Johnson & Johnson is undervalued –Here’s why

In a previous article I discussed whether we are in a dividend bubble or not. The search for yield has made shares in some companies in the REIT and utilities sectors overvalued. There are also some companies that currently “look overvalued” to the naked eye. Companies like Johnson & Johnson (JNJ) appear to be trading at a P/E ratio above 20. Before you dismiss the stock and move on to the next candidate, it might be a good idea to spend a few short minutes for further research.

The reason behind this perceived overvaluation of Johnson & Johnson is the fact that there were a few one-time charges against earnings, which decreased them. However, I have long argued that dividend investors should focus on recurring earnings, while ignoring one-time charge-offs that do not affect recurring earnings.

For example, back in the fourth quarter of 2011, Johnson & Johnson (JNJ) earned only 8 cents/share. Adding the earnings for the next three quarters totals $3.04/share. At current prices, this equates to a P/E of 23.30. If one takes the time to read the 4th quarter earnings release, they could see the following:

Fourth-quarter 2011 net earnings reflect after-tax charges of $2.9 billion, which include product liability expenses, the net impact of litigation settlements, costs associated with the DePuy ASR™ Hip recall program, and an adjustment to the value of a currency option and costs related to the planned acquisition of Synthes, Inc. Fourth-quarter 2010 net earnings included after-tax charges of $922 million representing product liability expenses, the net impact of litigation settlements, and costs associated with the DePuy ASR™ Hip recall program. Excluding these special items for both periods, net earnings for the current quarter were $3.1 billion and diluted earnings per share were $1.13, representing increases of 9.3% and 9.7%, respectively, as compared to the same period in 2010.

Adding back the $1.05/share, and EPS comes out to $4.09/share. But there was another one-time charge that JNJ recorded in Q2 2012:

Second-quarter 2012 net earnings include after-tax special items of $2.2 billion, consisting of non-cash charges primarily attributed to a partial write-down of in-process research and development and intangible assets related to the Crucell vaccines business, an increase in the accrual for the potential settlement of previously disclosed civil litigation matters, and transaction and integration costs related to the acquisition of Synthes, Inc. Second-quarter 2011 net earnings included after-tax special items of $772 million, consisting of net charges related to the restructuring by Cordis Corporation, the net impact of expenses related to litigation, DePuy ASR™ Hip recall costs, and a currency adjustment related to the acquisition of Synthes, Inc. Excluding these special items, net earnings for the current quarter were $3.6 billion and diluted earnings per share were $1.30, representing increases of 2.7% and 1.6%, respectively, as compared to the same period in 2011.

Without these one-time deals, earnings per share for Johnson & Johnson (JNJ) would have been 4.89/share, which makes current P/E ratio to be 14.50.

Overall, I like the fact that the company has managed to boost dividends for 50 years in a row. There are only a handful of companies which have managed to accomplish this in the US. Over the past decade, the company has managed to boost distributions at a rate of 12.40%/year.

The morale of the story is to always do a research that has some depth before throwing away any potential investment idea. I had the same conclusion for Abbott Laboratories (ABT) a few month ago as I am having now with Johnson & Johnson.

Full Disclosure: Long JNJ and ABT

Relevant Articles:

- Johnson & Johnson (JNJ) - A Reliable Dividend Grower
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- Abbott Laboratories is Cheaper than you think
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