Will the Dow Benefit From These Three Stocks?

Financial Services sector component stocks Visa (V +0.17%), Goldman Sachs (GS 0.47%), and Consumer Discretionary sector component Nike (NKE 0.20%) began the week as official Dow Jones Industrial Average (DJIA) components on Monday, September 23. Sports equipment and apparel maker Nike is the only one of this trio that could be considered an "industrial." While these companies may contribute to a higher DJIA in the future, who will likely benefit the most from their addition to the Dow?

In the not so "new normal" environment for U.S. financial markets since the Great Recession of 2009, the Federal Reserve has kept short-term interest rates artificially low at near 0% to drive down the cost of capital and spur borrowing, and thus growth. The Fed's policy is intended to achieve U.S. job growth, as higher employment will foster more spending by consumers. Instead of adding to their payrolls, many U.S. corporations have instead added long-term debt at historically low interest rates to repurchase shares, thereby boosting earnings per share (EPS). Wall Street uses EPS as one metric to make recommendations to investors. Higher earnings usually translate into higher stock prices, but taking on debt to buy back shares is a low-quality source of growth.

Did our Dow trio take advantage of low interest rates? Nike added $972 million in debt over the last two years and reduced its share count by nearly 37 million shares, but its average EPS rose 11.2% year over year. Visa reduced its float by 24.8 million shares, but without the use of debt. This did not help, as Visa had average EPS declines of -51%, and -53%. Goldman reduced debt by $15.56 million to $170.6 million and repurchased 42.5 million shares. Goldman saw a huge EPS increase, from $6.70 in the previous four quarters to $16.45 in the last four quarters.

Other Dow stocks have used repurchases to bolster earnings as well, including Coca Cola (KO +0.46%) and IBM (IBM +0.39%). Coke's quarter-over-quarter revenue growth over the last eight quarters has averaged 0%, but its EPS has increased on average 3%. For its quarter ending June 28, Coke's revenue jumped 16% while EPS skyrocketed 51% from the previous quarter. Over the same two-year period, Coke repurchased 159 million shares and increased its long-term debt by $2.76 billion dollars. IBM increased its long-term debt by $2.2 billion while repurchasing 93.2 million shares. 

Revenue
Revenue is always the most important metric for stock analysis because it directly relates to demand for a company's products and services. Both Nike and Goldman Sachs EPS growth is higher than revenue, suggesting that share repurchases are effective but earnings quality suffers as a result. Visa's repurchases were not enough to make its EPS trend positive.

Source: Capital IQ.

Operations
Nike's operating margin averages a respectible 13% since 2011, and its headcount has risen from 38,000 to 48.000. Because of Visa's extremely high gross margins averaging 96% (i.e., 4% cost of goods sold), the company reported very high operating and net profit margins of 61% and 31% average over the last two years, respectively. Visa added 1,700 staff during this period. Goldman's operating margin averages around 40%, but the company decreased staff from 34,700 in 2011 to 31,700 this year. 

Cash flow
Nike's operating cash flow margin over the last 12 months (LTM) averaged 8%, and it reported operating cash flow of $1.36 billion last quarter. Nike also saw a sizable increase in free cash flow for the last quarter to $993 million. Visa's operating cash flow margin LTM has been cut in half, from 44% in the prior four quarters to 22% in last four quarters. It's free cash flow averages $1.3 billion each quarter. Goldman's average operating cash flow margin LTM dropped from 56% to 46%.

Earnings quality
Goldman exhibits much better earnings quality than Visa or Nike. When operating cash flows decline, it usually means issues with accounts receivable or payable that affect earnings quality. Visa's decline is explained by a negative net income in the fourth quarter 2012. Nike frequently reports higher net income than operating cash, and we'd like this to be reversed. Goldman reduced payables during the last four quarters by 39% but its receivables dropped only 30%, and this covers most of the operating cash flow margin decline.

Valuation
So far this yea,r our new trio of Dow components has seen excellent price performance under the Fed's fiscal policies along with share repurchases. Visa's shares have risen over 24% since the start of 2013; Goldman Sachs is up nearly 24%, and Nike's stock has climbed almost 34%. At first blush, we might conclude that adding these companies to the Dow will be a positive event, since all three stocks have performed better than the Dow's combined performance to date of 14.3%.

Source: Capital IQ.

Their valuation metrics tell an interesting story. Despite its decent 14.5% revenue increase year over year, Visa appears overvalued along all metrics. Nike is overvalued based on its P/E ratio and P/CFO. Recall that Nike's revenue was up 8.5% year over year. Goldman Sachs appears to be undervalued relative to its revenue growth, which exceeds 38%.

Foolish bottom line
Our three Dow components stand to benefit from a continuation of Fed policies as well as their placement in the DJIA, regardless of how we define an "industrial" company. Each company offers something of value regardless of your investment style. As always, Foolish readers should base investment decisions in part on earnings quality.