Johnson & Johnson (NYSE:JNJ): Can It Deliver A Superior ROE To The Industry?

Johnson & Johnson (NYSE:JNJ) delivered a less impressive 2.07% ROE over the past year, compared to the 11.33% return generated by its industry. Though JNJ's recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on JNJ's below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of JNJ's returns. Let me show you what I mean by this. See our latest analysis for Johnson & Johnson

What you must know about ROE

Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 2.07% implies $0.02 returned on every $1 invested, so the higher the return, the better. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Pharmaceuticals sector by choosing the highest returning stock. However, this can be deceiving as each company has varying costs of equity and debt levels, which could exaggeratedly push up ROE at the same time as accumulating high interest expense.

Returns are usually compared to costs to measure the efficiency of capital. Johnson & Johnson’s cost of equity is 8.49%. Since Johnson & Johnson’s return does not cover its cost, with a difference of -6.43%, this means its current use of equity is not efficient and not sustainable. Very simply, Johnson & Johnson pays more for its capital than what it generates in return. ROE can be dissected into three distinct ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:

Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue Johnson & Johnson can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can determine if Johnson & Johnson’s ROE is inflated by borrowing high levels of debt. Generally, a balanced capital structure means its returns will be sustainable over the long run. We can examine this by looking at Johnson & Johnson’s debt-to-equity ratio. The most recent ratio is 57.50%, which is sensible and indicates Johnson & Johnson has not taken on too much leverage. Thus, we can conclude its current ROE is generated from its capacity to increase profit without a large debt burden.

Next Steps:

ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Johnson & Johnson’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.

For Johnson & Johnson, I've put together three fundamental factors you should further examine:

1. Financial Health: Does it have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
2. Valuation: What is Johnson & Johnson worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether Johnson & Johnson is currently mispriced by the market.
3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Johnson & Johnson? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!

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Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.