Add It Up: Dow Has further Upside

2/27/2012


While the Dow Jones Industrial Average is often criticized for comprising only 30 stocks, its limited membership can be an advantage when analyzing its prospects. By looking at individual company fundamentals for the 30 Dow stocks, you can see the forest in ways not possible when the view is obscured by 500 or more trees.

Because the Dow stocks have huge stock-market values — and because any reasonably diversified portfolio of 30 huge stocks will be highly correlated with broader indexes like the S&P 500 — the outlook for the Dow has implications for the broad market. Moreover, the Dow stocks are among the most intensely scrutinized in the world, with each followed by at least 10 Wall Street analysts.

So, what do the fundamentals of these closely followed blue chips tell us? Some details:

Share-price trends. It is hard to nitpick regarding the Dow's recent surge: 29 of the 30 stocks have positive returns for the past six months, while 25 are up year-to-date.

Operating momentum. Over the last 12 months, 26 Dow companies have grown earnings, while 27 have posted sales growth. Twenty posted higher per-share earnings in the most recent quarter, while 26 posted higher sales.

Earnings Estimates. Of the 30 Dow stocks, 21 are expected to post higher per-share earnings in their current fiscal year, and 29 are expected to report growth for their next fiscal year.

Valuations. On average, the 30 Dow stocks trade at 14 times trailing earnings and less than 13 times expected current-year earnings, pointing to decent upside potential if earnings meet expectations and P/E ratios revert to long-term norms.

Target prices

To gauge upside potential more precisely, we calculated target prices for each Dow stock nine ways. We multiplied trailing, estimated current-year, and estimated next-year earnings by average P/E ratios for the past three years, five years, and 10 years.

The table below shows results for this thought experiment, with nine target prices for the Dow. Assuming unchanged earnings, a move to the average P/Es of the past three and five years would put the Dow near 14,369, up 11%. A move to 10-year average P/Es would put the Dow at 16,799, up 30%.

TARGETS FOR DOW BASED ON PAST P/E RATIOS
Assuming all 30 Dow stocks moved to their average trailing price/earnings ratio of the last three years, the Dow Jones Industrial Average would trade at 14,369, up 11% from the current level of 12,966. Assuming consensus profit estimates for current fiscal years are accurate and trailing P/E ratios return to the 10-year averages, the Dow would trade at 17,724, up 37%, in about 12 months.
----------------- Implied Value Based On Per-Share Earnings -----------------
--- Trailing Earnings ---
Estimated
----- Current Year -----
Estimated
------- Next Year -------
Historical P/E
Target
%
Change
Target
%
Change
Target
%
Change
3-Year Average
14,369
11
15,191
17
16,982
31
5-Year Average
14,369
11
15,152
17
16,884
30
10-Year Average
16,799
30
17,724
37
19,701
52

Assuming consensus profit estimates are accurate, a move to three- or five-year norms for P/Es would put the Dow at 15,152 to 15,191 in about 12 months — and 16,884 to 16,982 in about 24 months. If P/Es revert to 10-year norms and next-year earnings estimates are accurate, the Dow would reach 19,701.

Conclusion

The Dow seems unlikely to reach 19,701 over the next two years, partly because such cyclical stocks as Caterpillar ($115; CAT), Boeing ($76; BA), and DuPont ($52; DD) seem unlikely to trade at significantly higher P/E ratios as earnings surge to record levels. Also, the fact that earnings expectations are eroding even as expectations for the U.S. economy are improving suggests consensus estimates are more optimistic than usual.

While we would not be surprised by a near-term pullback — especially if the Dow Transports remain under pressure — the availability of attractively valued large stocks like Cisco Systems ($20; CSCO), Intel ($27; INTC), and Microsoft ($31; MSFT) is one reason we feel comfortable with a mostly invested posture. Our buy lists have 90% to 92% in stocks, with the remainder in Vanguard Short-Term Investment-Grade ($10.73; VFSTX), a short-term bond fund with a current yield of 1.6%.

