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Chemical firms are cyclical companies. Their products range from coatings to consumer electronics and fluorochemicals and are essential inputs for the construction, defense, communication and transport industries, among many others. Investors, hence, can reasonably expect chemical firms to perform best when economic conditions are buoyant and corporate as well as consumer spending is high. Given the current state of the economy and a generally still depressed earnings outlook, chemical heavyweights such as E. I. du Pont de Nemours (NYSE:DD) and Dow Chemical (NYSE:DOW) could be interesting investment options for investors who bet on the next business cycle. Investments in chemical firms, however, are not without risk as the bankruptcy of chemicals producer LyondellBasell (NYSE:LYB) has shown. Since both companies, DD and Dow, are cheaply valued and pay decent dividends, investors get their EPS growth literally for free.

E.I. du Pont de Nemours and Company is a major diversified chemicals company that produces everything from industrial chemicals, herbicides, photovoltaic products and consumer electronics to coatings. Du Pont has a market capitalization of $46 billion and is a DJIA S&P 500 company.

Du Pont growth prospects are discounted

Du Pont is amazingly diversified, operating in a variety of segments such as Industrial Bioscience, Chemicals, Materials and Pharmaceuticals, producing market leading products which are sold to clients around the world.

Du Pont trades at only 10.6x earnings while paying investors a dividend of 3.5%. Since the company generates about $3.9 billion in free cash flow, I consider the dividend to be relatively secure. Analysts expect an annual earnings growth rate of 7.66% over the next 5 years which could also translate into dividend growth providing investors with an even higher yield.

With an average 2013 EPS of $4.71 and a multiple of 15, the company should be worth about $70.65 per share (44% upside potential). I consider Du Pont undervalued based on a low risk-profile, diversified segment portfolio, convincing EPS growth and low P/E ratio.

Investors should always enter into equity investments, such as DD, with stop loss limits as the announcement of adverse economic data or volatility in the equity markets could send Du Pont shares lower at any time.

Dow Chemical is another chemicals firm, that exhibits characteristics of a conglomerate. DOW operates in a variety of segments offering products ranging from chemical processing aids, plant biotechnology, photo-lithography applications and insulation material. DOW competes with Du Pont in all segments and along the value chain, and, similarly, sells its products to clients on a global basis. The company has a market capitalization of $37 billion and is a S&P 500 constituent.

DOW is relatively cheaper than Du Pont

The stock trades very cheaply at an earnings yield of over 10% and has a P/E ratio of only 9.8. EPS growth this year stands at 19% and analysts expect earnings to increase annually by a staggering 9.6% over the next 5 years (according to Yahoo).

Simply based on market valuation, I prefer Dow over Du Pont, because of a lower P/E and higher dividend - Dow Chemical pays about 4.09%.

The 2013 EPS estimate stands at $3.20. The fair value of the shares, derived from a 15x earnings multiple, comes in at $48, providing investors with a potential 54% upside potential in DOW common stock.

Summary

At current prices, investors are under-appreciating EPS growth prospects. A better economic climate will likely spur earnings growth and give credible justification for multiple expansion as the economy enters a new bull stage. Investors who have the patience to hold on to the above mentioned stocks and wait for this thesis to play out could do very well over the long-term. Investors should consider the implementation of stop loss limits as a prolonged period of uncertainty might negatively affect the share prices of these companies. Accordingly, general economic conditions pose the biggest investment risk for investors.

Source: 2 Undervalued Chemical Companies With Up To 54% Upside Potential