Eli Lilly (LLY -0.24%) is hogging the headlines as its market cap marches toward $1 trillion, and some of its industry peers are flying under the radar right now. Investors can buy one of the highest-quality pharmaceutical stocks at a discounted valuation thanks to recent market trends. Investors who want to own one of tomorrow's trillion-dollar stocks should consider Johnson & Johnson (JNJ 0.89%).
The $1 trillion club
Only a handful of companies have achieved a $1 trillion valuation, and the list is dominated by tech stocks. That list is bound to expand over time, though, and pharma stocks aren't too far away. Lilly's share price has ballooned this year thanks to optimism around its portfolio of weight loss and obesity treatments. The company's market cap is nearing $900 billion, and it seems certain to cross the $1 trillion threshold sometime soon.
Image source: Getty Images.
Unfortunately, the valuation and speculation tied to Lilly's rise might be off-putting to some investors. Volatility is on the table now that its forward P/E ratio is above 40.
Johnson & Johnson offers a compelling alternative that's on track to hit $1 trillion for investors who have a long-enough time horizon. The drugmaker was the global leader in pharmaceutical sales last year by a large margin. Its $85 billion of sales in 2023 were 30% higher than Roche's, the next biggest rival.
Johnson & Johnson has an investor-friendly valuation
Johnson & Johnson's valuation isn't incredibly cheap -- it's unusual for high-profile stocks to trade at irrational prices. That said, the valuation is a discount to certain peers and the stock's own historical levels.
Enterprise-value-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) is a popular alternative to the P/E ratio. EV-to-EBITDA controls for the impact of corporate debt, which makes it useful for comparing the valuations of businesses that have different capital structures.
Johnson & Johnson falls within the EV-to-EBITDA range of its pharmaceutical industry peers. The 10 largest drug companies by revenue last year were:
- Johnson & Johnson
- Roche
- Merck
- Pfizer
- AbbVie
- Sanofi
- AstraZeneca
- Novartis
- Bristol-Myers Squibb
- GSK
Most EV-to-EBITDA ratios in the peer group range from 10 to 16, so Johnson & Johnson's valuation appears reasonable at first glance. Long-term investors shouldn't consider this a discount to other competitors within the industry, but there's certainly room for modest appreciation.
JNJ EV to EBITDA (Forward) data by YCharts
It's also important to consider the current valuation relative to historical levels. Johnson & Johnson stock is relatively cheap compared to prior periods based on several key metrics. It's closer to the bottom of the five-year range for forward P/E ratio, EV-to-EBITDA, and price-to-free cash flow. The trend is comprehensive -- you can buy Johnson & Johnson stock for a cheaper price relative to almost every important business fundamental.
JNJ EV to EBITDA (Forward) data by YCharts
Interest rates play an important role in this trend. Rates are at their highest level in a long time, which is exerting downward pressure on stock prices. High rates encourage investors to buy lower-risk, lower-volatility securities such as corporate bonds and Treasuries. Risk is discouraged, and valuations tend to slump across the stock market.
Of course, that hasn't been universal for all industries. An artificial intelligence (AI)-fueled tech rally has pushed many stocks into relatively high valuation ranges, so the apparent discount in the pharmaceutical industry is also attributable to momentum and investor hype.
Importantly, Johnson & Johnson also pays an attractive 3% dividend yield. That's among the highest yields provided by this stock in recent memory.
JNJ Dividend Yield data by YCharts
Forecasting future cash flows and valuations involves a lot of guesswork, so there's error inherent in determining whether a stock is "cheap" based on the P/E ratio. Dividend yield is a more concrete metric. Johnson & Johnson will provide 3% returns in the form of cash distributions to shareholders as long as something unexpected doesn't cause the company to reduce its payouts.
Avoiding a value trap
Buying cheap stocks isn't always a good investment strategy. Discounted valuations often indicate a likelihood that cash flows or dividends are cut in the future.
It doesn't seem like Johnson & Johnson's financial performance is under any imminent threat. The company faces loss of patent protection on key products in the coming years, which will challenge sales growth. However, no drug accounted for more than 13% of total sales. Diversification and a huge portfolio prevent any single product from sinking the ship.
Johnson & Johnson's pipeline of future treatments currently in development also offsets the impact of patent cliffs. The company is often credited with one of the largest, most innovative, and most valuable pipelines In the industry. This should install Johnson & Johnson as a prominent leader for years to come. Its 77% payout ratio suggests that it can sustain its current dividend and maintain its Dividend King status.
The pharmaceutical industry is worth a look for any long-term investors looking for a value stock, and Johnson & Johnson is one of the best in class. Over the past few years, the market moved away from healthcare and pharmaceutical stocks that boomed starting in 2020. AI stocks have caught the headlines over the past few years, causing investors to pile into tech stocks. These trends created enticing valuations for slow and steady stalwarts like Johnson & Johnson.
As for the trillion-dollar threshold, Johnson & Johnson is a good candidate over the long term. Its current value is just under $400 billion, so its market cap needs to expand 160%. The first 30 basis points could come from expanding valuation ratios, but the rest likely depends on growing cash flows and dividends. Investors should expect single-digit annual growth over the long term, so the march to $1 trillion will probably take a decade. It's more a matter of "when" than "if" -- but it will take some time.
This isn't the right stock for investors seeking a quick buck. It is an attractive investment for people who want stable growth with current income.
