To Find Future Prices, Look Back

1/16/2012


When you consider purchasing a stock, focus on both what it costs today and the price you could see a year or more down the road.

Of course, nobody can precisely predict the future price of a stock. But you can improve your chances by looking backward at a few key valuation metrics. Stocks that trade well below the valuations they have sported in the past have a good chance of reverting back toward those long-run valuation ratios. Stocks cheap relative to historical norms for price/earnings, price/sales, price/book,and price/cash flow tend to outperform the average stock.

As a group, the mix of large, medium-size, and small stocks that make up the S&P 1500 Index don't look especially cheap relative to historical norms, as shown in the table below. The average stock in the S&P 1500 trades at a 2% discount to its five-near median price/earnings ratio and a 7% discount to the 10-year median. Fortunately, we need not buy the median stock, because we can find a number of attractively valued large-caps. The larger stocks in the S&P 500 Index look cheaper relative to their history than the smaller stocks in the S&P MidCap 400 and S&P SmallCap 600 indexes.

LARGE STOCKS CHEAP VERSUS HISTORY
While S&P 1500 Index stocks as a whole don't appear overly cheap relative to historical median valuations, the larger stocks in the S&P 500 Index seem more attractively valued than the smaller stocks in the S&P MidCap 400 and S&P SmallCap 600 indexes. S&P 500 stocks average discounts of 3% to five-year medians and 10% to 10-year medians for the five valuation ratios we considered.
Trailing
Vs. 3-Yr.
Median
Vs. 5-Yr.
Median
Vs. 10-Yr.
Median
Average S&P 500 Index stock
Price/Earnings
16.2
0.97
0.94
0.86
Price/Book
2.0
1.02
1.00
0.93
Price/Sales
2.9
1.03
0.99
0.91
Enterprise Ratio
8.8
1.03
0.98
0.92
Price/Cash Flow
10.6
0.99
0.95
0.88
Average of S&P SmallCap 600 and S&P MidCap 400 index stocks
Price/Earnings
19.4
1.00
1.00
0.97
Price/Book
1.9
1.03
1.01
0.94
Price/Sales
2.3
1.04
1.00
0.91
Enterprise Ratio
9.2
1.08
1.02
0.96
Price/Cash Flow
11.9
1.04
1.01
0.95
Average S&P 1500 Index stock
Price/Earnings
18.3
0.99
0.98
0.93
Price/Book
1.9
1.02
1.01
0.94
Price/Sales
2.5
1.04
1.00
0.91
Enterprise Ratio
9.1
1.06
1.01
0.94
Price/Cash Flow
11.4
1.02
0.99
0.92
Note: Averages exclude price/earnings ratios below 0 or above 75, price/book ratios below 0 or above 15, price/cash flow and enterprise ratios below 0 or above 35, price/sales ratios above 25, and relative valuation ratios above 5.

In the table below, we present implied prices to illustrate the potential upside of stocks trading at a discount to historical norms. Consider Microsoft ($28; MSFT), which trades at 3.2 times trailing sales, a 44% discount to the 10-year median of 5.9 times sales. To calculate an implied price based on the 10-year median price/sales ratio, we determine what the stock would cost if the valuation reverted to the median. In this case, Microsoft would trade at $50 per share, up 80% from current levels.

Implied prices have their limitations. First, while stocks tend to revert toward historical valuations, the trend is not absolute. Sometimes the company or the market changes, and revaluations are permanent. And sometimes stocks simply diverge from historical valuations for long periods before reverting. Second, even if a stock's valuation does revert, it won't necessarily go all the way back.

Investors should use implied prices not as target prices, but as indicators of stocks with upside. Do we expect Microsoft to rise 80% over the next year? No. But the stock looks cheap based on a number of historical valuation ratios, and we do expect market-beating returns as it moves back toward those long-run levels. The table below lists eight A-rated stocks that look attractive based on implied prices. Four are reviewed below. If you would like to see a list of stocks in the S&P 1500 Index with high implied prices, visit www.DowTheory.com/Go/Implied.

The nine implied prices shown in the table below imply average upside of 51% for BMC Software ($32; BMC). Shares trade at 10 times trailing earnings, less than half of the stock's five-year median P/E. If BMC's trailing P/E recovers only to 12 and the company meets the consensus profit estimate of $3.50 for the fiscal year ending March 2013, its shares will rise 33% over the next 15 months.

