Dow Has Little Upside, Significant Downside
Summary
- Dow has had a robust recovery from its 2020 COVID lows.
- The 4.5% yield sounds good, but the payout ratio is too high.
- The Wall Street consensus outlook suggests little room for gains.
- The option-implied outlook is bearish.
- There are no obvious catalysts for further upside.
Dow Inc. (NYSE:DOW) is a commodity chemical firm with a market cap of almost $47B. The company was spun out from conglomerate DowDuPont in April of 2019. Since its listing, Dow’s stock price has been volatile, ranging from a low close of $25.69 on March 9th, 2020 to a high close of $62.73 on March 1, 2021. Most of this volatility is, of course, due to economic uncertainty and disruption relating to COVID.
The Q4 earnings (reported on January 28th, 2021) beat the consensus EPS expectation by almost 21% (EPS estimate = $0.67, actual EPS = $0.81). The share price has gained more than 12% since this earnings release. Part of this increase is probably related to the prediction that DOW will enjoy an earnings boost from higher polyethylene prices following the recent severe weather along the gulf coast.
One feature of DOW that jumps out is the 4.5% dividend yield on a forward P/E of 17.16. The high yield is initially attractive, but it is worth noting that the payout ratio based on forward earnings is 77%, which is concerningly high.
Price history and basic statistics for DOW (Source: Seeking Alpha)
Wall Street Analyst Outlook
The consensus view from the ten ranked analysts surveyed by eTrade is that the stock is a buy and the twelve-month price target is $62.88. Note that the overall rating has toggled back and forth between buy and neutral over the past year. One fewer analyst with a buy rating would push the consensus rating to neutral. There is only about 3% in potential appreciation between the current price of DOW and the twelve-month consensus price target.
Wall Street analyst consensus rating and twelve-month price target (Source: eTrade)
The Wall Street consensus outlook compiled by Seeking Alpha is neutral, with a price target of $60.44, almost identical to the current share price. The Seeking Alpha consensus is calculated from twenty analysts, thirteen of whom give the stock a neutral rating and one who is very bearish.
Wall Street analyst consensus rating and price target (Source: Seeking Alpha)
Outlook from the Options Market
Another way to generate an outlook for a stock is to analyze the prices at which options on the stock are trading. The market prices of options provide information about traders’ consensus outlook on the probability of the price going above a certain level (call options) or below a certain level (put options) over some period of time (from today until the expiration date of the options). By aggregating market prices of call and put options with the same expiration date but different payouts (different strike prices), it is possible to employ a mathematical model to calculate the implied probability of all possible future returns.
This strategy is well-established in institutional finance. For some background, see the Minneapolis Fed’s web pages on their implementation. For a review of the literature on how options prices are useful in generating outlooks in general and with examples using my version of this approach, see this presentation.
The option-implied probabilities of expected price returns are charted as a probability distribution. When I chart the option-implied probability distribution for future return, I rotate the negative side of the distribution about the vertical axis so that the relative probabilities of positive and negative returns are easier to see.
The price outlooks derived from options prices are probabilistic rather than a specific forecast of the future price. The options prices may indicate increased or decreased likelihood of gains or losses and this provides insight into the prevailing beliefs of those buying and selling options.
I used options expiring on January 21, 2022, to generate an option-implied price return outlook between now and that date.
Option-implied price return probabilities between now and January 21, 2022 (Source: author’s calculations using options prices from eTrade)
The option-implied outlook is bearish, with the single most-probable price return over the period from now until January 21, 2022 (10.6 months) of -21% (the highest probability point on the negative return line in the chart above). More significant than just this peak probability is that the probability of negative returns is higher than for positive returns of the same magnitude for almost the entire range of possible return outcomes.
The annualized volatility calculated from this distribution is 39%.
Summary
DOW recently hit its 52-week high, thanks to a solid earnings report for Q4 2020 and positive outlooks. The forward P/E seems quite reasonable, although the dividend is eating up too much of the EPS for strong future growth. This is part of why the stock gets only a C+ grade on growth from Seeking Alpha’s Factor Grades. Consistent with this concern, the Wall Street analyst consensus is that the stock is already fully priced, with little potential for increases over the next year.
The option-implied price return outlook is bearish, suggesting an elevated probability of price declines between now and early next year. Considering the high payout ratio, the stock being right at the twelve-month price target, and the bearish option-implied outlook, my final rating is bearish.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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Comments (36)
This is great news. So over the last couple of months estimates for EBITDA have gone from $6.5 billion to $10 billion and going a lot higher. EBITDA will go to at least $14 billion. DOW stock still has crazy upside. And still over 4% dividend while you wait. And buybacks will now accelerate. Safe, liquid and excellent upside.
Long Dow
Good luck to all and cheers to DOW. May she keep on rolling.
