Dow Stocks for Growth: "Are You Kidding Me?"

Stocks in the Dow Jones Industrial Average (INDEX: ^DJI) are a fairly safe way to invest for the long term. Most of these companies have been around a very long time and have solid track records of growth, value, or both. Previously I've written that investors would rather receive higher dividends from Dow stocks instead of capital appreciation. I have also written about "Dogs of the Dow" stocks and a strategy for achieving very good returns using a dividend reinvestment strategy.

Both discussions, however, sidestep the issue of treating Dow stocks as growth investments. Common knowledge is that growth stocks will have higher price-to-earnings ratios because their earnings are expected to grow more quickly over time. To find a suitable growth stock, the P/E should be less than the sum of the earnings growth rate and dividend yield (or just the earnings growth rate if the company does not pay a dividend). If the P/E is lower than the sum of these two metrics, then there is room for the stock price to advance higher, or vice versa if the P/E is higher than earnings growth and dividend yield.

For this commentary, I'll focus on the three highest P/E Dow stocks: AT&T (NYSE: T); Verizon Communications (NYSE: VZ), and Alcoa (NYSE: AA).

Before I continue, a word about earnings quality. All three of these stocks have experienced declines in earnings quality since January for one reason or another, as evidenced by their TMF Earnings Quality Score. Earnings quality is partly a function of price, and as price rises, the EQ score can suffer.

AT&T
AT&T has two strikes against it right off the bat, because it has the highest dividend yield and P/E ratio of any stock in the Dow. It also has a payout ratio of 254% of earnings, which means it's using operating cash (or borrowed funds) to make the dividend payouts. However, the trailing-12-month $0.69 EPS does not tell the whole story because the company experienced a loss of $1.13 for the quarter ending Dec. 31, 2011. Nonetheless, the growth in EPS ($0.60 to $2.56) equals 271% -- well beyond the P/E ratios, current or forward looking. To be fair, analysts expect earnings growth to equal 9.59% over the next five years. If AT&T maintains its dividend yield and meets earnings expectations, the forward P/E of 14.05 is lower than the sum of 9.59% EPS growth and 4.9% dividend yield (14.49%), so the stock appears to be fairly valued via this methodology.

Verizon
Verizon is the second-highest dividend-yielding stock, and also the second-highest P/E stock in the Dow behind AT&T. Much like its competitor, Verizon reported a loss for the period ending Dec. 31, 2011 of $0.71 a share, bringing its trailing-12-month EPS down significantly. So, we need to do a similar analysis on Verizon to get a normalized earnings picture. The earnings growth rate is 200% if we calcuate the difference between $0.93 and $2.79, but analysts estimate earnings growth of 10.78% over the coming five years. This combined with the 4.5% dividend equals 15.28% growth, which is slightly lower than the forward P/E of 16.02. Using this methodology, Verizon's stock price could rise slightly.

Alcoa
It's unfair to compare Alcoa with either AT&T or Verizon directly, because the latter two companies compete in the telecom sector, and Alcoa is a materials sector company. Unfortunately, due to economic circumstances, Alcoa's price is depressed, which has pushed up its P/E ratio. Earnings are estimated to advance 148.65%, from $0.37 to $0.93 by the end of 2013, so we should again look for a normalized growth estimate on which to base a decision. Analysts expect Alcoa's earnings to grow 13.13% over the next five years. The sum of 13.13% and Alcoa's dividend yield of 1.4% equals 14.53%, higher than the forward P/E of 9.39%. This would rate Alcoa as a buy using this methodology.

Foolish Takeaway
Another method to value growth stocks is to compare stock price appreciation (or depreciation) instead of earnings growth with the forward P/E. The chart below shows each stock's price advance (decline) since January to gauge if price has advanced too far, or can rise further.

AT&T and Verizon's appreciation percentages combined with their dividend yields are well ahead of their forward P/Es, which means a pullback could be warranted for both stocks. Alcoa is underpriced based on this methodology. While I dislike absurdly high dividend payouts, all three stocks have sufficient cash flow per share to support these payouts, and cash flow is perhaps why these stocks rate as highly for earnings quality as they do. I don't think these stocks' dividends are in jeopardy unless EPS or cash flow suffers in the future. Investors should always base investment decisions on earnings quality.

One of the great things about companies like AT&T or Verizon is the solid dividends they pay, but there are even better ones out there. You can read about them in our special free report: "Secure Your Future With 9 Rock-Solid Dividend Stocks." To see which dividends made the grade, click here now.