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 (NYSE:JNJ), Consolidated Edison Inc. (NYSE:ED) and Cisco Systems, Inc. (NASDAQ: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.