These 3 Dow Stocks Might be Too Richly Valued for You

Don't chase yield if it means settling for a company with substandard growth.

Jul 21, 2014 at 4:30PM

For five years, American stock market indices have marched relentlessly higher, and for the better part of those five years, financial pundits have warned that market valuations are simply too high. The key metric behind these arguments has been the Schiller P/E, or the cyclically adjusted price-to-earnings ratio -- the CAPE -- which is an attempt by Yale economist Robert Shiller to present more historically accurate marketwide valuations by dividing the S&P 500's current price by an average of the inflation-adjusted earnings of all components over the preceding 10 years.

By this measure, today's market almost certainly is overvalued. The current S&P 500 CAPE of nearly 26 looks poised to push past 2007's levels and touch heights that have only ever been reached toward the ends of the two greatest market bubbles in U.S. history:

S&P 500 Cyclically Adjusted Price-Earnings Ratio Chart

S&P 500 Cyclically Adjusted Price-Earnings Ratio data by YCharts.

But while the S&P 500 may seem overvalued on the whole, savvy investors can still find good values in less-bubbly parts of the market. The S&P's P/E, which assesses valuations on the standard trailing 12-month basis, is currently only 19.1, and many of its individual components trade at even lower valuations. Larger stocks tend to be among the best bargains, and the large cap-focused Dow Jones Industrial Average (DJINDICES:^DJI) clocks in with an aggregate P/E of just 16.7, with 19 of its 30 components boasting P/E ratios below the S&P average.

Does that mean that the Dow is actually full of cheap stocks? Not quite. Shares of large-cap stocks have historically traded at lower multiples than the shares of smaller companies with greater growth prospects. Additionally, looking only at a stock's P/E can overlook one important element of its valuation -- the change in valuations against a long-term average that can often signal a swing from bearish to bullish sentiment, or vice versa.

On this measure, the Dow almost certainly is overvalued. Only five of its 30 components sport a trailing P/E below the five-year average of their P/E ratios. Of these five, two (AT&T (NYSE:T) and Verizon (NYSE:VZ), the index's two telecom representatives) are at unusually low valuations relative to their long-term averages after recording significant one-time gains on their generally accepted accounting principles earnings. They are not actually "cheap," since both companies' more relevant trailing price-to-free-cash flow ratios are currently above their five-year averages. Two of the remaining "cheap" stocks belong to financial components, which can also suffer huge swings in earnings from time to time.

Nearly every Dow component now trades at a P/E higher than its five-year average, but three stocks stand out in particular. Only Procter & Gamble (NYSE:PG), Merck (NYSE:MRK), and UnitedHealth (NYSE:UNH) have P/E ratios that are presently over 30% higher than their five-year averages. Each case is a bit different, but all have produced similar results in that time -- share prices have been pushed relentlessly higher by rising valuations, whether earnings have actually grown rapidly (as in UnitedHealth's case) or deteriorated (as they have for Merck):

MRK Chart

MRK data by YCharts.

UnitedHealth, despite leading all Dow components with a P/E nearly 40% higher than its five-year average, is actually one of the healthiest options of all 30 blue-chip stocks. Its 15.3 P/E is lower than most of its peers, and its bottom line has grown at a faster rate than all but one other non-telecom, non-bank Dow component. Merck and P&G, on the other hand, pose cautionary examples. While investors have flocked to these dividend superstars in search of safe returns, they have had to accept subpar bottom-line growth in the bargain: Only six other Dow components (including Merck) posted weaker earnings-per-share growth than P&G over the past five years; meanwhile, none have done worse than Merck, which is the only Dow component to endure a double-digit percentage-point drop in EPS since the recession ended. There's nothing wrong with investing in a company whose valuation is growing, but it's important to make sure it's growing for the right reasons.

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Alex Planes has no position in any stocks mentioned. The Motley Fool recommends Procter & Gamble and UnitedHealth Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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