Valuation of Johnson & Johnson's Ordinary Shares: Dividend Discount

Model and Capital Asset Pricing Model Approach

Abstract
This report aims to estimate the intrinsic value of Johnson & Johnson's (JNJ) ordinary
shares using the Dividend Discount Model (DDM) and assess the required rate of return utilizing
the Capital Asset Pricing Model (CAPM). As a dividend aristocrat with a consistent dividend
payment history, JNJ is a suitable candidate for DDM valuation. The analysis incorporates an
average annual dividend growth rate of 2.33% and an estimated dividend for the next year of
$4.87. The CAPM model, using a risk-free rate of 3.37%, average annual return of the S&P 500
Index (12.16%), and a calculated β of 0.3668, results in a required rate of return of
approximately 6.56%. The DDM estimates the intrinsic value of JNJ stock to be approximately
$124.62. Despite the inherent limitations of both models, they provide valuable insights into
stock valuation and required rate of return when used alongside other valuation methods.
The combination of the DDM and CAPM models offers a comprehensive analysis of
JNJ's intrinsic value and required rate of return. While the DDM assumes a constant dividend
growth rate and may not be suitable for stocks without dividend payments, it is an appropriate
method for valuing JNJ shares due to its consistent dividend payment history. The CAPM model,
despite its assumptions about diversified portfolios, market returns, and linearity of risk-return
relationships, is a widely accepted tool for estimating the required rate of return.
The calculated intrinsic value of JNJ stock and the required rate of return provide
investors with valuable information to make informed decisions regarding their investments.
Although the DDM and CAPM models have their limitations, they serve as useful tools in stock
valuation when used in conjunction with other methods. This report highlights the potential value
in JNJ shares and provides a basis for further investigation and analysis.
1. Introduction
This report aims to evaluate the intrinsic value of Johnson & Johnson's (JNJ) ordinary shares
using the Dividend Discount Model (DDM). Johnson & Johnson is a multinational healthcare
and pharmaceutical corporation operating in various segments, including pharmaceuticals,
medical devices, and consumer health products. The DDM is chosen as the primary valuation
model for this analysis because of JNJ's consistent dividend payments and its status as a dividend
aristocrat, making it an appropriate candidate for this model.

2. Company Profile and Rationale for DDM

2.1 Brief Description of Johnson & Johnson
Johnson & Johnson is a leading global healthcare company founded in 1886, headquartered in
New Brunswick, New Jersey, USA. The company operates in three main segments:
Pharmaceuticals, Medical Devices, and Consumer Health. Its well-known brands include
Tylenol, Band-Aid, Neutrogena, and Listerine, among others. With a strong global presence and
a diverse product portfolio, JNJ has maintained a leading position in the healthcare industry.

2.2 Suitability of DDM for Johnson & Johnson

The DDM is a suitable method for estimating the intrinsic value of Johnson & Johnson's
ordinary shares due to its long history of paying and increasing dividends. As a dividend
aristocrat, JNJ has increased its dividend payouts for over 25 consecutive years, demonstrating
the company's commitment to returning value to shareholders. This consistent dividend payment
history suggests that JNJ's future dividends can be reasonably forecasted, making the DDM an
appropriate valuation model.