DOW 30 STOCKS RANKED BY UPSIDE POTENTIAL BASED ON PAST P/E RATIOS
For all 30 stocks in the Dow Jones Industrial Average, we calculated nine target prices. Targets were generated by multiplying trailing earnings, expected current-year earnings, and expected next-year earnings by historical three-year, five-year, and 10-year norms for trailing price/earnings ratio. For Hewlett-Packard, the average of the nine price targets is $62, up 110% from current levels. A move to $62 for Hewlett would add 243 points to the Dow Jones Industrial Average. Stocks recommended for purchase are in bold.
-- Trailing Price/Earnings Ratio --
--- Per-Share Earnings ---
Target Prices Implied By Average P/Es
------- And Trailing And Expected Earnings -------
Company (Price; Ticker)
Current

3-Year
Avg.

5-Year
Avg.
10-Year
Avg.
Trailing
($)
Est.
Curr.
Year
($)
Est.
Next
Year
($)
Lowest
($)
Highest
($)
Avg. Of
All 9
Share-
Price
Targets
($)
Dow
Points
Added
With
Move
To Avg.
Share-
Price
% Chg.
To Avg.
Target
Hewlett-Packard
($29; HPQ)
6
11
13
17
4.87
4.10
4.54
44
85
62
243
110
J.P. Morgan Chase
($38; JPM)
9
18
16
15
4.47
4.70
5.35
67
96
78
303
104
Cisco Systems
($20; CSCO)
12
17
18
24
1.72
1.83
1.98
29
48
36
122
79
Alcoa ($10; AA)
15
28
21
22
0.71
0.58
0.96
12
27
18
56
71
Intel ($27; INTC)
11
14
17
23
2.55
2.54
2.76
35
62
46
145
70
American Express
($53; AXP)
13
21
19
20
4.11
4.22
4.68
77
98
86
254
64
Caterpillar
($115; CAT)
15
20
17
18
7.74
9.49
11.21
133
228
175
455
52
Bank of America
($8; BAC)
9
14
13
13
0.92
0.70
1.10
9
16
12
31
50
Microsoft
($31; MSFT)
11
12
14
22
2.76
2.70
3.01
33
67
46
112
47
Pfizer (21; PFE)
9
11
12
17
2.32
2.27
2.34
26
39
31
71
44
Boeing ($76; BA)
16
22
19
21
4.81
4.64
5.67
90
126
106
231
40
DuPont ($52; DD)
13
15
15
18
3.93
4.27
4.80
58
89
70
141
36
Merck ($38; MRK)
10
13
13
14
3.78
3.80
3.73
49
53
51
94
33
Chevron ($108; CVX)
8
10
10
12
13.44
12.81
13.45
122
158
136
211
26
Disney ($42; DIS)
16
15
15
21
2.66
2.99
3.39
40
73
52
78
25
Wal-Mart Stores
($60; WMT)
14
14
15
20
4.41
4.51
4.91
61
98
75
112
25
Exxon Mobil
($87; XOM)
10
12
12
14
8.42
8.18
9.12
97
125
108
159
24
Johnson & Johnson
($65; JNJ)
13
13
14
18
5.00
5.11
5.43
66
97
78
100
20
Coca-Cola ($69; KO)
18
18
20
22
3.85
4.08
4.47
71
97
83
105
20
3M ($88; MMM)
15
15
15
19
5.96
6.31
6.88
89
130
105
129
20
General Electric
($19; GE)
14
13
14
17
1.37
1.54
1.76
18
30
23
28
19
Procter & Gamble
($64; PG)
16
17
18
21
3.93
4.05
4.40
66
91
76
90
19
IBM ($193; IBM)
14
13
14
16
13.49
14.91
16.42
177
268
216
171
12
AT&T ($30; T)
14
13
14
16
2.20
2.36
2.54
28
40
34
25
11
United Technologies
($84; UTX)
16
14
15
16
5.29
5.74
6.67
75
106
88
33
5
McDonald's
($100; MCD)
19
17
17
17
5.28
5.73
6.34
88
111
99
(11)
(1)
Kraft Foods
($39; KFT)
18
15
16
17
2.18
2.29
2.51
33
43
38
(5)
(2)
Verizon Commun.
($38; VZ)
18
14
15
15
2.16
2.50
2.79
31
42
36
(17)
(6)
Travelers ($59; TRV)
18
10
9
14
3.25
5.74
5.96
29
84
55
(34)
(8)
Home Depot
($47; HD)
20
17
15
17
2.32
2.42
2.76
36
47
41
(45)
(13)
Average
14
15
15
18
72
113
33

 


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