Submitted by Joel Laceda as part of our contributors program.
When it comes to safe, defensive stocks, many people look to companies like Johnson & Johnson (NYSE: JNJ).
Initially, I can see why as it pays out a nice dividend yield in a business that should remain stable over the long-term. However, you should be careful about the price you pay for the safety.
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There are several reasons why Johnson & Johnson has come to our attention. The first is simply valuation. The company trades with a trailing P/E of over 20, and a forward P/E of almost 16 even though revenues are set to grow in the high single digits.
We estimate revenue growth next year to be in the range of 5%-7%, with earnings slightly above that at our estimate of 8%-10%. These are not bad numbers, but certainly not worth paying a premium.
What we’ve experienced over the past year in a stock like Johnson & Johnson is multiple expansion. This occurs when the price-earnings ratio increases, as investors are willing to pay a higher price for each dollar earned.
If a stock is trading at a trailing price-to-earnings ratio of 20, yet growing at less than half that, what’s the upside as an investor? Do you really believe it will trade at 30 times earnings? We certainly don’t.
In addition, with the Federal Reserve about to start shifting monetary policy, this will cause interest rates eventually to move up, lowering the value of the current dividend yield. Meaning, the stock will need to move down to make the dividend yield more attractive.
Were not alone in thinking that Johnson & Johnson might be topping out for the year, as we’ve seen a large number of call sellers at the October $95 strike price. This means that investors believe there is little chance that the price will move significantly above $95 by this fall.
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