2.3 Dividend Growth Stages

In the Dividend Discount Model (DDM), the number of growth stages represents the different
phases of a company's dividend growth over time. A single-stage DDM assumes a constant
dividend growth rate indefinitely, while a multi-stage DDM allows for varying dividend growth
rates during different periods, reflecting the changing dynamics of a company's growth and
dividend policy.
Justification for Dividend Growth Stages
For Johnson & Johnson, we have decided to use a two-stage DDM. This decision is based on the
following factors:
1. Industry Life Cycle: Johnson & Johnson operates in the healthcare industry, which is
characterized by continuous innovation, research and development, and evolving
 regulations. As a result, the company's growth and dividend policy are likely to experience
varying rates over time.
2. Company's Maturity: Johnson & Johnson is a well-established company with a long
history of stable and increasing dividend payments. However, it is still actively investing in
research and development, pursuing acquisitions, and exploring new market opportunities.
These factors suggest that the company's dividend growth may not remain constant over
time.
3. Historical Dividend Growth Rates: The calculated 3-year and 10-year CAGRs for
Johnson & Johnson (3.86% and 5.53%, respectively) show a difference in dividend growth
rates. This further justifies the use of a two-stage DDM to account for the variations in
growth rates during different time periods.
By using a two-stage DDM, we can better capture the dynamic nature of Johnson & Johnson's
dividend growth and provide a more accurate estimation of the intrinsic value of its ordinary
shares. In the first stage, we will use the 3-year CAGR as the initial dividend growth rate,
representing the company's short-term growth prospects. In the second stage, we will use the 10-
year CAGR as the long-term dividend growth rate, reflecting the company's potential growth
over an extended period.
3. Dividend Growth Rate
3.1 Method of Estimating Dividend Growth Rate
To estimate the dividend growth rate for Johnson & Johnson, we will use historical
dividend data from the past three and ten years. This method provides a comprehensive
understanding of the company's recent dividend growth patterns while also considering longer-
term trends.
The JNJ Dividends Only dataset from Yahoo Finance supports the calculations. We can
describe it as having historical dividend data for Johnson & Johnson from May 23, 2013, to
February 17, 2023. The dataset has the following columns:
1. Date: The date on which the dividend was paid.
2. Dividends: The dividend amount paid per share on the corresponding date.
Computed Fields from Excel
3. YEAR: The calendar year in which the dividend was paid.
¿ YEAR ( A 2)
4. Annual_Dividend: The sum of dividend payments made within a given calendar year.
¿ SUMIF(C :C , C 2 , B :B)
5. Growth_Rate: The growth rate of the annual dividend compared to the previous year.
This value is calculated as the percentage change between the annual dividends of
consecutive years.
¿( D 3 /D 2)−1
The dataset shows that Johnson & Johnson has consistently paid dividends to its
shareholders over the years. The annual dividend has generally increased over time, with some
fluctuations in the growth rate. Notably, the growth rate between 2022 and 2023 is negative,
which may indicate a decrease in the annual dividend for 2023. However, it is important to note
that the dataset only includes one dividend payment for 2023, so this may not represent the entire
year's dividend.
To estimate the dividend growth rate(s) for Johnson & Johnson, we will use the historical
dividend data and apply the Constant Growth Model (also known as the Gordon Growth Model).
This model assumes that dividends grow at a constant rate indefinitely, making it suitable for
mature, stable companies like Johnson & Johnson.
The Constant Growth Model formula for estimating the dividend growth rate (g) is as
follows:
 (1 /n )
g=(D 1/ D0) −1
where:
1. D1 = Dividend amount at the end of the period
2. D0 = Dividend amount at the beginning of the period
3. n = Number of years between D0 and D1

3.2 Calculation of Dividend Growth Rate

Using the provided historical dividend data, we calculate the Compound Annual Growth
Rate (CAGR) for both the 3-year and 10-year periods.
The CAGR formula is:

CAGR=(Ending Value/ BeginningValue)(1/ Number of Years) −1

For the 3-year dividend growth rate:

(1/ 3)
CAGR=(1.13/1.01) −1=3.86 %

For the 10-year dividend growth rate:

CAGR=(1.13/0.66)(1 /10) −1=5.53 %

Based on the calculated dividend growth rates, we can infer that Johnson & Johnson has
been consistently increasing its dividend payments over both the short-term (3-year) and long-
term (10-year) periods. The 3-year CAGR of 3.86% indicates a steady growth in dividends in the
recent past. This could be attributed to the company's strong financial performance and its
commitment to returning value to shareholders.
The 10-year CAGR of 5.53% demonstrates a higher growth rate over a more extended
period. This indicates that, despite market fluctuations and varying economic conditions,
Johnson & Johnson has managed to maintain a robust dividend policy, reflecting its stability and
resilience in the healthcare industry. The derived dividend growth rates provide essential
information for the subsequent steps of the DDM analysis, as they help in estimating the future
dividend payments and, ultimately, the intrinsic value of Johnson & Johnson's ordinary shares.
These growth rates serve as a testament to the company's financial strength and its ability to
consistently reward shareholders with increasing dividends.
4. Required Rate of Return: CAPM Estimation
4.1 Data Preparation
To prepare the data for the analysis, monthly stock price data for Johnson & Johnson
(JNJ) and the S&P 500 index was collected over the last three years. The JNJ data was sourced
from Yahoo Finance: monthly financial data for Johnson & Johnson (JNJ) from June 2020 to
May 2023.
Each row in the dataset represents a month, and the columns provide information on the
opening and closing prices, the highest and lowest prices, the adjusted closing price, and the
volume of shares traded for JNJ stock. Additionally, the dataset provides monthly returns for JNJ
and the S&P 500 index, excess returns for JNJ and the S&P 500 index over the risk-free rate. The
"Open," "High," "Low," "Close," and "Adj Close" columns contain stock prices for JNJ. The
"Volume" column provides the number of shares of JNJ traded during the month. The
"JNJ_Monthly_Returns" column represents the percentage change in JNJ stock price from the
beginning to the end of the month. The "Excess_Returns_JNJ" column shows the difference
between the monthly returns for JNJ and the risk-free rate. The "SP500_Monthly_Returns"
column represents the percentage change in the S&P 500 index during the month. The
"Risk_Free_Rate_Monthly" column provides the monthly risk-free rate. The
"Excess_Returns_SP500" column shows the difference between the monthly returns for the S&P
500 index and the risk-free rate.
The monthly stock prices were converted to monthly returns using the formula:

