Is the Dow Overpriced at 14K?
Robert is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
With the Dow Jones Industrial Average hitting a record high earlier this week, pundits claim conditions are eerily similar to October 2007 with excessive optimism and stretched valuations.
Really? The Dow's bull run has been driven by real earnings, not multiple expansion. Profits have grown, balance sheets are less leveraged and valuations have contracted.
Most Dow components have regained their profitability despite the depressed economic climate. These companies are operating lean by cutting costs, streamlining operations, and reducing head counts.
Most interesting has been corporate returns on equity jumping 5% since 2007. Companies have plowed profits into stock buybacks, reducing the number of shares outstanding significantly resulting in increased returns for investors.
While earnings and profitability have grown substantially for most Dow components, share prices haven't risen to reflect this.
Today, Johnson & Johnson (NYSE: JNJ) earns $16 billion in free cash flow versus $12 billion in 2007. In the past six years the company has increased iits dividend 30% and has bought back 13% of outstanding shares. Yet despite this, investors haven't recognized Johnson & Johnson's success. The stock is trading roughly in-line with its October 2007 price.
During the same time period Wal-Mart (NYSE: WMT) has managed an impressive international expansion, growing free cash flow from $4.3 billion in 2007 to $13.2 billion today. The company has increased its dividend 80% and has bought back 15% of its stock. Yet shares are trading only 40% higher.
Most Dow components are significantly less leveraged then they were at the height of the bull market in 2007. After being caught overextended during the great recession, corporations have pared down debt and are running more conservative balance sheets.
More impressive are the massive cash hordes sitting on the side-lines. For some Dow components, cash represents 10% or more of the company's market capitalization.
Cisco (NASDAQ: CSCO) is the best example of this phenomena. During 2012, the company generated $11.5 billion in operating cash flow. Yet despite paying $3.4 billion in dividends and buying back $5 billion in in stock, Cisco is still sitting on $46.4 billion in cash. This represents almost 50% of the company's market capitalization. Cisco can't pay shareholders fast enough.
Big cash holdings put a floor underneath the stock in the event of another market correction. Don't expect these greenbacks to sit the vault forever. Cash will likely be returned to shareholders in the future in the form of dividend hikes and share buybacks.
Despite higher profitability and reduced leverage, equities are trading at lower multiples compared to six years ago. At its peak in 2007, the Dow sported a 17 trailing earnings multiple. Today, the Dow is trades below 14 times earnings.
More importantly, equities are extremely cheap compared to other asset classes. Stocks have been marked down in the last decade as investors flee to the perceived safety of bonds and gold.
In 2007, a 10-year U.S. treasury bond yielded a hearty 4.7%. Today, the equivalent bond pays 1.9%; not even enough to keep up with inflation. The Dow looks inexpensive by comparison with a 6.4% free cash flow yield.
Foolish bottom line
It should be noted that the last time we saw radical monetary, investors hoarding gold, and a decade of flat equity returns we were on the eve of one of the greatest bull market in history; 1982.
Robert Baillieul has no position in any stocks mentioned. The Motley Fool recommends Cisco Systems and Johnson & Johnson. The Motley Fool owns shares of Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!