I never invest in a common stock without a clear expectation of the future returns that it can generate for me. Consequently, I consider this one of the most important steps in my research and due diligence process. Unfortunately, my experience in dealing with investors has led me to conclude that this important step is rarely taken. Most investors possess only a vague idea of what they might earn from investing in a given stock. Many people simply buy a stock hoping that it will go up, and if it pays a dividend, hopeful that the dividend will increase over time.
With this article, I’m going to share my specific process on how I estimate the future return that a stock can be expected to offer me. My primary example will be based on a current investment in the blue-chip Dividend Aristocrat Johnson & Johnson. Through this exercise I will offer a methodical approach designed to determine whether Johnson & Johnson is a viable investment choice at today’s valuation.
Johnson & Johnson: Forecasting Future Returns
In part 1 of this two-part series I reviewed Johnson & Johnson (JNJ), Consolidated Edison, Inc (ED) and Cisco Systems Inc (CSCO) from a historical perspective. Reviewing a company’s history and how the market has typically valued the company’s operating results is typically the initial step in my due diligence process. However, I consider forecasting the future potential of any company the most crucial step in my due diligence process.
Directly stated, I will never invest in a stock until I have made a determination of what rate of return the investment might potentially produce for me. This is essentially done under a most likely case, best case and worst case scenarios. I’m not naïve enough to believe that I can make these calculations with absolute precision. Instead, my objective is to determine future return possibilities within reasonable ranges of accuracy and predictability. But most importantly, this gives me more that a vague idea of what the return potential that a company might produce for me. I call this investing with my eyes wide open.
However, before I move on to my forecasting process, I would like to briefly review what I saw when I examined Johnson & Johnson’s valuation history over different time periods. You can examine my historical approach more comprehensively by reviewing the link to my previous article above.
In order to review historical valuations, I rely on the F.A.S.T. Graphs™ fundamentals analyzer software tool. I always start by looking at all of the company’s history available to me. The following long-term earnings and price correlated graph on Johnson & Johnson revealed two important aspects related to valuation. First of all, I noticed that the market applied a premium valuation on Johnson & Johnson shares from 1997 through the spring of 2007. However, from that point forward the market was valuing Johnson & Johnson’s shares at a lower valuation. I have drawn a line on the graph separating these two time periods. Note that the normal P/E ratio calculation of 20.2 is high because it is skewed by the high valuations over these first 10 years or so.
When I shortened the timeframe to cover the period 2006 to current, I discovered that the normal P/E ratio that the market has applied over this timeframe has been approximately 15. Importantly, I consider these more recent valuation levels more relevant. Therefore, my fair value assessment for Johnson & Johnson is set at the more conservative P/E ratio of 15 than at the longer-term normal P/E ratio of 20.2. Consequently, with the current blended P/E ratio at 18.1, I would consider Johnson & Johnson moderately overvalued at these levels. As promised, what follows will be the rate of return calculations I believe this valuation level offers.
When writing articles like this I can only include a picture of a live fully functioning graph. Therefore, I have arranged to have a live fully functioning F.A.S.T. Graphs™ available to readers. Next I will offer a few simple calculations utilizing the Forecasting Calculators and their calculating functionality. However, the calculators allow me to run numerous “what-if” calculations based on various assumptions. If the reader follows the below link they will be able to quickly and easily run as many of their own calculations as they desire.
Here is the link for a FAST and FUN Preview of F.A.S.T Graphs using the stock symbol JNJ
Once you follow the link, scroll down to the Forecasting Calculators where you will find five calculators that can be utilized to estimate the future return potential on Johnson & Johnson. Each calculator is color-coded and the following screenshot illustrates how to access each calculator. My first calculation will be based on utilizing Johnson & Johnson’s normal P/E ratio of 15 (the dark blue tab and border).
The calculator is presenting forecasts based on the consensus analyst estimates reporting to S&P Capital IQ. With this Johnson & Johnson example there are 23 analysts forecasting earnings for fiscal year-end December 2016 and 25 analysts forecasting earnings for fiscal year-end 2017. From there, the number of analysts drops off to 17 analysts for fiscal year-end 2018 and only 11 analyst for fiscal year-end 2019. This information is found at the bottom of the graph as “# Analysts.”
Assuming that these analysts are reasonably correct, and the company’s stock price was valued at a normal P/E ratio of 15.3 (red circle), then Johnson & Johnson would be expected to deliver a total annualized rate of return of only 3.57% out to December 31, 2019. Personally, I would consider this too low of a rate of return potential which is due to moderately high current valuation. I consider this, as I will elaborate later, my most reasonable case scenario.
In contrast, if I ran these calculations utilizing the long-term historical normal P/E ratio of 20.1 (red circle), the investment in Johnson & Johnson looks a lot more attractive. Although I would consider this a possibility, my confidence that Johnson & Johnson would trade at that valuation is low. Therefore, I would consider this more of an optimistic or best case scenario. Nevertheless, the 11.97% total annual rate of return would be considered attractive.
At this point, I’ve run these expected and best case scenarios utilizing the specific consensus analyst estimates over the next few years. However, many investors hold a rather jaundice view of the accuracy of analyst estimates. On some companies these negative views on analyst estimates are justified, however, there are certain companies where the analysts’ track records have been exceptional. Johnson & Johnson happens to be one of those companies that analysts have tended to estimate correctly.
The following “Analyst Scorecard” summary shows that analysts have been accurate with their forecasts on Johnson & Johnson virtually 100% of the time. This record assumes a 10% margin of error for forecasts made one year in advance, and a 20% margin of error for forecasts made two years in advance.
This next screenshot provides a more detailed look at the record of analysts making a one year in advance forecast of earnings on Johnson & Johnson. Therefore, I think it is reasonable to