This undervalued stock could join the race with Eli Lilly for the $1 Trillion Club

Eli Lilly (LLY 0.21%) is grabbing headlines as its market cap marches toward $1 trillion. But even as the market continues to gauge growing demand for anti-obesity drugs and bids for weight-loss companies, it could ignore other pharmaceutical businesses.

As a result, quite a few pharma stocks are currently flying under the market’s radar, and investors may be looking for solid opportunities to buy some high-quality businesses at discounted valuations due to recent market trends.

One such business that could eventually be in the trillion dollar club is Johnson & Johnson (JNJ 0.79%).

The trillion dollar club

Only a handful of companies have reached a $1 trillion valuation, most of which are technology stocks. This list, however, will expand over time, and pharmaceutical stocks are not far behind. Lilly’s share price has risen this year on optimism about its portfolio of weight loss and obesity treatments. The company’s current market cap is $850 billion and looks certain to cross the $1 trillion mark soon.

Image source: Getty Images.

Unfortunately, Lilly’s valuation and growth speculation could be off-putting to some investors. Volatility is on the table now that the forward P/E ratio is above 40.

Johnson & Johnson offers a compelling alternative, which is also on track to hit $1 trillion for investors with a long enough time horizon. The drugmaker was the global leader in pharmaceutical sales last year by a wide margin. Its revenue of $85 billion in 2023 was 30% higher than Roche‘s, the next biggest rival.

Johnson & Johnson has a favorable rating for investors

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), or EV/EBITDA for short, is a popular alternative to the P/E ratio. EV/EBITDA controls for the impact of corporate debt, making it useful for comparing valuations of businesses that have different capital structures.

Johnson & Johnson falls within the EV/EBITDA range of its peers in the pharmaceutical industry. The chart below tracks the projected EV/EBITDA of the 10 largest drug companies by trailing 12-month revenue.

Most EV-EBITDA ratios in the peer group range from 10 to 16, so Johnson & Johnson’s valuation of 12.8 times forward EBITDA seems reasonable at first glance. Long-term investors shouldn’t consider this a discount to other industry competitors, but there’s certainly room for modest appreciation.

JNJ EV to EBITDA data (before) by YCharts.

However, it is also important to consider the current valuation relative to historical levels. In this regard, Johnson & Johnson stock is relatively cheap compared to prior periods based on several key metrics. It is closer to the bottom of the five-year range for the forward P/E ratio, EV-EBITDA and price-to-free cash flow. The trend is comprehensive – you can buy Johnson & Johnson stock at a cheaper price compared to almost all of the business’s fundamentals.

JNJ EV to EBITDA data (before) by YCharts.

Interest rates play an important role in this trend. Rates are at long-term highs, putting downward pressure on equity prices. High rates encourage investors to buy low-risk, lower-volatility securities such as corporate bonds and Treasuries. Risk is discouraged and valuations tend to fall on the stock market.

Of course, this was not universal for all industries. An artificial intelligence (AI)-fueled tech rally has pushed many stocks into relatively wide valuation ranges, so the apparent pullback in the pharma industry is also attributable to investor momentum and hype.

Importantly, Johnson & Johnson also pays an attractive dividend yield of 3%. This is among the highest returns this stock has offered in recent memory.

JNJ Dividend Yield Data by YCharts.

Forecasting future cash flows and valuations involves a lot of guesswork, so there is an inherent error in determining whether a stock is “cheap” based on the P/E ratio. Dividend yield is a more concrete measure. Johnson & Johnson will offer 3% of profits in the form of cash distributions to shareholders, as long as something unexpected doesn’t cause the company to cut its payouts.

Avoiding a value trap

Buying cheap stocks is not always a good investment strategy. Discounted valuations often indicate a likelihood that cash flows or dividends will be reduced in the future.

Johnson & Johnson’s financial performance does not appear to be under any imminent threat. The company faces the loss of patent protection for key products in the coming years, which will cause sales growth. However, no drug accounted for more than 13% of total sales. Diversification and a huge portfolio prevent any one 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 payout ratio of 77% suggests it can maintain its current dividend and maintain its Dividend King status.

The pharmaceutical industry is worth a look for any long-term investor looking for a value stock, and Johnson & Johnson is one of the best in class. Over the past few years, the market has moved away from healthcare and pharmaceutical stocks, which have been rising since 2020. AI stocks have gained attention in recent years, prompting investors to focus on technology stocks. These trends have created attractive valuations for slow-and-steady stalwarts like Johnson & Johnson.

As for the trillion dollar mark, Johnson & Johnson is a good long-term candidate. Its current value is just under $400 billion, so its market cap needs to expand by 160%. The first 30 basis points could come from widening 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 likely take a decade. It’s more a matter of “when” than “if” — but it will take some time.

This is not the right stock for investors looking for a quick buck. It is an attractive investment for people who want stable growth with current income.