Value Is Relative

11/18/2013


Just because a stock's price/earnings ratio has dipped lower than usual doesn't necessarily make it a good value. But comparing valuations to historical norms is a good starting point in the search for bargains, for at least three reasons:

Relative valuation works. The ratio of the price/earnings ratio to its five-year median has been one of the most effective Quadrix metrics for one-month holding periods over the past 10 years and among the best relative-value measures for 12-month holding periods.

IMPLIED PRICES SUGGEST STOCKS AREN'T CHEAP
Using historical norms for price/earnings ratios and trailing and estimated earnings, we calculated target stock prices nine ways for companies in the S&P 500 Index. Stocks generally appear expensive. But return potential improves when you consider future earnings. For example, using 10-year average P/E ratios and estimated next-year earnings, S&P 500 stocks have an average upside of 15.3% and 69% trade below their implied prices.
----------- Implied Prices Based On Historical Average P/E Ratios Using ------------
--- Trailing Earnings ---
Estimated Current-
------- Year EPS -------
Estimated Next-
------- Year EPS -------
3-
Year
P/E
(%)
5-
Year
P/E
(%)
10-
Year
P/E
(%)
3-
Year
P/E
(%)
5-
Year
P/E
(%)
10-
Year
P/E
(%)
3-
Year
P/E
(%)
5-
Year
P/E
(%)
10-
Year
P/E
(%)
% below
implied price
26
26
39
35
30
45
55
49
69
% above
implied price
74
75
61
65
70
55
45
51
31
                   
Average
price change
(6.4)
(8.7)
0.7
(4.0)
(7.0)
2.9
7.3
4.3
15.3
Median
price change
(9.7)
(12.5)
(4.7)
(8.0)
(10.5)
(2.0)
1.7
(0.4)
8.7

Investors often prize what's in short supply, and few stocks look cheap relative to their historical norms. Just 24% of S&P 1500 Index stocks trade below their five-year median P/E, compared to the norm of 52% since 1994. The month-end low of 21% was set in July.

Relative valuation can provide perspective on the big picture. We've calculated stocks' implied prices assuming their P/E ratios revert to historical norms and the companies meet consensus profit estimates.

INDUSTRY COMPARISON
The table shows how 24 industries stack based on nine versions of implied price change using historical P/E ratios and trailing and estimated earnings. All data represent the average stock in an S&P 500 industry group. Only two groups look cheap based on all nine ratios — technology hardware and software & services.
--------------------- Implied Price Change Based On Averagr P/E Ratios Using ---------------------
----- Trailing Earnings -----
--- Est. Current-Year EPS ---
---- Est. Next-Year EPS ----
Industry (No. Of Companies)
3-
Year
P/E
(%)
5-
Year
P/E
(%)
10-
Year
P/E
(%)
3-
Year
P/E
(%)
5-
Year
P/E
(%)
10-
Year
P/E
(%)
3-
Year
P/E
(%)
5-
Year
P/E
(%)
10-
Year
P/E
(%)

Average
Price
Change
(%)

Technology Hardware
& Equipment (22)
9
14
46
16
19
53
26
32
66
31
Telecom Services (6)
48
(9)
7
53
(6)
10
69
2
18
21
Software & Svcs. (29)
7
9
23
10
11
25
21
22
40
19
Real Estate (18)
4
9
(3)
6
7
(1)
20
22
12
8
Transportation (11)
(9)
(5)
5
(4)
0
11
10
16
28
6
Banks (14)
(9)
9
13
(10)
8
11
(6)
15
18
5
Pharmaceuticals
and Biotechnology (25)
(3)
(10)
4
3
(6)
8
16
7
21
4
Retailing (32)
(1)
(4)
1
(3)
(6)
1
13
9
17
3
Commercial &
Professional Services (12)
(7)
(7)
5
(4)
(4)
7
5
5
17
2
Health Care Equipment
& Services (30)
(6)
(8)
4
(6)
(7)
5
5
3
15
1
Semiconductors &
Semiconductor Equip. (16)
(12)
(7)
(2)
(9)
(5)
6
3
4
24
0
Energy (43)
(6)
(11)
(9)
(5)
(9)
(10)
16
11
12
(1)
Diversified Financials (28)
(10)
(14)
5
(11)
(14)
6
0
(2)
20
(2)
Automobiles & Comp. (7)
(14)
(9)
(14)
(7)
(1)
(7)
6
15
9
(2)
Consumer Services (12)
(9)
(13)
(3)
(7)
(11)
0
5
0
12
(3)
Insurance (21)
(6)
(16)
(3)
2
(11)
3
5
(7)
7
(3)
Materials (31)
(16)
(15)
(6)
(10)
(10)
(3)
3
0
11
(5)
Capital Goods (40)
(13)
(13)
(3)
(11)
(12)
(2)
(2)
(3)
7
(6)
Consumer Durables
& Apparel (16)
(13)
(15)
(9)
(10)
(14)
(6)
3
(3)
7
(7)
Utilities (31)
(4)
(13)
(7)
(6)
(13)
(7)
(1)
(8)
(2)
(7)
Food & Staples Retailing (8)
(13)
(16)
(7)
(13)
(16)
(7)
1
(3)
7
(7)
Household & Personal
Products (6)
(13)
(16)
(8)
(10)
(14)
(6)
(1)
(5)
4
(8)
Food Beverage & Tobacco (26)
(11)
(17)
(12)
(8)
(14)
(8)
1
(4)
3
(8)
Media (16)
(17)
(17)
(14)
(17)
(20)
(13)
(2)
(4)
2
(11)

Based on those criteria, two industries within the technology sector — hardware & equipment and software & services — look like particularly fertile grounds for bargain hunters, as shown in the table above. Meanwhile, retailers and banks represent attractive pockets in sectors that otherwise look pricey.