Monthly Return =(Current ¿−Previous ¿ )/Previous ¿

Risk-free rate data for the same period was collected from the U.S. Department of the Treasury's
website. I calculated the excess returns for JNJ and the S&P 500 index by subtracting the risk-
free rate from their respective monthly returns.

4.2 Model Specification and Estimation

Using the OLS method, the Capital Asset Pricing Model (CAPM) was specified as follows:

Excess ¿=α + β∗Excess¿ 500+ ε

where:
Excess_Returns_JNJ is the excess return of JNJ stock
α is the intercept term
β is the sensitivity of JNJ stock's excess returns to the market's excess returns
Excess_Returns_SP500 is the excess return of the S&P 500 index
ε is the error term
Ordinary Least Squares (OLS) regression was performed in Excel using the SLOPE and
INTERCEPT functions to estimate the parameters α and β.

α 0.001744881
β 0.366761641
(𝑅𝑖) for April 0.007115137
Jensen's
Alpha (α_J)
for April 0.038488078

4.3 Estimation Results and Discussion

The results of the regression analysis are as follows:
α (intercept): 0.001744881
β (sensitivity to market returns): 0.366761641
An example calculation of Jensen's Alpha (α_J) for April is as follows:
¿ Excess ¿ ( April)−(α + β∗Excess¿ 500( April))
¿ 0.03950684−(0.001744881+0.366761641∗(−0.001979812))
JNJ's positive alpha (α) of 0.001744881 suggests that the stock has generated a small average
excess return, even when the overall market's excess return is zero. This indicates that JNJ may
have outperformed the market on average, after accounting for the risk-free rate.
The beta (β) value of 0.366761641 for JNJ implies that its excess returns are less sensitive to
changes in the market's excess returns compared to a stock with a beta of 1. This lower beta
indicates that JNJ is less risky compared to the overall market. Consequently, JNJ's stock price
fluctuations might be lower in comparison to the broader market, making it a relatively more
stable investment.
The example calculation of Jensen's Alpha for April, which resulted in a value of approximately
0.038488078, highlights that JNJ outperformed the market by around 3.84% in that month after
adjusting for risk. This suggests that the company's performance was strong relative to the
overall market during that period.
5. Intrinsic Value Calculation
Intrinsic Value=( D 1/(r −g))
Where:
1. D1 = Expected annual dividend for the next year
2. r = Required rate of return
3. g = Dividend growth rate
To calculate the average return of the S&P 500 index using the historical data provided, we will use the
'SP500_Monthly_Returns' column in Excel.
First, calculate the average monthly return. In an empty with the following formula:

¿ AVERAGE([range of SP500 ¿ ])
¿ AVERAGE( H 3 : H 34)
Next, we convert the average monthly return to an annual return using the following formula:
12
¿ ( 1+average monthly return ) −1
The average annual return of the S&P 500 index based on the dataset is 0.121612849799211,
approximately 12.16%.

