Johnson & Johnson (NYSE: JNJ) trades at a Sales Multiple of 4.6x, which is lower than the Healthcare sector median of 5.2x. While this makes JNJ appear like a stock to add to your portfolio, you might change your mind after gaining a better understanding of the assumptions behind the EV / Sales ratio. In this article, I will break down what a Sales Multiple is, how to interpret it and what to watch out for.
Understanding Valuation Multiples and EV / Sales
A multiples valuation, also known as a comparable companies analysis, determines the value of a subject company by benchmarking the subject’s financial performance against similar public companies (peer group). We can infer if a company is undervalued or overvalued relative to its peers by comparing metrics like growth, profit margin, and valuation multiples.
An Sales Multiple, also known as Enterprise Value-to-Sales Multiple (EV / Sales), measures the dollars in Enterprise Value for each dollar of revenue. To determine if a company is expensive, it’s far more useful to compare EV / Sales multiples than the absolute stock price. Furthermore, its key benefit over the P/E multiple is that it’s capital structure-neutral, and, therefore, better at comparing companies with different levels of debt. The general formula behind a Sales Multiples valuation model is the following:
Enterprise Value = Revenue x Selected Multiple
A sales multiple is not meant to be viewed in isolation and is only useful when comparing it to other similar companies. Since it is expected that similar companies have similar EV / Sales ratios, we can come to some conclusions about the stock if the ratios are different. I compare Johnson & Johnson’s sales multiple to those of Pfizer, Inc. (NYSE: PFE), Merck & Company, Inc. (NYSE: MRK), Bristol-Myers Squibb Company (NYSE: BMY) and Eli Lilly and Company(NYSE: LLY) in the chart below.
Since Johnson & Johnson’s sales multiple of 4.6x is higher than the median of its peers (4.0x), it means that investors are paying more than they should for each dollar of JNJ’s revenue. As such, our analysis shows that JNJ represents an overvalued stock. In fact, finbox.io’s Sales Multiples Model calculates a fair value of approximately $110.00 per share which implies roughly -11.0% downside.
Note that the selected multiple of 4.1x in the analysis above was determined by averaging Johnson & Johnson’s current sales multiple with its peer group.
Understanding the EV / Sales Ratio’s Limitations
Before jumping to the conclusion that Johnson & Johnson should be banished from your portfolio, it is important to understand that our conclusion rests on two important assumptions.
(1) the selected peer group actually contains companies that truly are similar to Johnson & Johnson, and
(2) the selected peer group stocks are being fairly valued by the market.
If the first assumption is not accurate, the difference in sales multiples could be due to a variety of factors. For example, if you accidentally compare Johnson & Johnson with lower growth companies, then its sales multiple would naturally be higher than its peers since investors reward high growth stocks with a higher price. In addition, revenue multiples are highly correlated with profit margins so differences in EBITDA margin often explain differences in valuation.
source: sales multiples model
Now if the second assumption does not hold true, Johnson & Johnson’s higher multiple may be because firms in our peer group are being undervalued by the market.
What This Means For Investors
As a shareholder, you may have already conducted fundamental analysis on the stock so its current overvaluation could signal a potential selling opportunity to reduce your exposure to JNJ. However, keep in mind the limitations of a sales multiples valuation when making an investment decision. There are a variety of other fundamental factors that I have not taken into consideration in this article. If you have not done so already, I highly recommend that you complete your research on Johnson & Johnson by taking a look at the following:
Valuation Metrics: what is Johnson & Johnson’s free cash flow yield and how does it compare to its publicly traded peers? This metric measures the amount of free cash flow for each dollar of equity (market capitalization). Analyze the free cash flow yield here.
Risk Metrics: what is Johnson & Johnson’s cash ratio which is used to assess a company’s short-term liquidity. View the company’s cash ratio here.
Efficiency Metrics: return on equity is used to measure the return that a firm generates on the book value of common equity. View Johnson & Johnson’s return on equity here.
As of this writing, I did not hold a position in any of the aforementioned securities and this is not a buy or sell recommendation on any security mentioned.