Thursday, October 18, 2012

DJIA Stocks With the Highest and Lowest P/Es

According to this, the five stocks in the Dow Industrials with the highest P/Es based upon 2013 earnings estimates:

Barron's - Dow Industrials Consensus Earnings

Stock                                     | P/E
Home Depot (HD)            | 17.5
Coca-Cola (KO)                 | 17.4
Procter & Gamble (PG)  | 16.4
Verizon (VZ)                     | 16.0
McDonalds (MCD)           | 15.5

Naturally, these look a bit more expensive based upon 2012 earnings.

Now, here's the stocks that currently have single-digit P/Es among the Dow Industrials:

Stock                                     | P/E
Chevron (CVX)                 | 9.0
Microsoft (MSFT)            | 8.9
Cisco (CSCO)                      | 8.8
Caterpillar (CAT)             |  8.2
JP Morgan (JPM)             | 8.1
Hewlett-Packard (HPQ) | 3.8

Adjusting for net cash and investments on the balance sheet, Microsoft (MSFT) and Cisco (CSCO) actually sell at an even lower multiple of earnings.*

Unfortunately, many of Cisco's earnings estimates are made on a non-GAAP basis. In my view, that creates an optimistic view of the company's earnings power over the long haul. The inflated earnings picture come primarily from not including stock-based compensation. Some might be willing to disregard stock-based compensation as an expense. I'm not. It's true that it often makes sense when valuing a company to ignore non-cash expenses. Not in this case. The cost of stock-based compensation is economically very real for long-term shareholders (i.e. have a material impact on per share intrinsic value) even if difficult to estimate precisely ahead of time and not an immediate hit to free cash flow.

Cisco - Adjusting for net cash and investments while using a more conservative estimate of earnings the net result is still a stock with a P/E around 7 or so.**

Microsoft - Sells for less than 8 times earnings after adjusting for net cash and investments.

Clearly, Hewlett-Packard is priced as earnings are going to continue sinking. In fact, that multiple implies the expectation is that it's going to happen rather quickly. The problem, of course, is understanding the company's prospects far into the future. Does it have a sustainable business with at least decent economics even if at a substantially lower than current level of earnings? That's all it needs to prove at this point with that kind of P/E. Alternatively, will earnings power just continue to take hits until there's little, if any, intrinsic business value left? We'll see. The range of outcomes seems pretty wide. It'll be a rocky road until the answer to questions like this become at least somewhat more apparent.

Keep in mind certain stocks among the Dow Industrials have a substantial range of earnings estimates. Alcoa (AA) and Bank of America (BAC) come to mind. So the so-called "consensus" may not mean a whole lot. Those with the broadest ranges likely have difficult to judge business prospects (at least in the near-term and maybe longer). A wide range of estimates may not necessarily indicate a low quality business (though it often does), but describing the estimates as "consensus" seems like more than a slightly flexible use of that word.

Also, as far as I'm concerned, it's better to pretty much ignore the consensus and come up with my own estimate of current intrinsic value*** -- and how much it seems likely to change over time -- based on conservative numbers for future earnings power (and long run expected return on capital). To me, how the business performed over the previous business cycle should be weighed heavily. If current prices seem likely to produce a nice long-term risk-adjusted return based upon conservative estimates, there'll be no complaints if the business ends up having even more earnings power than assumed. Whether management can be trusted to allocate capital intelligently and, most importantly, whether the business has a sustainable economic moat need be judged well, of course.

Those less economically sensitive (Coca-Cola is one example) businesses are likely to have rather modest drops in earnings even if the global economy slows (though it would certainly at least temporarily throttle growth). The financial crisis provided some pretty good evidence of Coca-Cola's earnings persistence. Even if there were a temporary reduction in the Coca-Cola's earnings, it would do little damage the company's per share intrinsic value (and how it increases over the long haul) in my view.

Too bad the stock has gotten a bit pricey.

In contrast, expect the more economically sensitive businesses to have meaningful adjustments in earnings estimates in periods of severely reduced economic activity. A business more sensitive to economic activity requires earnings to be normalized across a complete business cycle to get a good read on its true P/E.

Finally, five years ago, back in October of 2007, the DJIA was just over 14,000. According to this Barron's article, at that time the forward P/E of the stocks that made up the index was 16.1.

Five years later, with the DJIA now at roughly 13,500, the forward P/E is more like 11.7.

So the Dow Jones Industrial Average may not be higher than it was five years ago, but it's not because the underlying per share intrinsic value of the company's in that index hasn't increased.


Long positions in KO, PG, CVX, MSFT, CSCO established at much lower than recent market prices. Small long position in HPQ established when it was more expensive than where it has traded recently.

* Enterprise value = market capitalization minus cash and investments plus debt. The substantial amount of net cash and investments these two companies have results in an enterprise value that's far lower than market value. Roughly 1/4 of Microsoft's market value is made up of net cash and investments. Nearly 1/3 of Cisco's market value comes from its net cash and investments. Naturally, the result is lower enterprise value to earnings for both companies.
** I use GAAP earnings so stock-based compensation expense -- admittedly a crude estimate of what ultimately will be the true expense -- is taken into account. Using GAAP is a conservative estimate of earnings since the GAAP numbers also include expenses related to amortization of acquisition-related intangible assets. Unlike stock-based compensation, those non-cash amortization expenses aren't necessarily material in an economic sense looking forward. A company that regularly overpays for the assets they acquire will adversely impact intrinsic value. One reason to include amortization expenses when valuing a company is to build in additional margin of safety in case the company ends up doing just that in the future. Still, those willing to be less conservative in estimating value have a reasonable argument in not counting amortization of acquisition-related intangible assets.
*** Estimates of intrinsic value is actually more a range of likely values and certainly is not a precise number. There's little room for false precise when estimating value. 
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