Is The Dow Overvalued? Comparing Historical Valuations With Fundamentals

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 |  Includes: CSCO, DIA, DIS, GE, INTC, MSFT, SPY
by: Investing Doc

Summary

Though historical valuations methods are valuable for estimating fair value, these methods assume P/E ratios will revert to the mean, though the vast distribution of underlying data is still unknown.

A "bottoms-up", fundamentals-based, estimate of fair value can be useful as a supplementary tool that takes into account company's current circumstances and future prospects.

Using a fundamentals-based approach, I estimate the Dow to be just slightly undervalued with a median P/FV of 0.98, though analysts' estimates suggest an additional 7% upside to current values.

It's widely accepted that our United States Congress has a lower approval rating (of about 8-10% or so) than hipsters, zombies, and hemorrhoids. What's also widely known is that our congress-critters are reelected to their office at an astonishing rate -- about 90% as of 2012. One would think that if Congress really were that hated, that sentiment would be borne out not just in the polls but also at the ballot box, but it's not. Maybe it's because -- due to any number of issues -- voters don't have any reasonable alternatives. Or maybe it's because, despite voters' disapproval of Congress at large, they actually tend to really love their own representatives. Congress, then, is hated as a whole, but, at the individual level, is actually pretty much adored. And so we keep getting the government that we may not necessarily want, but certainly deserve.

Maybe the same thing could be said about the stock market. I've read article after article on Seeking Alpha talking about how the market at large is due for a large correction and how valuations are wildly overstretched. And I see just as many articles wondering why those predicted corrections aren't happening (or at least not on the scale that many of us seem to think are warranted). Many of these articles take the tack of looking at historical PE and other relative valuations, or else rely upon technical analysis, and for the most part, these seem to indicate that indeed the markets are overvalued or operating without a significant level of support. And yet, people still seem to be bullish on stocks. What gives?

There have been many arguments made, by people way smarter than me on this stuff, that the primary reason for this has to do with the environment that we're in. That's the gerrymandering argument: you've got no alternative to stocks. Bonds are unattractive. Cash yields nothing. And this makes a lot of sense. But what if the other possibility also exists: that, at the aggregate level, people hate the market, but at the individual level, investors just love what they have? In other words, what if the market truly is acting efficiently, and reflecting underlying fundamentals?

Furthermore, are there problems with using historical valuations? As I've started learning about investing, I've read many a reference to the Shiller cycle-adjusted price-earnings ratio, and how it looks positively anemic compared to today's nose-bleed PE ratios. Is it fair to use measures like these to determine fair values for stocks today? Writing in this months' StockInvestor newsletter, Morningstar analyst Matt Coffina writes:

The Shiller P/E is far from perfect. For example, it is slow to incorporate new information, and it may penalize stocks for too long after a once-in-a-generation event such as the 2008-2009 financial crisis. More importantly, the average Shiller P/E can shift dramatically over time, which can make historical comparisons misleading. In the 100 years through 1988, the median Shiller P/E was 14.1. In the roughly 25 years since, the median has been 23.5-- two-thirds higher than the preceding century. Anyone waiting for the Shiller P/E to revert to its very-long-run historical average would have been kept out of stocks for almost the entirety of the past 25 years.

Coffina M. Morningstar StockInvestor, August 2014: Is the Stock Market Overvalued?

Experimental Protocol:

With these questions in mind, I decided to do an experiment and take a bottoms-up look at some stocks. Instead of looking just at historical valuations (which I still view as valuable), I wanted to compare historical valuations with valuations derived from my own discounted cash flow calculations using my own Monte Carlo multi-stage DCF calculator. To keep things fair, I utilized the same set of assumptions, including calculation of WACC, for each individual security. I also wanted to see how these estimates compared with market analyst consensus estimates, as gathered from public sites like Yahoo!Finance and Finviz.com. I wanted a sufficient sample size of analysts, so I had to choose widely covered stocks, and I didn't have the time to go through all 500 S&P (NYSEARCA:SPY) stocks, so I went with the venerable Dow (NYSEARCA:DIA). To derive FVEs from historical price ratios, I used an exponentially blended product of PE, PS, and PB, weighted towards the present, then inversely weighted by standard deviation over a 10-year period. I applied the result to both trailing EPS, BVPS, and revenue per share, as well as forward estimates.