Apple ($520; AAPL) shares have risen 31% since the end of June, though they are still down 2% so far this year. The stock looks cheap at 13 times trailing earnings, a 21% discount to its five-year average. But Apple appears to be revving up the growth engine that stalled in the past year. Per-share profits, down in four straight quarters, are projected to rise 9% to $43.43 in fiscal 2014 ending September. If Apple meets the current consensus and its P/E ratio returns to the five-year average, then shares will rally 34% in the next year.

The mobile-device market still has a long runway for growth. By 2017, Apple expects the global market to support annual sales of 1.7 billion smartphones, up 70% from current levels, and 400 million tablets, up 78%. Apple took a 13% global share of smartphones in the September quarter and 30% for tablets. Apple, earning ranks of 95 for Value and 98 Overall, is a Focus List Buy and a Long-Term Buy.


Cognizant Technology Solutions ($92; CTSH) shares have rallied to a record high since the company topped consensus estimates for both per-share profits and revenue in the September quarter. Cognizant also updated its 2013 guidance, implying revenue growth of at least 21%. At the time of the announcement, the consensus projected earnings per share of $1.05, up 14% from year-ago levels, on 19% higher revenue.

Management sees improving demand for outsourcing services and strong discretionary spending for consulting. With revenue up 32% so far in 2013, Europe (18% of total sales) continues to gain strength, while U.S. health reform has led health-care payers, providers, and pharmacy-benefit managers to seek Cognizant's help to improve the quality of care and lower costs.

Cognizant scores above 80 in five of six Quadrix categories, earning an Overall rank of 98. The exception is a Value score of 60. But as shown in the table below, the stock looks to have room to run, especially given the consensus 2014 profit estimate of $4.76 per share, which calls for 18% growth. Cognizant Technology Solutions is a Focus List Buy and a Long-Term Buy.


At 15 times trailing earnings, Express Scripts ($65; ESRX) shares trade 32% below their five-year average. That looks cheap relative to its peers, with health-care-services stocks in the S&P 1500 Index averaging trailing P/E ratios of 19. The stock also trades at 0.5 times trailing sales, lower than 85% of our research universe; the price/sales ratio ranks among the very best Quadrix factors for 12-month returns over the past one- , five- , and 10-year periods.

Express Scrips has made some investors nervous by refraining from offering much insight on 2014. But the consensus expects the company to grow earnings per share 11% over the next 12 months, compared to its peer-group average of 7% growth. Yet the stock's forward P/E ratio is less than 14, a 33% discount to its peer group. Express Scripts, scoring above 90 for both sector-specific ranks, is a Buy and a Long-Term Buy.


As Mylan ($41; MYL) wraps up a sluggish year of generic-drug launches, management sees 2014 earnings per share rising 19% on 12% sales growth. That outlook implies per-share profits of $3.39, a penny above the current consensus. If management meets its 2014 profit target and the P/E ratio, currently 15, returns to its three-year average of more than 16, then shares will climb 26% over the next 15 months.

To reach that guidance, Mylan will rely on strong demand for generic drugs, a big acquisition, and share repurchases. Mylan has assured investors that it remains on track to close its $1.6 billion of Agila Specialties by the end of December; management seems confident it will resolve U.S. regulatory concerns raised in a warning letter sent to an Agila factory in India.

Mylan also announced a fresh $500 million stock-repurchase plan, enough to buy back roughly 3% of its shares. Looking farther out, Mylan expects to launch a generic version of the asthma treatment Advair by 2016 — two years ahead of its rivals. Mylan is a Focus List Buy and a Long-Term Buy.


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STOCKS WITH ROOM TO GROW
Below we present A-rated stocks that trade below their three-, five-, and 10-year average price/earnings ratios based on trailing and estimated earnings. Stocks recommended for purchase are presented in bold.
--------------- Implied Price Change Based On Average P/E Ratios Using ---------------
--- Trailing Earnings ---
Est. Current-Year EPS
--- Est. Next-Year EPS ---
-- Quadrix Scores --
Company (Price; Ticker)
3-
Year
P/E
(%)
5-
Year
P/E
(%)
10-
Year
P/E
(%)
3-
Year
P/E
(%)
5-
Year
P/E
(%)
10-
Year
P/E
(%)
3-
Year
P/E
(%)
5-
Year
P/E
(%)
10-
Year
P/E
(%)
Avg.
Price
Change
(%)
Value
Overall
Apple ($520; AAPL)
9
22
76
19
34
93
31
46
111
49
95
98
Bed Bath & Beyond
($76; BBBY)
1
2
9
6
7
14
18
20
28
12
83
95
Cisco Systems
($24; CSCO)
12
21
68
16
25
74
25
34
86
40
93
92
Cognizant Technology
($92; CTSH)
5
6
31
10
12
38
28
30
60
24
60
98
Deere ($82; DE)
22
29
44
24
30
46
13
18
33
29
93
95
EMC ($24; EMC)
51
58
85
57
64
92
78
87
119
77
93
81
Express Scripts
($65; ESRX)