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dow wall street equities nyseDON EMMERT

The Dow Jones industrial average has outpaced the S&P 500 Index and Nasdaq composite in 2011, perhaps indicating that high-quality stocks are taking the lead in this maturing bull market. The following five Dow stocks, still undervalued on a historical basis and relative to peer investments, are safe bets as the economy strengthens. Below, the stocks are ordered by forward earnings multiple, from cheap to cheapest.

5. Chevron is an integrated oil and gas company, with exploration, production and refining operations. Chevron is still remarkably cheap, despite ranking as the best-performing Dow stock of 2011 so far, with a 19 per cent gain. It trades at a trailing earnings multiple of 11, a forward earnings multiple of 9, a book value multiple of 2.1, a sales multiple of 1.1 and a cash flow multiple of 6.9, 56 per cent, 35 per cent, 59 per cent, 55 per cent and 25 per cent discounts to oil and gas industry averages. Its PEG ratio, a measure of value relative to growth, of 0.6 demonstrates a 40 per cent discount to fair value.

Chevron's fourth-quarter net income surged 72 per cent to $5.3-billion (U.S.), or $2.64 a share, as revenue gained 9.3 per cent to nearly $50-billion. Its gross margin widened from 21 per cent to 24 per cent and its operating margin expanded from 10 per cent to 13 per cent. Chevron held $17-billion of cash and $11-billion of debt at quarter's end, for a quick ratio of 1.3, a debt-to-equity ratio of 0.1 and a net cash position of $5.6-billion. Chevron receives "buy" calls from 75 per cent of analysts in coverage, indicating optimism.

Bullish Scenario: Credit Suisse forecasts that Chevron will rise 20 per cent to $130 in 12 months.

Bearish Scenario: JPMorgan predicts that the stock will fall 14 per cent to $93 during 2011.

4. Pfizer is a global pharmaceutical company, designing, manufacturing and selling drugs. Pfizer's stock has risen 16 per cent in 2011, ranking as the third best-performing Dow stock. Yet, it remains undervalued on an absolute and comparative basis. Pfizer sells for a trailing earnings multiple of 20, a forward earnings multiple of 8.9, a book value multiple of 1.9 and a sales multiple of 2.4, 24 per cent, 15 per cent, 63 per cent and 21 per cent discounts to drug industry averages. Its PEG ratio, at 0.2, indicates an 80 per cent discount to estimated fair value, based on long-term growth estimates.

Pfizer's fourth-quarter net income more than tripled to $2.9-billion, or 36 cents a share, as revenue grew 6.3 per cent. The gross margin narrowed from 81 per cent to 80 per cent and the operating margin contracted from 21 per cent to 20 per cent. Pfizer carried $28-billion of cash and $44-billion of debt at quarter's end, for a quick ratio of 1.5 and a debt-to-equity ratio of 0.5. Of the researchers following Pfizer, 21, or 70 per cent, advocate purchasing its shares, seven suggest holding and two say to sell.

Bullish Scenario: JPMorgan ranks Pfizer "overweight", expecting a gain to $25 within 12 months.

Bearish Scenario: Citigroup rates Pfizer "hold", forecasting a marginal drop to $20.

3. Merck , like Pfizer, is a pharmaceutical company. Merck's stock has dropped 8.3 per cent in 2011, underperforming equity benchmarks. It is cheap on a relative basis and currently ranks as the third highest-yielding Dow component, with an annual payout of 4.6 per cent. Merck trades at a forward earnings multiple of 8.7, a book value multiple of 1.9, a sales multiple of 2.2 and a cash flow multiple of 9.5, 18 per cent, 62 per cent, 27 per cent and 20 per cent pharmaceutical peer discounts. Its PEG ratio of 0.1 signals a huge 90 per cent growth discount.

Merck swung to a fourth-quarter net loss of $532-million, or 17 cents a share, from a year-earlier profit of $6.5-billion, or $2.35. Revenue increased 20 per cent to $12-billion. The gross margin fell from 91 per cent to 85 per cent, but the operating margin stretched from 23 per cent to 28 per cent. Merck held $12-billion of cash and nearly $18-billion of debt at quarter's end, for a quick ratio of 1.3 and a debt-to-equity ratio of 0.3. The stock receives "buy" calls from 67 per cent of researchers in coverage.

Bullish Scenario: Credit Suisse values Merck's stock at $44, implying 33 per cent upside over 12 months.

Bearish Scenario: Jefferies rates Merck "hold", expecting a drop of roughly 10 per cent in the next year.

2. JPMorgan Chase is a diversified financial-services company. JPMorgan's stock has appreciated 9.1 per cent in 2011, outpacing the S&P 500. JPMorgan recently gained approval from federal regulators to boost its dividend from 5 cents to 25 cents. Assuming sustainability, the stock now yields 2.6 per cent, increasing in relevance to income-oriented investors. It remains undervalued, trading at a trailing earnings multiple of 12 and a forward earnings multiple of 8.4, respective discounts of 14 per cent and 24 per cent to industry averages. It's expensive based on cash flow.

The bank's fourth-quarter net income increased 47 per cent to $4.8-billion and earnings per share stretched 51 per cent to $1.12, helped by a smaller float. Revenue climbed 12 per cent to nearly $30-billion. The gross margin jumped from 60 per cent to 78 per cent and the operating margin widened from 33 per cent to 48 per cent. The bank held $272-billion of cash and $617-billion of debt at quarter's end. JPMorgan ranks as analysts' favorite Dow stock, receiving positive reviews from 84 per cent of researchers.

Bullish Scenario: Oppenheimer & Co. expects JPMorgan to rally 32 per cent to $61 over 12 months.

Bearish Scenario: Nomura forecasts a more modest climb of 8 per cent to $50 within the next year.

1. Hewlett-Packard makes computer hardware and servers. HP's stock has dropped 2.6 per cent in 2011, lagging U.S. indices. HP is the cheapest Dow dividend stock on the basis of forward earnings. It sells for a trailing earnings multiple of 11, a forward earnings multiple of 7.2, a book value multiple of 2.2, a sales multiple of 0.7 and a cash flow multiple of 7.1, 45 per cent, 49 per cent, 52 per cent, 77 per cent and 42 per cent discounts to computer and peripherals peer averages. Its PEG ratio of 0.3 indicates a 70 per cent discount to estimated fair value.

HP's fourth-quarter net income grew 16 per cent to $2.6-billion and earnings per share increased 26 per cent to $1.17, boosted by a lower share count. Revenue ascended 3.6 per cent to $32-billion. The gross margin extended from 26 per cent to 27 per cent, but the operating margin remained steady at 10 per cent. HP held $9.9-billion of cash and $20-billion of debt at quarter's end, for a quick ratio of 0.7 and a debt-to-equity ratio of 0.5. It receives "buy" ratings from 74 per cent of analysts.

Bullish Scenario: Citigroup forecasts that the stock will rise 58 per cent to $65 over the next 12 months.

Bearish Scenario: Goldman Sachs values HP at $38, suggesting 7 per cent of downside in the next year.

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