The Clearly Undervalued Gem in the High-Flying Dow

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Financials had a good day yesterday and the Dow hit 10,000 for the first time in a year.

That's the news.

Now for the question: Will it last?

Most probable answer: No.

Some will certainly disagree. After all, we all know the adage about bull markets climbing a wall of worry. And a cursory glance at the Industrial Average does indeed suggest there is a lot of room for upside.

The Dow trades at 14.5 earnings, a little less than its five-year historical average of 16.5 times earnings. And the index has ranged as high as 21.7 times earnings in that period, a level of valuation that would, if applied equally to the Average's constituents, elevate the Blue Chip Index to 13,585 -- nearly the 14,000 level it briefly reached pre-crash, about a year ago.

But if you take the index apart and put it back together, logically examining each piece, the picture is a little less rosy. The Dow, based on historical average valuations and current 2009 EPS estimates, should end the year at 9,786.83, about a -2.3% drop from today's levels.

If that helps your index option trading, I'm glad.

But let's not stop there. Let's see what it means for the 30 individual stocks that make up the index.

The Dow is being lead by 12 stocks who are selling at historically rich valuations, notably Bank of America ( BAC ) , at 109 times trailing twelve-month earnings. The chart below shows the companies that are trading at above their five-year average earnings multiple. Company Oct. 14 Close Current P/E 5-Year P/E Average 3M ( MMM )$76.5717.416.9American Express ( AXP )$35.0919.217.0Bank of America ( BAC )$18.59109.617.0Boeing ( BA )$52.5126.820.0Caterpillar ( CAT )$54.5115.213.3Chevron ( CVX )$75.469.99.2Cisco (Nasdaq: CSCO)$24.3821.020.0Du Pont ( DD )$34.5624.216.2Exxon Mobil ( XOM )$71.8412.211.6Home Depot ( HD )$27.3816.814.4Intel (Nasdaq: INTC)$20.8324.819.4JP Morgan Chase ( JPM )$47.1630.815.6
The trick here, in my view, is not to see who's overvalued -- who not to buy -- but who has still has a chance to tack on some gains based on their likely 2009 results.

That leaves 17 potentially undervalued companies. ( Alcoa ( AA ) , which has a net loss for the past 12 months, is excluded from both lists.)

Here are those companies, sorted by relative historic undervaluation. Company Current P/E 5-Year P/E Average Discount to Historical Valuation General Electric ( GE )11.016.6-50.5%Pfizer ( PFE )7.610.7-40.6%AT&T ( T )10.413.9-33.3%Procter & Gamble ( PG )15.620.4-30.6%Verizon ( VZ )11.514.6-26.8%Merck ( MRK )10.112.8-26.5%Kraft ( KFT )14.017.6-25.7%Johnson & Johnson ( JNJ )13.316.6-24.6%Microsoft (Nasdaq: MSFT)15.218.0-18.7%Hewlett-Packard ( HPQ )12.815.2-18.0%United Technologies ( UTX )13.816.3-17.5%Wal-Mart ( WMT )14.617.1-17.5%McDonalds ( MCD )15.517.5-13.2%Disney ( DIS )16.218.1-12.0%IBM ( IBM )13.715.4-11.9%Travelers ( TRV )10.311.4-10.5%Coca-Cola ( KO )17.919.2-7.1%
General Electric ( GE ) strikes me as the clear and obvious pick from this list. The company's diverse mix of business units makes it a proxy for the overall U.S. economy. If we accept general market movement as a reasonably accurate leading indicator of the economy, then GE may well have the most to gain as conditions improve across the board, even if current valuation, historical valuation and earnings estimates point to a slight -2.3% correction to the Dow.

Below, the chart gives the 30 Dow components and their Oct. 14 closing prices and then calculates the Dow Jones Industrial Average using its current divisor. The "Fair Value" column is the result of each companies EPS estimate times its five-year average earnings multiple. The column uses an adjusted divisor -- so as to exclude Alcoa -- to suggest the index's year-end value. Company Oct. 14 Close Current P/E Average 5-Year P/E 2009 EPS Estimate "Fair Value" 3M$76.5717.416.9$4.24$71.66Alcoa$14.32NA16.0-$0.70NAAmerican Express$35.0919.217.0$1.17$19.83AT&T$25.8310.413.9$2.07$28.69Bank of America$18.59109.617.0$0.39$6.62Boeing$52.5126.820.0$1.96$39.24Caterpillar$54.5115.213.3$1.46$19.42Chevron$75.469.99.2$4.46$40.90Cisco$24.3821.020.0$1.32$26.44Coca-Cola$54.8417.919.2$3.06$58.78Du Pont$34.5624.216.2$1.83$29.70Exxon Mobil$71.8412.211.6$3.91$45.24GE$16.8411.016.6$0.98$16.24Hewlett-Packard$47.8912.815.2$3.74$56.66Home Depot$27.3816.814.4$1.51$21.74IBM$128.3513.715.4$9.77$150.16Intel$20.8324.819.4$0.97$18.77Johnson & Johnson$60.5513.316.6$4.56$75.65JP Morgan Chase$47.1630.815.6$1.83$28.55Kraft$26.2914.017.6$1.96$34.44McDonalds$57.5015.517.5$3.89$68.11Merck$32.9010.112.8$3.24$41.47Microsoft$25.9615.218.0$1.68$30.27Pfizer$17.377.610.7$1.97$21.02Procter & Gamble$57.3115.620.4$3.74$76.30Travelers$48.6610.311.4$5.24$59.63United Technologies$63.7613.816.3$4.08$66.30Verizon$28.9411.514.6$2.47$35.96Wal-Mart$50.1914.617.1$3.57$61.19Walt Disney$28.9116.218.1$1.77$32.00Subtotal1325.29  Subtotal1280.99Divisor0.132319  Adj. Divisor0.130889    Dec. 31 Oct. 14 Dow 10,015.86   Dow9,786.83


Andy Obermueller

Editor, Government-Driven Investing

Disclosure: Andy Obermueller owns shares of GE.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

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