Question

Johnson and Johnson, a leading manufacturer of healthcare products, had a return on equity in 2022 of 35%, and paid out 40% of its earnings as dividends. It earned a net income of $1,625 million on a book value of equity of $5,171 million. As a consequence of healthcare reform, it is expected that the return on equity will drop to 22% in 2023 and that the dividend payout ratio will remain unchanged. Lay out details and steps for the following questions:

A. Estimate the growth rate in earnings based upon 2022 numbers alone
B. Estimate the growth rate in 2023, when the ROE drops from 35% to 22%.

Answer 1

The sustainable growth rate (SGR) for Johnson & Johnson in 2022 is 21%, calculated using the ROE of 35% and a 40% dividend payout ratio. In 2023, with an anticipated ROE of 22%, the estimated SGR drops to 13.2%, assuming the dividend payout ratio remains unchanged.

Step-by-step explanation:

Growth Rate in Earnings Based on 2022 Numbers

To estimate the growth rate in earnings for Johnson & Johnson based on the 2022 numbers, we use the formula for sustainable growth rate (SGR): SGR = ROE × (1 - dividend payout ratio). The Return on Equity (ROE) for Johnson & Johnson in 2022 is 35%, and the dividend payout ratio is 40%. Thus, the SGR for 2022 would be: SGR = 0.35 × (1 - 0.40) = 0.35 × 0.60 = 0.21 or 21%.

Growth Rate in 2023 with Reduced ROE

For the year 2023, the expected ROE is 22%, but the dividend payout ratio remains the same at 40%. The estimated SGR for 2023 would be: SGR = 0.22 × (1 - 0.40) = 0.22 × 0.60 = 0.132 or 13.2%. This reflects the impact of a decrease in ROE on the company's ability to grow earnings without external financing.

The calculation shows how the expected healthcare reform results in a reduced growth rate for the manufacturer due to a lower ROE.

Answer 2

Based on a 35% ROE and 40% dividend payout ratio in 2022, Johnson and Johnson's earnings growth rate was 21%. With an expected ROE decrease to 22% in 2023, the estimated earnings growth rate drops to 13.2%, assuming the dividend payout ratio stays constant.

Step-by-step explanation:

To calculate the growth rate in earnings for Johnson and Johnson based on the 2022 numbers, we need to consider the retained earnings that were not paid out as dividends. Since the company had a return on equity (ROE) of 35% and paid out 40% of its earnings as dividends, it retained 60% of its earnings to reinvest in the business (100% - 40% dividend payout ratio). The growth rate (g) can be found using the formula g = ROE × (1 - dividend payout ratio).

By inputting the numbers from 2022 into this formula, we get g = 0.35 × (1 - 0.40) = 0.35 × 0.60 = 0.21, or 21%. This means that, based on 2022 numbers alone, the earnings growth rate for Johnson and Johnson was 21%.

Now, for the estimate in 2023 when the ROE is expected to drop to 22%, the growth rate would similarly be calculated as g = 0.22 × (1 - 0.40) = 0.22 × 0.60 = 0.132, or 13.2%. Thus, if the dividend payout ratio remains unchanged, the anticipated growth rate in 2023 would be 13.2% based on the lower ROE.