I didn't really know which way this would turn out, though I suspected that historical valuations would turn out to be lower than current ones, as that seems to be the one point that everybody can agree on. The data follow:

Component Current Price DCF FVE Relative FVE Analyst Target Average Median P/FV DCF P/FV Relative P/FV Consensus P/FV SD (absolute) SD (%) SD P/FV
JPM* $56.75 $58.00 $77.00 $66.56 $67.19 0.84 0.98 0.74 0.85 $7.77 11.56% 11.67%
BA $123.16 $119.97 $163.01 $154.32 $145.76 0.84 1.03 0.76 0.80 $18.58 12.75% 14.09%
CSCO $24.43 $28.91 $31.10 $25.96 $28.66 0.85 0.85 0.79 0.94 $2.11 7.35% 7.51%
WMT $73.90 $94.99 $72.66 $80.39 $82.68 0.89 0.78 1.02 0.92 $9.26 11.20% 10.98%
PG $81.78 $107.11 $79.64 $87.18 $91.31 0.90 0.76 1.03 0.94 $11.59 12.69% 12.22%
GE $25.64 $25.49 $30.20 $29.78 $28.49 0.90 1.01 0.85 0.86 $2.13 7.48% 7.93%
UTX $105.63 $111.40 $103.19 $129.88 $114.82 0.92 0.95 1.02 0.81 $11.16 9.72% 9.46%
DD $65.25 $69.69 $73.26 $68.47 $70.47 0.93 0.94 0.89 0.95 $2.03 2.88% 2.84%
IBM $187.38 $226.06 $185.45 $194.79 $202.10 0.93 0.83 1.01 0.96 $17.37 8.59% 8.28%
CAT $105.74 $101.26 $126.22 $113.24 $113.57 0.93 1.04 0.84 0.93 $10.19 8.98% 9.06%
PFE $28.64 $27.33 $30.62 $34.08 $30.68 0.93 1.05 0.94 0.84 $2.76 8.98% 9.08%
MSFT $44.79 $47.41 $49.05 $47.00 $47.82 0.94 0.94 0.91 0.95 $0.89 1.86% 1.84%
V* 210.19 223 202 249 $221.05 0.95 0.94 1.04 0.84 $19.31 8.74% 8.43%
NKE $77.13 $85.60 $68.24 $86.08 $79.97 0.96 0.90 1.13 0.90 $8.30 10.38% 11.33%
CVX $126.10 $129.26 $126.79 $135.61 $130.55 0.97 0.98 0.99 0.93 $3.71 2.85% 2.81%
MCD $93.79 $104.15 $82.83 $102.32 $96.43 0.97 0.90 1.13 0.92 $9.65 10.01% 10.87%
JNJ $101.17 $109.94 $91.57 $108.96 $103.49 0.98 0.92 1.10 0.93 $8.44 8.16% 8.71%
AXP* $86.60 $79.92 $84.04 $98.51 $87.49 0.99 1.08 1.03 0.88 $7.97 9.11% 8.75%
TRV* $92.13 $93.00 $88.00 $96.80 $92.60 0.99 0.99 1.05 0.95 $3.60 3.89% 3.93%
KO $40.88 $46.17 $39.60 $45.21 $41.06 1.00 0.89 1.29 0.90 $6.57 16.00% 18.54%
MMM $141.92 $155.38 $119.34 $152.77 $142.49 1.00 0.91 1.19 0.93 $16.41 11.52% 12.70%
UNH $81.47 $74.75 $79.79 $90.00 $81.51 1.00 1.09 1.02 0.91 $6.34 7.78% 7.62%
XOM $99.03 $100.84 $89.38 $102.63 $97.62 1.01 0.98 1.11 0.96 $5.87 6.01% 6.29%
HD $83.69 $90.30 $69.34 $87.00 $82.21 1.02 0.93 1.21 0.96 $9.20 11.20% 12.24%
T $34.74 $33.32 $32.35 $36.18 $33.95 1.02 1.04 1.07 0.96 $1.63 4.79% 4.69%
MRK $58.61 $55.98 $53.15 $61.83 $56.98 1.03 1.05 1.10 0.95 $3.62 6.34% 6.23%
GS $171.90 $161.00 $154.00 $178.00 $164.33 1.05 1.07 1.12 0.97 $10.08 6.13% 6.00%
DIS $89.28 $88.50 $72.25 $92.86 $84.54 1.06 1.01 1.24 0.96 $8.87 10.49% 11.33%
INTC $34.17 $33.37 $28.00 $33.58 $31.65 1.08 1.02 1.22 1.02 $2.58 8.16% 8.72%
VZ $48.80 $46.21 $28.19 $54.50 $42.97 1.14 1.06 1.73 0.90 $10.99 25.57% 31.89%
Total $2,594.69 $2,728.32 $2,522.42 $2,843.49 $2,698.08 0.96 0.95 1.03 0.91 $238.97 8.95% 5.02%
Median Values 0.97 0.98 1.03 0.93
Click to enlarge

