December 3, 2010 § Leave a comment

NB: For these CAPS picks, I will be using a lot of things that I’ve learned over the past couple of years of investing. Discount Cash Flow models, balance sheet analysis, Free Cash Flow analysis. In the CAPS picks I wont stop and explain every single tool. I will go into them in future blog entries (ie: “What is a DCF!?”) but for these, I am assuming previous knowledge.

For my CAPS page, click here

My investment strategy is a pretty simple one. When something takes a big dip, or falls out of favor for any reason (say, a Tylenol recall, for example; just pulling it off the top of my head) or the stock price seems to take a beat down for silly reasons, I take notice and start my due diligence. And if that thing has a nice dividend attached to it, all the better.

So enter my first pick for the CAPS page (and I actually have this in my portfolio too.)

My first pick for my CAPS page in Johnson and Johnson ($JNJ). JNJ is one of those fantastic cash generating companies. They are pretty close to being models of consistency: 12% earning growth (10 yrs), 11 % FCF growth (10 yrs), 10 years of raising book value (this for me is a big plus), ROE over 25% annual for 10 years, 15bn of cash sitting around. In other words: they are very good at running their business.

Yeah, but are they cheap?

In order to find this, I need to determine their fair value and then I need to see if the pitch coming from the mound is attractive (ie: lower than my perceived fair value.)

For a company that has such a good track record a DCF model can be helpful in seeing if it is cheap. In my DCF models, I normally like to use a higher discount rate (like around 15%) mainly to build in more margins of safety, but for more of what I perceive to be a steady company, I don’t feel nervous using a lower rate (like around 12%.) Especially if they have a dividend (and especially if that dividend is at a nice juicy 3%.) I also tend to lean more towards using the FCF growth over 10 years as the growth rate rather than the earnings growth rate. (I’d love to know if this is smart, or totally stupid.)

So if you plunk all these numbers into a DCF

EPS: $4.75
Growth rate: 11%
Terminal Growth Rate: 4%
Discount Rate: 12%
Book value: $7.9

You get the intrinsic value of roughly $75 a share. JNJ currently trades at $62.56. Seems that a model company is selling at a 15% off price. Mix in a 3% and this seems like a pretty smart choice.

Pretty smart, but not “blow your socks off.” Smarter people than me will be able to allocate their capital in a much better value play than I can. And I want to be one of those people one day that can learn how to find those sorts of things. But for now I can’t resist owning something as fantastic as JNJ–and have them pay me annually–at what I perceive to be a 15% discount. CAPS worthy and portfolio worthy. (That being said, a 15% margin of safety isn’t very big. It’s actually less than I am normally comfortable with. But not for JNJ.)

Hit me up with your thoughts on my method. I’d love to hear it!



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