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The bullish sentiment on Wall Street continued without a pause last week, as the Federal Reserve added its stimulus to earlier moves from the European Central Bank and the Chinese government to try to stem Europe's financial crisis and spur economic growth. As details on the latest round of quantitative easing came out, the markets soared and kept on rising right into the weekend. The Dow Jones Industrials (INDEX: ^DJI ) gained 2% for the week and sits at five-year highs.
With the entire market going gangbusters, the few skeptics who've argued that stocks are overvalued have largely gotten drowned out in the euphoria, despite the Dow's huge run since early 2009. Yet while some Dow stocks still look reasonably priced, other stocks may well have had such amazing gains that they're looking a bit pricey.
Watching for warning signs
That's why I decided to take a look at the Dow's 30 components -- to try to identify which stocks are priced for perfection and which ones still have more room to run. Today, we'll look at the stocks that at first glance to be extremely expensive.
Probably the first Dow stocks that jump out at value-conscious investors are telecom rivals AT&T (NYSE: T ) and Verizon (NYSE: VZ ) . Sporting trailing earnings multiples between 40 and 50 and trading near multiyear highs, it'd be easy to conclude that they're priced at levels far too high to be sustainable.
The problem with drawing that conclusion, though, is that for the telecom industry, looking at GAAP earnings can be extremely misleading. Telecoms have a truly massive amount of depreciating assets on their balance sheets. For instance, as of its latest quarter, AT&T had $264 billion in property, plants, and equipment, with accumulated depreciation amounting to $156 billion. For Verizon, the corresponding numbers are $218 billion in depreciable assets and $130 billion in accumulated depreciation.
The resulting hits to net income that these companies take each and every quarter are equally massive. Just in the past quarter, Verizon took a $4.1 billion charge for depreciation, which was more than twice what it eventually posted in net income attributable to common shareholders. AT&T took a $4.5 billion hit, compared with net income of $3.9 billion.
As a result, it's better to look at other valuation measures when looking at telecoms. For instance, looking at enterprise value to earnings before income tax, depreciation, and amortization, AT&T's current level between 7 and 8 is well within the range of the past several years. Verizon's corresponding level of about 6 also fits well with its historical experience. As a result, neither AT&T nor Verizon looks nearly as overvalued as its raw P/E might suggest.
When you shift to look at multiples based on forward earnings projections, two other stocks appear at the top of the list: Alcoa (NYSE: AA ) and Home Depot (NYSE: HD ) . These two companies have essentially gone in opposite directions lately, with Home Depot rebounding strongly as an accelerating recovery in the housing market appears to be taking place, while Alcoa continues to struggle under the weight of weakness in industrial activity and dour pricing conditions in the aluminum market.
By all accounts, Alcoa needs the entire world to get its act in order. The market for aluminum is a global one, and even if QE3 brings improvement to the U.S. economy, that will only go so far to get Alcoa out of its long-term funk. Action in Europe and China to boost output will have a much greater impact on Alcoa's prospects going forward, but with S&P Capital IQ putting a forward multiple of 19 on the stock, it's already pricing in a considerable recovery for the future.
Home Depot, on the other hand, concentrates on the U.S., and it's done a good job throughout housing's downturn at keeping its share price moving higher. At 18 times forward earnings, the stock may not seem ridiculously priced. But those projections already assume a 20% jump in earnings in fiscal 2013 and an almost 15% earnings boost for the year ending January 2014. That isn't unreachable if the U.S. economy bounces back strongly, but if anything happens to rain on housing's parade, then Home Depot is vulnerable to a stock-price setback.
Don't pay too much
As you can see, relying just on raw P/E isn't enough. You also have to look deeper. With telecoms, you should look at entirely different metrics to remove the impact of depreciation. Alcoa and Home Depot, on the other hand, require better economic times to justify their valuations.
Valuation is just one aspect of a successful stock. Read The Motley Fool's special report on the Dow and find out about three Dow stocks that have great long-term potential. The report is absolutely free, so get your copy today.