Friday, July 20, 2012

Where Is the Value in Many Widely Held U.S. Stocks?

Starting price matters in an investment's subsequent return.  We've heard so much for so long about the virtues of stocks that pay significant dividends (including from me).  But starting price does matter, and new buyers of many U.S. stocks will not be getting a good value.  This will impede their future returns.

Take, for example, one of the most widely held dividend stocks, Verizon.  Not long ago, Verizon's dividend yield was 5.5%, which looked very good against other stocks and fixed-income alternatives.  But it now looks to me that it should be swapped into a better a different stock that offers better value.

After the 24% rise in the stock in the last year, the dividend yield on Verizon is now 4.4%.  This still looks good compared to many others stocks, and especially when compared with the 1.5% yield on a 10-year U.S. Treasury note or the 3% on a typcial intermediate-term, investment-grade bond mutual fund.  But the $.50 quarterly dividend comprises 80% of Verizon's estimated earnings per share for 2012.  This is extraordinarily high.  If the payout ratio were closer to 50% of earnings for a mature company such as Verizon, I would be more comfortable.

How is the stock's valuation?  Based on the company's earnings, the valuation is extraordinarily poor.  The stock now sells for 18 times estimated earnings per share for 2012.  Such a high valuation either implies that investors expect a rebound from temporarily depressed earnings or sustainable, significant earnings growth.  Neither seems likely, as Verizon's earnings are only slightly higher than they were three years ago.  I would much prefer buying a stock like this at a price/earnings ratio between 10 and 13.

How is the financial condition?  It, too, is poor.  The ratio of debt to shareholders' equity is 120%, which is high but manageable.  However, the company's pension fund is underfunded by an estimated $32 billion.  When this is added to the debt, the adjusted ratio of debt to equity is 218%.  Furthermore, though the company has a positive net worth of assets minus liabilities when including goodwill and other intangible assets, its tangible net worth is much worse.  When deducting the intangible assets, the tangible net worth (book value) of the company is negative.  The (intangible) Verizon brand name surely has considerable value, but is it worth nearly three times the tangible net assets of the company? 

Verizon isn't unusual in its lack of value.  Similarly, Coca-Cola reported roughly flat earnings growth for its latest quarter, but the stock sells for 19 times estimated 2012 earnings.  Its dividend yield is 2.6%.  Another market leader, Home Depot, not long ago offered good value at about 12 times earnings with a dividend yield of 3%.  But the stock has risen 41% over the last year, and it now sells for more than 17 times earnings and yields 2.3%.  I see little value at its current level.

Again, starting price matters in an investment's subsequent return.

With valuations of many of the most widely held stock now at 15-20 times earnings and their share prices up 20% or more over the past year, I advise general caution toward U.S. stocks.  Cash, which so many investors disdain, provides the means with which to take advantage of better buys in the stock market in the days ahead.

Steve Lehman

S & P 500:  1377

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