Thursday, January 12, 2012

Five Dow Stocks with the Highest Earnings Yield

Here is the five Dow stocks with the highest earnings yield (inverse price to earnings) based upon consensus earnings:

Dow Industrials Consensus Earnings

Stock                                     | Earnings Yield
Hewlett-Packard (HPQ) | 16%
Bank of America (BAC)  | 15%
JPMorgan (JPM)              | 14%
Chevron (CVX)                 | 12%
Pfizer (PFE)                        | 11%

Some things to consider:

- Chevron may seem cheap but, there are other large, integrated oil companies that appear even cheaper. These happen to be located in economically dismal Europe yet derive their economics globally. Examples include BP (BP) and Total (TOT). Considering the capital intensiveness of these businesses they should have low multiples in my view.

- If you adjust for net cash and investments* on the balance sheet, Microsoft (MSFT) and Cisco (CSCO) would displace Chevron and Pfizer in the top five.
(Many estimates of Cisco's earnings are non-GAAP. In my view, it creates an optimistic view of the company's true earnings power. This inflated earnings picture is primarily the result of stock-based compensation.)

- Earnings season is just ahead so what is revealed in each earnings report may change the consensus (up or down) meaningfully in the coming weeks. To be clear, I NEVER use another analyst's estimate to figure out intrinsic value. Personally, I don't think any investor should use someone else's numbers or assumptions. It's also why I do not believe in making stock recommendations (something I'd never do). I think the work has to be done by the owner so that person really knows, in a substantive way, why they want to own a specific stock.

- Instead of using someone else's estimate, I come up with my own calculation of current intrinsic value** (and how it may change over time) using conservative future earnings power (and return on capital). I weigh heavily how the business performed over the previous business cycle. If I think the price paid produces a nice long-term risk-adjusted return based upon these conservative estimates, I'm certainly not going to mind if the business ends up having even more earnings power than I assumed. I also make subjective judgments on whether management can be trusted to allocate capital intelligently and, ultimately, how confident I am the business has a sustainable economic moat. There are many other subjective judgments to be made so spreadsheets matter less than some may think. An investor that doesn't take the time to get their arms around these things shouldn't really be buying an individual stock in my view.

- I own shares of some banks but my view continues to be that most banks are not really worth the trouble. The larger ones, for the most part, are just too complex to really understand.

- While some of the banks appear very cheap, most have rallied substantially in recent weeks. Bank of America has a wide range of estimates among analysts so the so-called consensus earnings are really anything but a consensus. On the other hand, Bank of America is not yet producing the kind of profits it likely can once its house in order. The question is will material dilution end up happening, especially at a low stock price (making the dilution even more painful), hurting the shareholders who already own it. A tough call that doesn't seem worth the risk to me considering alternatives (something I've said on a prior occasion).

A double digit earnings yield implies an expectation for earnings to shrink, in some cases substantially, proving these estimates to be too optimistic. It would seem that, near recent market prices, most of these just have to prove that their business is not in some kind of secular decline or near a cyclical peak (revealing true earnings power to be much lower than it now seems). Watch out for highly cyclical businesses. Low P/Es turn out to be anything but sometimes.

Otherwise, eventually the earnings yield gets high enough to compensate an owner for the risks even if no meaningful growth is in the cards.*** Now, if it turns out these businesses do begin to profitably grow in a sustained way again, even if modestly, long-term owners of the shares can do quite well at a double digit earnings yield entry point.

Still, on a risk-adjusted basis, these five stocks seem less attractive near recent prices than some other higher quality alternatives.

Adam

I've either already established long positions in the above stocks or have the intention to accumulate shares slowly over time if, as I hope, they continue to get cheaper.

* Cash and investments minus debt.
** Estimates of intrinsic value is actually more a range of likely values and certainly is not a precise number. There's no need for false precision when it comes to estimating value.
*** As long as management makes intelligent, shareholder-friendly, use of the capital. Not exactly guaranteed.
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