This is the Pharma Stock to Buy

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

Pharmaceutical companies are facing a massive patent cliff that threatens to derail the industry's growth prospects for the next few years. As a result, industry leaders like Eli Lilly (NYSE: LLY) and Merck (NYSE: MRK) are being discounted by the market. But one company is better-equipped to handle the patent cliff than others, an advantage the market recognizes.

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At first glance, Johnson & Johnson (NYSE: JNJ) looks like the most expensive company in the table. Eli Lilly, Merck, and Novartis (NYSE: NVS) each trade at lower multiples of free cash flow than Johnson & Johnson. But JNJ deserves to trade at a premium to its peers due to its diversified operations and relatively low exposure to the patent cliff.

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Each of the companies converts about the same amount of sales into pre-tax income. This is expected due to similarities between the companies. But the most telling number is the pre-tax return on tangible invested assets.

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A company's pre-tax return on tangible invested assets, calculated as pre-tax income as a percentage of non-cash tangible assets, reveals how much the company earns for every dollar it invests in the business. Johnson & Johnson creates far and away more value per dollar invested than any other company in the pharma space. This means that growth at JNJ is worth more than at other companies. As a result, JNJ should trade at a premium to its peers.

In a recent article, I said that you'd be hard-pressed to find a company that converts a more reliable percentage of sales into free cash flow than Microsoft and GE. Well, JNJ is one of the few exceptions.

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Since 2002, Johnson & Johnson has averaged a 20.25% free cash flow margin with a coefficient of variation of just 0.1. The reliable conversion of sales into free cash flow is a testament to the company's market position and competitive advantages. Since the cash flows are more reliable, investors can treat JNJ equity more like a bond. Investors who want a 5% yield should pay 20x free cash flow; investors who want a 7.5% yield should pay 13.3x free cash flow, and so on.

If you value JNJ, NVS, MRK, and LLY on normalized free cash flow yield, you end up with yields in the 7-8% range. Basically, the market values each company's cash flow roughly the same. But Johnson & Johnson is clearly the more reliable company and should trade at a lower yield (higher price) than its peers.

In addition, only about 3% of Johnson & Johnson's pharmaceuticals revenues is expected to be impacted by the patent cliff. Not only is this a relatively modest impact compared to the threats facing competitors, but the loss of revenue in the pharmaceutical division will be diluted by strong operations in JNJ's other healthcare-related segments.

Johnson & Johnson is a great company facing few headwinds, yet it trades at a similar multiple of normalized free cash flow to its peers. Investors looking to get exposure to the pharmaceutical space should strongly consider an investment in JNJ.

titans8904 has no positions in the stocks mentioned above. The Motley Fool owns shares of Johnson & Johnson. Motley Fool newsletter services recommend 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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