Shares fell in October when BMC conceded that its depleted sales force would likely hinder revenue growth for the next few quarters. That weakness is compounded by worries about lower spending on technology in the year ahead. Industry researcher Gartner cut its 2012 global tech-spending forecast to $3.8 trillion in January, implying 4% growth, down from a previous growth target of 5%. However, BMC's valuation already reflects plenty of uncertainty, and the company's cash flow has shown encouraging growth. Earning a Value score of 89, BMC Software is a Buy and a Long-Term Buy.


J.P. Morgan Chase ($36; JPM) boasts a balance sheet stronger than that of most peers and a leading market share in its key businesses. But the bank is still haunted by ghosts of the mortgage mess, while its investment-banking and trading operations slog through the malaise of the muted recovery. That leaves investors to wonder how much of the weakness is merely cyclical and how much stems from structural changes caused by the new regulations that force banks to hold more capital and curb trading activity.

Last month, J.P. Morgan said December-quarter revenue from its investment bank (27% of sales in the 12 months ended September) would be comparable to September-quarter levels, implying about 3% year-over-year growth. Complete results were slated for release Jan. 13, after the Forecasts went to press. Plenty of pessimism is already baked into the stock, trading at a 26% discount to its five-year median price/book ratio. J.P. Morgan Chase is a Long-Term Buy.


Oracle ($27; ORCL) shares still haven't fully recovered from their 12% swoon on Dec. 21 following a rare profit and sales miss for the November quarter. Oracle reported surprisingly weak revenue for new software licenses as businesses became more cautious about spending on technology. However, deferred revenue for software licenses jumped 12% from the August quarter, marking Oracle's strongest sequential growth in seven quarters, which could presage stronger revenue growth in the February quarter.

Shares trade 23% below their three-year median for trailing sales; should Oracle return to that historical norm, the stock would trade at $34. At less than 12 times trailing earnings, shares trade 38% below their three-year median and 23% below the median for technology stocks in the S&P 1500 Index. Earning a Value score of 81 — versus its 14-month average of 60 — Oracle is a Focus List Buy and a Long-Term Buy.


St. Jude Medical ($35; STJ) shares have slumped 34% since hitting an all-time high in May. At 11 times trailing earnings, the P/E hovers near its lowest level in more than a decade. A return to St. Jude's five-year median price/sales ratio would vault the stock 45% to $51.

The shares reflect concerns about the possible loss of market share for implantable defibrillators following the recall of St. Jude's Riata defibrillator leads (flexible wires that connect a defibrillator to a patient's heart), which were discontinued in December 2010. The wires inside the leads can penetrate the insulation and short-circuit the device — at least one patient has reportedly died as a result of such problems. The defective leads seem concentrated in the oldest versions of the implants — about 2,000 of the 79,000 active Riata leads in the U.S. — while the newer leads use a different design with better insulation. Management appeared to assuage investors' worst fears on Jan. 9 by preannouncing December-quarter revenue and earnings in line with the consensus. St. Jude Medical is a Long-Term Buy.

STOCKS WITH HIGH IMPLIED PRICES
We calculated implied prices based on nine historical valuation ratios, and all eight of the recommended stocks listed below have implied prices higher than the current price based on all nine of those metrics.
----------------------------------------- Implied Prices Based On -----------------------------------------
----- Price/Sales Ratio -----
----- Price/Book Ratio -----
----- Enterprise Ratio -----
Company (Price; Ticker)
Vs.
3-Yr.
Median
($)
Vs.
5-Yr.
Median
($)
Vs.
10-Yr.
Median
($)
Vs.
3-Yr.
Median
($)
Vs.
5-Yr.
Median
($)
Vs.
10-Yr.
Median
($)
Vs.
3-Yr.
Median
($)
Vs.
5-Yr.
Median
($)
Vs.
10-Yr.
Median
($)
Avg.
Implied
Price
($)
Avg.
Implied
Gain
(%)
Agilent Technologies
($39; A)
41
43
40
47
47
45
53
56
68
49
25
Apache ($98; APA)
134
133
133
133
136
137
130
127
121
131
34
BMC Software
($32; BMC)
45
47
41
48
51
41
47
49
61
48
51
Hewlett Packard
($27; HPQ)
47
58
58
44
50
44
35
41
48
47
77
J.P. Morgan Chase
($36; JPM)
41
42
46
45
49
55
77
71
70
55
53
Microsoft ($28; MSFT)
28
32
50
34
40
39
28
37
52
38
36
Oracle ($27; ORCL)
34
35
39
35
37
47
34
37
45
38
42
St. Jude Medical
($35; STJ)
47
51
72
48
53
68
43
47
71
56
57
Note: Averages exclude price/book ratios below 0 or above 15, enterprise ratios below 0 or above 35, and price/sales ratios above 25.

 


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