s earnings, JNJ knows how to generate cash!
Buffett tells us we should look at 4- and 5-year histories to judge the performance of a company and that we should look primarily at the intrinsic value of a company and pay a fair or bargain price. Let’s follow the lead of this investing genius:
You can’t possibly analyze the health or value of a business without looking at ten years or more of financial history. In JNJ’s case, we’ll look at the growth of the business from 1997-2006. Looking at 4- and 5-year histories of the Free Cash Flow and Shareholder Equity (net worth) of JNJ, we find that Free Cash Flow had a median growth rate of 16.1% and that net worth grew at a median rate of 14.6%. We use median rates to analyze various 4- and 5-year timeframes from 1997-2006.
Considering that, when buying a business (i.e., stock), you are buying the net worth of the company and any future cash that the company can produce, JNJ was a heck of a company from 1997 to 2006. Moving on:
At the end of 2006, JNJ had $39.3 billion in net worth-that is the basis for calculating the value. If you bought JNJ and it went out of business tomorrow, you would be entitled to you fair share of $39.3 billion.
But we don’t expect JNJ to go out of business tomorrow. We expect it to be in business for twenty or more years. Because of that, we need to figure out how much cash we expect it to produce for the next twenty years. Though JNJ’s year-to-year Free Cash Flow changed frequently, running up 45.1% one year, dropping 14.8% another, we need to look at JNJ as a business-a business that can survive or thrive over the long term.
JNJ’s Free Cash Flow grew an average of 16.1% in various timeframes-and that is the basis for our projection of its future cash. Because of JNJ’s multi-year consistency in the past, we can reasonably expect JNJ to grow its Free Cash Flow 16.1% in the future-at least for ten years. Beyond that, we can expect growth to slow down-say, to 5% a year. (If we’re wrong and JNJ grows 16.1% for twenty years, we end up making a lot more money.
With $11.6 billion of Free Cash Flow in 2006, a 16.1% growth rate for ten years, and a 5% growth rate for years eleven to twenty, JNJ can reasonably expected to generate $966.9 billion of cash over the next twenty years. But we want to earn 15% or more on JNJ so we have to buy that cash at a discount today. After all, we are buying $39.3 billion of net worth and the right to $966.9 billion of cash-but we can’t pay full price or we would have a 0% return.
Microsoft Excel® tells us that we can buy Johnson & Johnson’s expected $966.9 over twenty years for $201.7 billion today. Doing so, we would earn 15% a year in each of the next twenty years. If we bought the entire company today, we could reasonably expect a 15% return if we paid $201.7 billion for the future cash and $39.3 billion for today’s net worth: a total purchase of $241 billion.
Johnson & Johnson is growing Free Cash Flow like gangbusters-but at what cost? The company has some $31 billion in debt. We need to know if management is using debt as an asset to fuel growth, or if they are borrowing to the point that our company is going to choke.
A quick look at the Cash Return On Invested Capital (CROIC) tells us that management is very rational-to the tune of 20.8%. For every dollar that the company has in assets and long-term borrowing, it creates an additional $0.21 of cash. Unless interest rates soar beyond 20%, JNJ appears to be doing a wonderful job of borrowing money, generating cash from those borrowings, repaying the loans, and rewarding shareholders with excess cash without putting up its own money.
Two problems-both easily remedied:
Johnson & Johnson is worth $241 billion. It has 2.9 billion shares of stock available for purchase. A quick division ($241/2.9) tells me that JNJ is worth $83.10 a share. I don’t need $241 billion-I need $83.10 for each share I want to buy.
Though JNJ appears to be worth $83.10 a share, that number is only good if the company performs as I expect it to-continuing to grow Free Cash Flow at 16.1% for ten years. But there are no guarantees in business. In fact, just about anything can happen. Why should I lose money if it does?
To protect myself, I need a 25% or more discount on the value of the company. Because JNJ is an industry leader, 25% is more than enough for me to comfortably and confidently invest in JNJ.
A 25% discount on a value of $83.10 a share results in a target buy price of $62.33 a share. Hey, isn’t that right about where Buffett was buying JNJ earlier this year?
Edit (July 13, 2007): A lot of you have been asking to see the spreadsheet for this JNJ analysis. I am happy to oblige, but remember that you use this at your own discretion. I am not providing any investment advice or recommendations: download the JNJ analysis (Excel®, 24kb)
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