*Some DCF fair values are cribbed from Morningstar. I wasn't smart enough to figure out how to get the DCF model to work for certain companies. I confess, I'm an MD, not a CFA. I do know how to work the Intarweb, though.

Discussion of Findings:

So what do the data show me? Well, first off, there's just way too much uncertainty to drive any sort of direct actionable recommendations from this, but few patterns do stand out:

1) On average, the components of the DJIA appear to be fairly valued to modestly overvalued. My own DCF calculations, which I admit tend to be optimistic, indicate that the Dow is just a wee bit undervalued, with a P/FV estimate of 0.98. This actually looks a bit more conservative than analysts' consensus P/FV estimates of 0.93. If indeed accurate, the Dow would need to trade up by about 300 to a level of 16,900 or more to be fully fairly valued. If analysts are correct, we'd be talking about a level of rise of over 1,000 points to 17,800 for the market to be fully valued.

2) On an historical basis, though, the Dow looks mildly overvalued by about 3%, with a value of 1.03. This isn't surprising; in fact, this was an expected finding. This result suggests that the market will have some legwork to do in order to catch up to investors' current expectations even as earnings continue to grow into next year-- or, as many people have posited, that a correction is due. A correction that brought valuations back down to historical averages would imply about a 3% drop, which would be a 500 point drop to about 16,100 or so.

The following chart suggests where the DJIA would need to trade if trading at the fair values suggested by each of the aforementioned metrics.

Hypothetical DJIA levels at fair valueClick to enlarge

Source: self-produced. 10-year financial data from Morningstar; self-calculated DCF estimates. Analyst consensus estimates from Finviz.com and Yahoo!Finance.

3) There is still significant variation between individual valuations even while using historical ratios. The standard deviation of the group of historical ratio valuation is a substantial 20%. Moreover, on a relative basis, there are significant discrepancies between companies. Using PE, Verizon (NYSE:VZ) appears wildly overvalued on an historical basis; its historical blended PE comes out to 39.5, which compares favorably to a forward PE of 12.4 -- but its PB and PS ratios are usually much smaller than where they are now, 4.6 and 1.13 respectively, vs. 13.6 and 1.3 currently.

4) A few issues seem overvalued by most metrics, and a few undervalued by most metrics. Disney (NYSE:DIS) trades at a meaningful premium to my DCF estimate as well as historical ratios, and is nearly fairly valued as compared to analysts' consensus. Intel (NASDAQ:INTC) also appears to be trading well above its fair value by all 3 metrics. Meanwhile, a few companies, like Cisco (NASDAQ:CSCO), General Electric (NYSE:GE), and Microsoft (NASDAQ:MSFT) appear to be modestly to just mildly undervalued, with all 3 metrics generally agreeing with each other.

Summary:

So all in all, the market appears to be slightly undervalued currently by most metrics, but analyst data seems to suggest that most analysts are way more bullish on individual stocks than you'd think. Morningstar currently lists a Fair Value estimate for the DIA of $168.74, which is about in-line with my own estimates and suggests that the DIA is about 2% undervalued currently. Again, that looks highly conservative to analysts' consensus estimates.

It would appear, then, that all the talk of an imminent correction may be correct, and analysts may be making all the right sounds about it, but that hasn't translated into any significant change in their estimates for individual stocks. What this implies, I leave to the reader to decide. In the meantime, I will personally use the current market action to start positions in what few undervalued issues I can find, or else accumulate positions in fairly-valued, high quality companies with sustainable advantages, and a high probability of high single-digits to double digits earnings growth.

Disclosure: The author is long PG, V, MCD, KO. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

General Disclaimer: This article provides opinions and information, but does not contain recommendations or personal investment advice to any specific person for any particular purpose. The author is not a professional financial advisor. Do your own research or obtain suitable personal advice. You are responsible for your own investment decisions.