INDEX INTELLIGENCE: DJX—A Fundamental Look at the Dow
optionetics.com
By Frederic Ruffy, Optionetics.com
4/9/2003 3:00:00 PM
The Dow Jones Industrial Average ($INDU) surged to start trading this week on signs that US-led coalition forces were set to takeover Baghdad and perhaps declare a military victory. Prior to the rally, stocks had performed relatively well on hopes that the end of war would lift a significant economic burden that had been weighing on investor sentiment. However, while the end to the war may help boost the economy, it might eventually lead the focus of attention away from geopolitical events and back at fundamentals. In that respect, investors might not have as many reasons to cheer because a look at the valuations at many of America’s largest companies reveals that many stocks today are still not cheap.
The Dow Jones Industrial Average consists of thirty well-known US corporations. The full list is included in the table below. Currently, twenty-nine of the thirty companies are actually profitable. Only Hewlett-Packard (HPQ) has failed to deliver profits. Notice that it is the only Dow company with a negative price-to-earnings (P/E) ratio. The average P/E ratio of the other components is 21.00.
Is a P/E ratio of 21.00 high or low? Well, the price to earnings ratio is generally a function of growth rates. That is, when a company is growing earnings rapidly, it will command a higher price-to-earnings ratio when compared to a company with a slow rate of earnings growth. Therefore, when looking at valuations, it is important to consider the P/E ratio only in relationship to growth rates.
Dow Component
Symbol
Price-to-Earnings Ratio
2003-2004 Earnings Growth Rate (%)
PEG
Alcoa Inc.
AA
36.0
49.56
0.73
Amer. Express
AXP
17.1
11.11
1.54
Boeing
BA
9.6
7.54
1.27
Citigroup Inc.
C
12.7
11.38
1.12
Caterpillar Inc.
CAT
22.6
54.19
0.42
Du Pont
DD
21.4
33.52
0.64
Disney (Walt)
DIS
31.2
32.31
0.97
Eastman Kodak
EK
11.6
6.64
1.75
Gen'l Electric
GE
17.9
9.26
1.93
Gen'l Motors
GM
10.2
14.94
0.68
Home Depot
HD
16.5
14.88
1.11
Honeywell Int'l
HON
11.2
22.09
0.51
Hewlett-Packard
HPQ
neg
22.88
nm
Int'l Business Mach.
IBM
25.9
13.66
1.90
Intel Corp.
INTC
35.9
33.90
1.06
Int'l Paper
IP
56.0
108.59
0.52
Johnson & Johnson
JNJ
26.3
13.36
1.97
Morgan (J.P.) Chase
JPM
31.7
24.07
1.32
Coca-Cola
KO
26.1
10.38
2.51
McDonald's Corp.
MCD
20.1
3.76
5.35
Minnesota Mining
MMM
26.1
12.63
2.07
Philip Morris
MO
5.8
8.66
0.67
Merck & Co.
MRK
17.6
9.73
1.81
Microsoft Corp.
MSFT
28.1
5.88
4.78
Procter & Gamble
PG
21.1
9.85
2.14
SBC Communications
SBC
9.6
4.88
1.97
AT&T Corp.
T
11.5
-20.97
-0.55
United Technologies
UTX
13.2
8.09
1.63
Wal-Mart Stores
WMT
29.8
14.29
2.09
Exxon Mobil Corp.
XOM
20.6
-6.22
-3.31
The most common way of comparing P/E ratios to growth rates is with the price-to-earnings-growth rate, or PEG, formula. It is computed by dividing the company’s P/E ratio by its earnings growth rate. For example, if XYZ is trading at a price to earnings ratio of 50 and the earnings growth rate of the company is 25%, the PEG ratio equals 2.00 (50/25). Generally, when companies are trading at P/E ratios well below their growth rates, the stock is considered undervalued. In the case of XYZ, the PEG ratio of 2 suggests overvaluation.
The table above shows the expected earnings growth rates for the thirty Dow stocks for 2003 and 2004. Two of the companies, AT&T (T) and Exxon Mobile (XOM), are expected to see earnings declines during that period. The remaining twenty-eight companies are expected to see average earnings growth of 20.4%. Therefore, based on analyst (polled by First Call) estimates, the earnings growth rate is very close to the price-to-earnings ratio. However, the average PEG ratio (excluding HPQ, XOM, and T) is relatively high. The average PEG ratio is 1.65 and suggests that many of the components of the Dow are, on average, still overvalued.
Looking over the individual components of the Dow reveals an important aspect of today’s market. Namely, there seems to be a wide disparity among individual stocks in terms of valuation. There are a large number of stocks that appear undervalued using various metrics like the PEG formula, and a large number that seem overvalued. In other words, the terms “undervalued” and “overvalued” might not be suitable terms when discussing the market as a whole. Instead, traders might want to take a sector or stock-specific approach, and analyze each company based on their own specific fundamentals.
Frederic Ruffy
Senior Writer & Index Strategist
Optionetics.com ~ Your Options Education Site
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