Here's Why Johnson & Johnson Is Valued at Its Highest P/E in a Decade

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Healthcare conglomerate Johnson & Johnson (NYSE: JNJ) is what you might refer to as a "mainstay investment" for a lot of people. It's the largest publicly traded healthcare company in the U.S. by a mile, and it's arguably the definition of a safe income stock, which is what makes it a popular holding among senior investors, as well as more risk-averse buy-and-hold investors.

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J&J's formula for investing success

There's little denying that J&J has a lot to offer. Its business model consists of more than 265 separate operating companies, which allows Johnson & Johnson the ability to seamlessly divest slow-growing and non-complementary assets, as well as acquire and install quicker growing and complementary businesses, without so much as a hiccup to its core operations.

Johnson & Johnson also has a geographically and segmentally diverse set of operations. It relies on its pharmaceutical business to drive strong growth, high margins, and substantial pricing power. Meanwhile, medical devices serves as a long-tail growth opportunity for an aging world, and consumer health products, while slower growing, provide steady and predictable cash flow, as well as a front-facing brand image for the company.

And let's not forget what J&J has been able to do in the income column. Johnson & Johnson is sporting a 55-year streak of having increased its annual dividend payout, placing it among an elite group of income stocks known as Dividend Aristocrats. In order to be a Dividend Aristocrat, a company has to have raised its payout for a minimum of 25 years. At 55 years, you can count on both hands the number of publicly traded companies that have a longer annual streak than J&J. 

Put this all together and it's not hard to see why J&J has been a long-term outperformer.

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Johnson & Johnson's stock is at its priciest level in a decade -- here's why

More recently, though, it's been leaving the broader S&P 500 in the dust. Over the trailing five-year period, Johnson & Johnson's stock is up a brisk 123%, compared to a 78% return for the S&P 500. This sort of outperformance for a company that traditionally grows around the mid-single digits is unexpected.

What's also a bit surprising is J&J's current valuation with respect to its price-to-earnings ratio. At 22.2 times its trailing-12-month profits, the company is at its priciest valuation over the past decade. The same can be said for J&J's price-to-book (5.1) and price-to-cash flow (19) ratios, which are at decade highs. 

What's pushing Johnson & Johnson's valuation to new heights, you ask? I contend that the company's focus on pharmaceuticals in recent years, via internal investments, collaborations, and acquisitions, is giving investors hope of a faster intermediate-term growth rate.

Back in 2012, J&J generated $25.4 billion in full-year sales from pharmaceuticals and $67.2 billion worldwide from all segments. This works out to about 37.7% of total sales from pharmaceuticals. However, in the first quarter of 2017, the company reported $8.25 billion in pharma sales out of $17.77 billion in worldwide revenue across all segments. This works out to 46.4% of total sales. In just over four years, pharmaceuticals have grown as a function of total sales by nearly 9 percentage points.

The upside to leaning more heavily on pharmaceuticals is that it should result in a higher profit margin for the company. This is because most drugmakers (J&J included) have exceptionally strong pricing power and inherent advantages when operating domestically. As J&J pushes closer to a 50% reliance on pharma revenue as a percentage of total sales, we may even see earnings-per-share growth accelerate, which could certainly account for J&J's priciest valuation over the past decade.

On the other hand, leaning more heavily on pharmaceuticals will also expose J&J to future patent cliffs when its branded therapies lose their exclusivity and become subject to generic competition. Additionally, should Congress and President Trump find a way to pass drug price reforms, J&J could be forced to take its lumps. Thankfully for investors, the chances of prescription pricing reforms gaining traction anytime soon appears slim at best.

Expect J&J to stay active with acquisitions and collaborations

For J&J's shareholders, the evidence is pretty clear that the company plans to continue investing heavily in pharmaceuticals through acquisitions and collaborations.

For example, J&J recently closed its acquisition of Actelion, bringing the Swiss-based drugmaker's portfolio of specialized pulmonary arterial hypertension drugs under its wing. J&J typically aims for small- and mid-cap buyouts, so the Actelion purchase at $30 billion is very much outside its norm. Nevertheless, the acquisition is expected to boost J&J's long-term growth rate by between 1.5% and 2% annually. 

In 2014, as another example, J&J worked out a licensing deal with clinical-stage biotech Geron (NASDAQ: GERN) for its experimental myelofibrosis and myelodysplastic syndromes drug imetelstat. In early-stage studies, imetelstat demonstrated partial and complete responses in some myelofibrosis patients, marking the first time ever in a clinical study targeting myelofibrosis that objective responses were observed. Previous drugs had only worked to diminish symptoms associated with the disease and did nothing for the actual root cause. If approved, imetelstat has blockbuster potential, giving Geron the ability to earn up to $935 million (inclusive of its up-front cash and milestone revenue), as well as sales royalties.

And even more recently, we saw J&J increase its dividend by just 5%, which was the smallest percentage increase this decade. What this likely implies is that J&J does want to take care of its long-term shareholders, but it also wants to keep as much cash flow at the ready to make earnings-accretive acquisitions, should they present themselves.

It's possible that J&J's focus on pharmaceuticals could lead to a bit more volatility for a traditionally non-volatile stock, but there aren't red flags that would suggest investors cash in their chips here with the company at its priciest valuation in a decade.

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Sean Williams has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Johnson & Johnson. The Motley Fool has a disclosure policy.