The 30 stocks within the Dow Jones Industrials (DJINDICES:^DJI) represent the cream of the crop among the giants of American industry. Yet just because those companies are well-established and solid leaders in their respective fields doesn't automatically mean their stocks are good values. Even Dow stocks can get caught up in speculative fervor that can boost their share prices well beyond fair value.
One tool many investors use to determine valuation is the earnings multiple. But before you rely solely on the ratio of price to earnings in deciding whether a stock is too expensive, you have to understand some of the factors that can make P/Es misleading. Let's look at four of the Dow stocks with the highest P/Es right now to see whether they're truly overvalued or whether other factors are at play.
2 telecom giants
Verizon (NYSE:VZ) weighs in with the highest P/E in the Dow, with shares trading at a whopping 85 times earnings. But Verizon's income statement is more complicated than most companies, as it has two major factors that affect its reporting earnings. The largest is the ongoing minority interest in earnings that it has to allocate to Vodafone's 45% minority interest in the Verizon Wireless joint venture, which had an impact of more than $10 billion over the past 12 months. Indeed, now that Verizon is buying out Vodafone's interest in Verizon Wireless, we could see substantial movement in earnings simply because the telecom will no longer have to deal with that minority-interest hit on its income statement.
But another issue hits telecoms generally: large amounts of depreciation and amortization that are largely non-cash items but which affect earnings. AT&T (NYSE:T) reported more than $18 billion in depreciation and amortization expenses over the past 12 months, helping pull its earnings down and resulting in a P/E above 26. Verizon has similar expenses of about $16 billion. AT&T is well-known for its landline legacy, and Verizon also has extensive landline assets. Those networks have largely become obsolescent, but the companies are still recognizing the money they spent to create them, even though in some cases those expenses were paid decades ago.
As a result, many telecom investors focus more on cash flow as a measure of valuation than P/E, or they prefer to back out some of the impact in evaluating earnings more fairly. Despite their high P/Es, many investors feel quite comfortable with the dividend and growth prospects for both AT&T and Verizon.
Paying for growth
Another reason to feel comfortable paying high earnings multiples for stocks is that some companies have enough growth potential to justify high valuations. Nike (NYSE:NKE) boasts a P/E of almost 25, making some reflexively decide it's overvalued. But Nike has produced impressive growth for decades, and company executives expect further revenue gains of almost 20% by its 2015 fiscal year and another 20% within the next two years after that. With almost complete command of the U.S. market for basketball footwear and apparel, Nike is largely able to define its own profit margin by wielding its pricing power over consumers. Even as the company pushes into China and other emerging markets, its hugely valuable brand allows it to charge much higher prices than those local markets would normally bear. With pushes like e-commerce also driving growth, bullish investors can make a strong case for Nike's continued success even at current earnings multiples.
The same history of outperformance applies to Home Depot (NYSE:HD), which currently carries a P/E of almost 23. It's easy to look at the home-improvement retailer as an overhyped play on the housing market's recovery, which now stands at a crossroads given the recent rise in interest rates that threatens to make home-buying much less affordable. But what many newer investors ignore is that Home Depot found ways to thrive even before the housing market recovered, appealing to the renovation and home-maintenance market as homeowners sought ways to make their existing homes more desirable rather than simply selling them and trading up to higher-value homes. With projections for further growth irrespective of homebuying activity, Home Depot also has many investors excited about its prospects.
Looking at earnings multiples is a reasonable place to start, but you can't stop your examination of a stock there. Only by looking at the full picture can you put P/Es into context and make a smart judgment of a stock's overall promise as a long-term investment.
Fool contributor Dan Caplinger has no position in any stocks mentioned. You can follow him on Twitter: @DanCaplinger. The Motley Fool recommends Home Depot and Nike and owns shares of Nike. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.