It's tough to figure out what the true value of a stock is. For many of the most promising stocks in the market, by the time you find out about a company, other investors have pushed its valuations to nosebleed levels. If you just close your eyes and pay whatever the market will bear for a stock, then you'll often end up with a company that never catches up to its lofty valuation. Even when you're talking about blue-chip companies of the Dow Jones Industrials (DJINDICES: ^DJI ) , paying too much for performance can lead to some lousy investments.
Today, let's turn our attention to the Dow stocks that have the highest valuations on a price-to-earnings multiple basis, with an eye toward determining whether they'll be able to deliver the results that will back up their expensive share prices. First, though, let's look at the problem that buying a highflying stock at a premium price can cause for your portfolio.
The right company at the wrong price
Back at the end of the second millennium, and Wal-Mart (NYSE: WMT ) had enjoyed an unparalleled run of success as of late 1999. With its stock having jumped 12-fold during the amazing bull market of the 1990s, Wal-Mart had experienced huge growth in sales, profits, and dividend payouts.
But to buy the stock at that point, you had to be willing to pay a premium valuation of 58 times trailing earnings. That left the company in a terrible position to deliver the high expectations of investors who'd paid that price.
Wal-Mart actually did a good job of delivering on those expectations. Since late 1999, Wal-Mart's revenue has risen 175%, and the company has tripled its bottom-line profit. Payouts are now almost eight times bigger than they were 13 years ago. Yet since then, the stock has only provided a total return of about 20%, and it only fetches an earnings multiple of about 14. That's attractive for new investors, but if you've held the stock since 1999, Wal-Mart has largely been dead money -- and serves as a good warning for those buying stocks at peak valuations.
Are expensive stocks ever worth it?
If you never pay up for a promising stock, though, you'll miss out on some true opportunities. Despite the increased risk, you'll sometimes find high-priced stocks that are still worth it even if you have to pay more than you'd ideally like.
Looking at the five stocks with the highest earnings multiples today, you'll find several turnaround candidates in the mix. For Hewlett-Packard (NYSE: HPQ ) , the only Dow company to have negative earnings over the past 12 months, rampant pessimism about its core PC market has forced HP to revamp its entire strategy, seeking to follow other tech giants away from commoditized hardware toward higher-margin services. In the past few months, value investors have jumped into the stock, helping it recover from its huge drop of more than 60% from February to November of last year. If the company can execute on a legitimate turnaround plan, then HP definitely has potential to become a tech powerhouse again.
Similarly, Alcoa (NYSE: AA ) has had to fight a weak aluminum market for years and trades at about 50 times depressed trailing earnings. The company hasn't given up on the aluminum industry, though, and has actually pursued deals to strengthen its position at the expense of less-committed competitors. Once the global economy recovers more rapidly, Alcoa stands to benefit greatly from increased demand for aluminum in a growing construction and infrastructure-building environment.
For Bank of America (NYSE: BAC ) , P/E ratios are somewhat misleading because its current multiple of 30 includes plenty of charges for settlements with regulators and other parties over the mortgage meltdown. Now that the bank has largely put its major liabilities behind it, its earnings multiple should fall even without further share-price gains. Based on analyst estimates, the stock has a forward multiple of less than 12.
Finally, telecom giants Verizon and AT&T (NYSE: T ) weigh in with P/Es in the 40-45 range. The problem with using earnings-based valuations for telecom companies is that they fail to take proper measure of the substantial depreciation that network assets have on GAAP earnings. Moreover, AT&T took a massive one-time charge related to its failed merger with T-Mobile in 2012, skewing earnings downward even further. When you look at cash-flow-based valuation measures, both companies look much more reasonably priced.
Should you pay up?
Despite their appearance of having high prices, all of these companies have strong potential. B of A has had a huge run upward and arguably has the highest risk, but the telecoms are still reaping the benefits of their wireless networks, and both HP and Alcoa have seen shares slump enough to give them substantial upside in a recovery.
Paying up for premium stocks is part of Motley Fool co-founder David Gardner winning game plan, and with his track record of successful stock picks, David has brought great success to members of his Supernova service. Find out more by taking a personal tour of the service, which you can get now by clicking here. Don't wait, though, as this offer will end soon.