Everything is relative, especially market valuation.
A utility, for instance, with its steady, slow-growth business, is never going to command the earnings multiple of a rapidly growing biotech firm or high-tech upstart. That's why it's best to make valuation comparisons within industries.
It's also reasonable to evaluate a company against an index. For instance, the composite earnings multiple -- that is, the P/E ratio -- of the 30 stocks that make up the blue-chip Dow Jones Industrial Average is 11.6.
In other words, the combined market capitalization of these companies is 11.6 times the profits they have generated in the past 12 months. Or you could say that a dollar of earnings costs $11.60.
It doesn't make much sense to compare the Dow to anything other than its past performance. The Dow is now at about 8,700, far from its late-2008 peak near 14,000. That means the prices that factor into that market cap have fallen. That's been offset by an overall declined in earnings since the Great Recession began. Both of those things have affected the aggregate valuation of the index, which is now -23.4% lower than it was two years ago, when the Dow's P/E was 15.18.
If a Dow company's valuation relative to its earnings has fallen by more than the Dow, that suggests upside potential. Earnings and prices are likely to return to their historical norms.
Here's a look at the Dow, excluding Alcoa, which has posted a net loss for the past 12 months and, as such, has no earnings multiple. Note that only stocks that are undervalued to their typical valuation are included in the table.
|Company (Ticker)||Current P/E||Historical P/E||% Undervalued|
|General Electric (NYSE: GE)||7.05||12.36||-43.0%|
The most undervalued company is General Electric (NYSE: GE). The Connecticut-based conglomerate, given its reach of its business units, is a proxy for the American economy. It's a strong long-term buy for three reasons:
GE not only has a diverse product lineup, but many of its offerings are in line with key administration policies for clean energy, digital medical records and upgrading the nation's electric grid. Washington is committing hundreds of billions to these areas, and GE is the No. 1 or No. 2 player in each.
The company can be expected to deliver profts of between $1.92 and $2.26 a share in a good economy, earning about a 10% net profit margin. Though its take for the first two quarters is about half its typical results, that's because of broader economic concerns, not any significant problems with GE. Buy GE for the next two years. Don't overlook it because of the past two quarters.
GE has a history of managerial excellence. Jeffrey Immelt may not have the star power of Neutron Jack Welch, but he's been a steady hand during turbulent times. There are two reason Warren Buffett invests: A good business and management he trusts. GE has both. And not only is Buffett a shareholder, he also lent the company $3 billion by purchasing $3 billion worth of preferred shares in October 2008.
On top of those three reasons, GE has historically paid a modest dividend (currently a little more than 3%). You don't even need a broker: Investors can buy shares direct. The account requires an initial investment of $250 and allows for additional purchases of as little as $50, which can be automatically deducted from a checking account.