Given the calculated and the other sourced values, we can calculate the intrinsic value using the
following inputs:
1. Forward Dividend & Yield: 4.76 (2.93%)
The forward dividend and yield represent the expected dividend payment and yield for
the next year. The forward dividend is an estimate of the total dividend payment that a
company will distribute over the next 12 months. It is calculated by taking the most
recent dividend payment and annualizing it, often by multiplying the most recent
quarterly dividend by four. The forward dividend yield is calculated by dividing the
forward dividend by the current market price of the stock. In this analysis, the forward
dividend of Johnson & Johnson is 4.76, and the forward dividend yield is 2.93%, from
Yahoo Finance for JNJ.
2. Risk-Free Rate: 3.37%
The risk-free rate used in this analysis is 3.37% (U.S. Department of the Treasury, 2023).
This rate was obtained from the U.S. Department of the Treasury's website, specifically
the Daily Treasury Yield Curve Rates page. The risk-free rate is typically represented by
the yield on a government bond, such as U.S. Treasury bonds, as these bonds are
considered to have minimal credit risk. In this case, the selected risk-free rate
corresponds to the yield on a 10-year U.S. Treasury bond as of May 2023. The U.S.
Department of the Treasury provides daily updates on the yield curve rates for various
 Treasury securities, which serve as a benchmark for interest rates in financial markets.
By using the risk-free rate in the calculations, we can account for the time value of
money and the inherent risk associated with investing in a particular asset, as compared
to a virtually risk-free investment in government bonds.
3. Average Annual Return of the S&P 500 Index: 12.16%
4. Average Annual Dividend Growth Rate (g): 2.33%
The required rate of return (r) using the CAPM model:
r =Risk−Free Rate+ β∗(Market Return−Risk −Free Rate)
Using the provided data and the estimated β from the CAPM regression (0.3668):
r =3.37 %+ 0.3668∗( 12.16 %−3.37 % ) r=6.56 %
Next, calculate the expected annual dividend for the next year (D1):
D 1=Current Dividend∗(1+ g ) D 1=4.76∗( 1+2.33 % ) D 1=4.87
Now, we can calculate the intrinsic value using the DDM formula:
Intrinsic Value=(4.87 /(6.56 %−2.33 % )) Intrinsic Value=$ 124.62
6. Discussion and Conclusion
The Dividend Discount Model (DDM) and the Capital Asset Pricing Model (CAPM)
were employed to estimate the intrinsic value of Johnson & Johnson (JNJ) stock and its required
rate of return, respectively. The CAPM estimation resulted in a required rate of return of
approximately 6.56%, using a risk-free rate of 3.37%, the average annual return of the S&P 500
Index (12.16%), and a calculated β of 0.3668. The DDM calculation incorporated an average
annual dividend growth rate of 2.33% and the estimated dividend for the next year of $4.87.
Using these inputs, the DDM estimated the intrinsic value of JNJ stock to be approximately
$124.62. The calculated intrinsic value of Johnson & Johnson's ordinary shares at $124.62
represents the estimated fair value of the company's shares based on the assumptions of the
model, including dividend growth rates and the required rate of return. This intrinsic value is a
theoretical estimation and may differ from the actual market price due to various factors such as
market sentiment, economic conditions, and company-specific developments.
The intrinsic value calculation and comparison with the market price can be used as a
starting point for further analysis and decision-making. Investors should consider other factors
such as the company's financial health, competitive position, industry outlook, and management
quality before making an investment decision. Additionally, it is crucial to diversify investments
across multiple sectors and assets to reduce overall portfolio risk.
6.2 Critique of DDM and CAPM
While both the DDM and CAPM provide valuable insights into stock valuation and
required rate of return, they possess limitations and challenges. The Dividend Discount Model
relies on several inputs and assumptions, such as dividend growth rates, required rate of return,
and forward dividends. Changes in these variables can significantly impact the estimated
intrinsic value. Conducting a sensitivity analysis by varying these inputs can provide a range of
intrinsic values and help investors understand the potential impact of changes in the assumptions.
The model assumes that dividends will grow at a constant rate indefinitely, which may not
always be the case. In reality, companies may experience changes in dividend policies,
fluctuating growth rates, or even dividend cuts due to various factors such as economic
conditions, industry trends, and company performance. Additionally, the DDM may not be
suitable for companies with a low or no dividend payout, as the model relies on dividends as the
primary source of valuation.
The DDM assumes a constant dividend growth rate, which may not be an accurate
reflection of the company's future performance. Additionally, it may not be suitable for stocks
that do not pay dividends, as they would be deemed worthless by the model.
The CAPM, on the other hand, assumes that investors hold a diversified portfolio, market
returns are normally distributed, and that the relationship between the stock's risk and return is
linear. These assumptions may not hold true in reality, leading to potential inaccuracies in the
estimated required rate of return. Despite these limitations, the DDM and CAPM can serve as
useful tools in the analysis of a stock's valuation when used in conjunction with other valuation
methods.
References
1. U.S. Department of the Treasury (2023). Daily Treasury Yield Curve Rates. Retrieved
from https://home.treasury.gov/resource-center/data-chart-center/interest-rates/
TextView?type=daily_treasury_yield_curve&field_tdr_date_value_month=202305
2. Yahoo Finance (2023). Johnson & Johnson (JNJ). Retrieved from
https://finance.yahoo.com/quote/JNJ?p=JNJ&.tsrc=fin-srch