Figuring out the real value of a stock is one of the most challenging things about learning to invest well. Too often, by the time you hear about a stock, other investors have already bid the price of the shares through the roof. If you ignore how much a stock costs and simply jump blindly onto the bandwagon, then you may well find yourself like those folks who bought LinkedIn up above $120: wondering what they were thinking. Even with blue-chip companies, paying too much for a stock can leave you with plenty of regrets.
Today, I'm going to take a look at the Dow stocks with the most expensive valuations to figure out whether they have the business prospects to back up those high valuations -- or whether they're likely to face big headwinds going forward. But first, let's look at a past example of a great company that turned out to be a lousy investment.
The right company at the wrong price
Wal-Mart (NYS: WMT) stood on top of the retail world back in late 1999. With its stock up more than 1,100% in the roaring 1990s, the company had seen 15% annual growth for five full years in both revenue and profits. Wal-Mart had also pushed its dividend up at a 19% clip between 1994 and 1999.
But unfortunately for those who were just getting in, the stock carried a premium valuation of 58 times trailing earnings. That left the company struggling to meet the high expectations that investors had for it going forward.
In large part, Wal-Mart delivered on those expectations. Since late 1999, Wal-Mart's revenue has risen 160%, and the company has tripled its bottom-line profit. Payouts are now seven times as big as what they were 12 years ago. Yet since then, the stock has barely moved, because of one thing -- the market now only gives the shares an earnings multiple of about 13. That may be low enough to be attractive to investors now, but for those who've owned the stock over the past 12 years, Wal-Mart is a prime example of how buying stocks at peak valuations can turn your investing dollars into dead money for a very long time.
Are expensive stocks ever worth it?
Nevertheless, giving up entirely on highly valued stocks would force you to miss out on some true opportunities. You have to be more careful when you consider high-priced companies, but sometimes, you'll find stocks that are still worth it even if you have to pay more than you'd ideally like.
Let's look at the five stocks from the Dow Jones Industrials (INDEX: ^DJI) with the lowest earnings multiples today.
5-Year Average Return
Current Dividend Yield
Merck (NYS: MRK)
Kraft Foods (NYS: KFT)
McDonald's (NYS: MCD)
Home Depot (NYS: HD)
Procter & Gamble (NYS: PG)
Source: S&P Capital IQ. As of Dec. 29.
These stocks have all done better than the Dow's flat performance since the end of 2006, although Merck didn't quite manage to do so when you consider dividend payments for the average. The question, though, is whether these stocks have what it takes to keep rising. Consider the stories behind these companies:
Merck investors are scared about the loss of patent protection on asthma treatment Singulair next year. But with five recently approved drugs and eight more planned for FDA consideration in 2012 and 2013, Merck is doing its best to keep its pipeline full.
Kraft shares have been premium-priced since August, when the food giant announced that it would spin off its North American grocery business to focus on its snack and candy segments. Spinoffs have been popular ways to unlock value lately, but in the end, shareholders will need to get good results from both resulting companies to justify an investment now.
McDonald's has had a string of record highs. The company that stood up to Starbucks (NAS: SBUX) with its McCafe line of coffee drinks and continues to wow investors with global growth. Some may be concerned that the stock is getting ahead of itself, however.
Home Depot has investors hopeful that a long-awaited turnaround for housing may be coming in the near future. But false alarms have disappointed shareholders before.
Procter & Gamble is the gold standard of consumer goods. But if the economy takes off, it's vulnerable to defensive investors who jump ship and move to higher-growth stocks.
Should you pay up?
Despite their being high-priced, some of these companies still look promising to me. Merck in particular should see its P/E come way down next year if analyst expectations prove correct. McDonald's also seems to have momentum on its side, which could justify its high valuation. But for P&G, Home Depot, and especially Kraft, I'd rather see what happens in the next few months before I'd commit to taking action.
If that leaves you without promising buy candidates, though, don't fear. I happen to know one stock that's outside the Dow but has some huge potential. Read all about it in our brand-new free report: "The Motley Fool's Top Stock for 2012." But let me suggest that you not wait long -- grab your copy today before it's gone.
At the time thisarticle was published Fool contributorDan Caplingeroccasionally pays up for the good stuff, but it's pretty rare. You can follow him onTwitter. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Starbucks and Wal-Mart.Motley Fool newsletter serviceshave recommended buying shares of Starbucks, Home Depot, Procter & Gamble, Wal-Mart, and McDonald's, as well as creating a diagonal call position on Wal-Mart. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Fool'sdisclosure policyalways has the right price.
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