General Electric (GE) has been on an impressive run since late 2011, moving up roughly 65%, which currently leaves the stock near multi-year highs. There is at least one metric, however, that suggests that GE's run may not be done. GE's price to book multiple has been steadily creeping up since the financial crisis from under 1 to a current value of about 1.9. This has been occurring at the same time that a little known actuarial calculation has been serving to deteriorate GE's book value each year since the financial crisis. The calculation has nothing to do with GE's business lines, revenues, profits or anything else commonly associated with generating book value. Instead, GE's pension program it offers to employees has been suffering actuarial losses for several years since the financial crisis as a result of the zero interest rate policy environment in which we live. This article will take a look at its effect on GE's balance sheet and what may happen when ZIRP is finally lifted.
To understand what has been happening to GE's book value as a result of the pension program, you must first understand how the calculation works and what it represents. GE, and any other company with a defined benefit program, must report its Projected Benefit Obligation, or PBO, which, in rough terms, means the amount of money the company calculates will be owed to its employees upon retirement given certain assumptions including average years of service, salary growth, and the one we are most interested in, the discount rate. GE must discount its PBO, which is a liability, by whatever discount rate it deems reasonable in order to account for the time value of money. As we will see, since the Federal Reserve began its assault on high interest rates, GE's discount rate applied to its PBO has been steadily falling. The effect this has is to inflate the value of the PBO, dwarfing the plan assets GE has set aside to pay for the PBO, and creating a liability on the balance sheet. This liability then serves to decrease book value.
This table, with data pulled from GE's 10-Ks, shows the discount rate GE has used to calculate its PBO annually, the value of the PBO in millions of dollars, and the actuarial loss incurred primarily as a result of a progressively lower discount rate, also in millions of dollars.
What we see from this table is interesting. First, GE's PBO was calculated to be roughly $45 billion in 2008 but at the end of last year, that number had inflated to $63.5 billion. This means that GE's balance sheet, as a result of the PBO, had increased liabilities of $18.5 billion. This is a substantial hit to book value as we know that GE's book value is currently about $128 billion. Of course, the PBO is offset by the plan assets GE has set aside to invest and eventually pay benefits to its employees when they retire and those assets amounted to $44.7 billion at the end of 2012. This means that GE's pension plan is currently underfunded by about $18.8 billion. The result of this predicament is a liability on GE's balance sheet of $18.8 billion, decreasing book value as the company's liabilities have increased with no corresponding asset or shareholders' equity increase.
The point of all of this was to show what will happen once ZIRP becomes a memory and GE begins to use a more "normal" discount rate to calculate its PBO again. Of course, nobody knows for sure when that will happen but we do know that it will at some point. Regardless, we can calculate from the table above that GE has added $13.75 billion in liabilities simply due to interest rate adjustments. If you don't believe me, this is what the 10-Ks say; management admits substantially all of the actuarial losses are due to falling discount rates. The upside of this is that once discount rates begin to rise again, GE will recognize windfall actuarial gains, boosting book value.
If GE only reverses the $13.75 billion actuarial losses incurred since 2008, applying GE's current price to book multiple of 1.9 implies that GE's market cap could see a boost of up to $26 billion over time, simply from book value readjustment. Additionally, GE's pension fund could potentially go from being a liability on its balance sheet to an asset if plan assets begin to exceed the PBO. This could happen if GE contributes more money to its pension assets, if the discount rate used to calculate the PBO begins to rise again, or a combination of the two. Another benefit of the PBO declining due to a higher discount rate is that GE doesn't actually have to make a cash outlay for this to happen. If GE decides to contribute to its pension assets, it has to actually transfer cash into the plan assets; with the discount rate rising and reducing the value of the PBO, GE doesn't have to use any cash at all but still gets to reap the benefits of a decreased liability on its balance sheet.
While the actual value of the PBO adjusting to a more moderate and realistic discount rate in the future is difficult to quantify right now, we can take an educated guess using historical and current information. If GE's price to book multiple holds at 1.9 or greater in the future and GE's PBO does reduce to the point where plan assets once again cover it, we could see an adjustment in GE's share price upward as book value investors see GE getting progressively cheaper by that metric. With GE's PBO discount rate at the lowest that I could find on record, now is the time to take advantage and pick up shares that are already cheap on a historical price to book basis and look to be getting even more so when interest rates moderate in the future.
With indexes at or near all-time highs, it might be prudent to wait for a broad pullback before adding to your position or initiating a new position in GE. However, we have seen here that GE's pension has the ability to become a good thing for shareholders in the medium term as the ludicrous discount rate that is used to calculate it currently moderates and potentially provides shareholders with a valuation-based upward adjustment.