Now's The Time For Megacaps

3/7/2011


Are U.S. stocks cheap?

The typical answer to that question involves the price/earnings ratio of the S&P 500, an index that weights company values and earnings by stock-market capitalization. But because of the outsized influence of megacap stocks with the biggest market values, the cheapness of the S&P 500 Index and that of the typical U.S. stock can diverge significantly.

Today, with the largest stocks the least expensive, the S&P 500 Index is cheap relative to the average U.S. stock. For example, the S&P 500 Index trades at 14 times expected 2011 earnings — below the norm of 16 since 1956, according to Bloomberg. But the average stock in the S&P 500 trades at roughly 17 times expected 2011 earnings, and the average is nearly 20 for the more than 4,000 stocks in our Quadrix® universe.

Consider the table below, which looks at average and median valuation ratios for four sets of stocks. The median divides a set into two equal-numbered groups. For example, one-half of the stocks in the S&P SmallCap 600 Index have a trailing P/E ratio below 19.6, with one-half above 19.6. Because the median is less influenced by outliers with very high P/Es, it provides a useful alternative to the simple average.

BIGGEST STOCKS OFFER BEST VALUES
--- S&P SmallCap 600 ---
---- S&P MidCap 400 ----
-- S&P 500 (Large-Cap) --
-- Largest 50 in S&P 500 --
Average
Median
Average
Median
Average
Median
Average
Median
Trailing price/earnings ratio
Current
23.3
19.6
23.0
19.8
20.4
17.3
17.6
15.6
Norm since '94
21.2
17.7
21.2
17.8
21.1
18.2
23.0
21.0
Current premium vs. norm (%)
10
11
8
11
(3)
(5)
(24)
(26)
% of mos. w/ cheaper ratio (%)
85
71
82
88
43
36
13
13
Enterprise value/EBITDA
Current
11.6
9.4
11.3
9.5
10.8
9.5
10.4
9.6
Norm since '94
10.7
8.6
10.8
8.9
11.1
9.3
13.5
12.2
Current premium vs. norm (%)
8
9
5
7
(3)
2
(23)
(21)
% of mos. w/ cheaper ratio (%)
74
73
68
71
36
47
18
26
Price/cash flow ratio
Current
15.2
13.0
15.3
12.6
13.6
11.8
12.3
11.0
Norm since '94
13.6
11.0
13.6
11.1
13.6
11.3
16.7
14.9
Current premium vs. norm (%)
12
18
13
13
0
5
(26)
(26)
% of mos. w/ cheaper ratio (%)
77
82
88
79
43
54
13
14
Notes: All ratios based on trailing results , with negative ratios and those above 75 excluded. All comparisons based on month-end numbers since October 1994.

The enterprise ratio equals enterprise value (the value of debt and equity, less cash) divided by EBITDA (earnings before interest, taxes, depreciation, and amortization). The price/cash flow ratios below are based on the shorthand version of cash flow, in which depreciation and amortization are added to net income.

All three ratios tell a similar story: Stocks in the S&P SmallCap 600 and S&P MidCap 400 are somewhat expensive relative to the norms since 1994; the large stocks in the S&P 500 trade roughly in line with historical norms; and the 50 largest S&P 500 stocks trade at big discounts to historical norms. Among our other findings:

• Based on average and median valuations, the largest 50 stocks trade at 21% to 26% discounts to 16-year norms. Based on month-end P/E ratios, the largest 50 have been cheaper in only about 13% of the months since 1994.

• The largest 50 stocks are not only cheap relative to historical norms, they are also cheap relative to other stocks. The median P/E for the top 50 is less than 16, versus 17 for all S&P 500 stocks and nearly 20 for stocks in the S&P 600 and S&P 400. Since 1994, the largest stocks have typically traded at a premium valuation. Today, relative to the broad market, the top 50's median and average valuation ratios are near 16-year lows.

• Among the largest 50 stocks, which today have a minimum market value of about $51 billion, several high-quality names offer attractive values. Listed below are 10 Forecasts recommendations from the top 50, all of which trade at discounts relative to 10-year average P/E ratios.

MEGACAPS AT A DISCOUNT
--- Trailing P/E Ratio ---
Company (Price; Ticker)
Current
10-Year
Norm
Abbott Labs ($47; ABT)
11.2
19.7
Apple ($339; AAPL)
18.9
35.1
Exxon Mobil ($85; XOM)
13.7
14.1
Hewlett-Packard ($43; HPQ)
8.8
18.4
IBM ($162; IBM)
14.0
16.9
Intel ($22; INTC)
10.6
25.0
J.P. Morgan ($46; JPM)
11.6
15.7
Microsoft ($27; MSFT)
11.3
25.1
Oracle ($33; ORCL)
17.0
23.6
Wal-Mart ($54; WMT)
13.1
22.3

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