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 stockmarket 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 QuadrixÂ® 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 equalnumbered groups. For example, onehalf of the stocks in the S&P SmallCap 600 Index have a trailing P/E ratio below 19.6, with onehalf 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.

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 16year norms. Based on monthend 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 16year lows.
• Among the largest 50 stocks, which today have a minimum market value of about $51 billion, several highquality names offer attractive values. Listed below are 10 Forecasts recommendations from the top 50, all of which trade at discounts relative to 10year average P/E ratios.
MEGACAPS AT A DISCOUNT 

 Trailing P/E Ratio 


Company (Price; Ticker) 
Current 
10Year Norm 
Abbott Labs ($47; ABT) 
11.2 
19.7 
Apple ($339; AAPL) 
18.9 
35.1 
Exxon Mobil ($85; XOM) 
13.7 
14.1 
HewlettPackard ($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 
WalMart ($54; WMT) 
13.1 
22.3 