Is Johnson & Johnson a Good Stock to Buy?

Meena is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Johnson & Johnson (NYSE: JNJ) currently trades at 23 times trailing earnings, which we’d normally consider to be a bit high for a stable consumer health and healthcare company. Revenue was 7% higher in the third quarter of 2012 than in the same period in 2011. While earnings were down, that decrease was entirely due to higher research and development expenses; if we strip out an in-process R&D expense pretax income was actually up 4%, and there were increases in the normal R&D item as well. Of course, it’s possible that for whatever reason these increases in spending are permanent rather than that they are one-time items which will be reversed in the coming quarters, allowing the company to capitalize on its higher revenues merely on a delayed basis. In theory, however, Johnson & Johnson should not need to dedicate further revenue growth to research and development and as we can see from these results it would likely not have to increase other costs by much either.

Yet even if we assume a modest increase in earnings we’re not sure that the company’s recent performance justifies its current valuation. Wall Street analyst expectations are for $5.49 per share in earnings for 2013, implying a forward P/E of only 13. That would be a more reasonable multiple for the company, though it of course depends on higher net income this year than last year. It should also be noted that Johnson & Johnson is something of a classic defensive stock, and it does have both a low beta (at 0.4) and a moderately high dividend yield (at 3.4%).

Johnson & Johnson was billionaire Ken Fisher’s Fisher Asset Management’s second largest single-stock holding by market value at the end of September, with a position of close to 11 million shares (find more of Fisher's stock picks). It was also the top pick of Fairfax Financial Holdings; Fairfax is managed by Prem Watsa, who has been called “the Warren Buffett of Canada.” Research more of Watsa's favorite stocks. George Soros was buying Johnson & Johnson during the third quarter as well (check out more stocks Soros was buying).

While Johnson & Johnson is a megacap healthcare company providing pharmaceuticals and medical instruments, and so we can compare it to Merck (NYSE: MRK), Pfizer (NYSE: PFE), and Covidien (NYSE: COV), many of its products are such household items that Procter & Gamble (NYSE: PG) might actually be the closest peer. Procter & Gamble has a slightly lower beta than Johnson & Johnson, and a roughly equal dividend yield. Its most recent quarterly report shows a small decline in both revenue and earnings compared to the same period in the previous fiscal year, though the sell-side expects improving numbers here: the trailing and forward P/Es are 19 and 16, respectively. As with Johnson & Johnson, those multiples are too high for us to consider the stock as a value play.

Merck and Pfizer have similar pricing to Johnson & Johnson: they trade at about 20 times trailing earnings and at 11 times forward earnings estimates in each case. With earnings growth not particularly good, and negative in Pfizer’s case, we don’t think that we’d want to depend on analyst optimism coming true here. Covidien’s business has been about flat, according to recent reports, and its trailing P/E is 15. At that pricing we’d want to see some amount of sustainable earnings growth, and so perhaps Covidien would be a good stock to watch for its next quarterly report.

Too much of Johnson & Johnson’s current valuation appears to be based on expectations of future earnings growth for such a mature company- particularly one whose bottom line is showing little growth even when we assume that recent increases in R&D will turn out to be one-time events. As a result we wouldn’t be buying the stock right now and its peers do not look like good values either.

This article is written by Matt Doiron and edited by Meena Krishnamsetty. They don't own shares in any of the stocks mentioned in this article. The Motley Fool recommends Covidien Ltd., Johnson & Johnson, and The Procter & Gamble Company. The Motley Fool owns shares of Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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