By Cagdas Ozcan
General Electric (GE) is one of the biggest diversified technology and financial services corporations in the world. The company has an illustrious history of dividends, which has seen a constant increase on an annual basis. At the moment, GE pays an annual dividend of $0.76 for a dividend yield of 3.31%. In order to assess the dividend stability of the company, we have decided to use our free cash flow model for GE. In this article, we have tried to perform a deep analysis of the cash flows of the company. We also estimated the fair value of GE to see whether the stock offers a fair entry level or not.
Free Cash Flows:
Free Cash Flows
Depreciation and Amortization
Funds from Operations (FFO)
change in noncash current assets
change in noncash current liabilities
Operating Cash flows
Free Operating Cash Flow
Source: SEC filings
In the past three years, the company has experienced some volatility in its net income. At the end of 2010, GE's net income stood at just above $11.6 billion, which went up to over $14 billion by the end of 2011. However, by the end of 2012, net income again came down to $13.8 billion. The same trend is apparent in funds from operations, and the current sum stands at $23.2 billion, slightly below $23.33 billion of the last year. The cash flows from operations stand at substantially lower levels in 2012 as compared to 2010. At the end of 2010, cash flows from operations were $36.12 billion, which came down to $31.33 billion by the end of 2012. The firm has been successful in converting most of its sales into cash flows indicating high quality of earnings.
GE invests a heavy amount of funds in capital expenditures, which has been increasing in the past three years. At the end of 2010, the firm spent $9.8 billion in capital expenditures; however, by the end of 2012, the capital expenditures for GE have gone up to $15.12 billion. As a result, the free cash flows demonstrate a declining trend over the past three years. Free operating cash flows were the highest in 2010, due to high levels of cash flows from operations coupled with the lowest capital expenditures in the past three years. At the end of 2012, free cash flows stood just below $16 billion.
Funds from Operations(FFO)/Total Debt
FFO/Capital spending requirements
(Free Operating Cash Flow + Interest expense )/ Interest expense
For my analysis, I have used three ratios. FFO to total debt ratio shows that the debt of the company is adequately covered with the FFO. Most of the long-term debt comes from GE Capital, the financial arm of the company. In fact, the ratio has improved over the previous three years. The reason for an improving ratio is an increase in cash flows, and a decrease in the debt.
The second ratio indicates that one of the most important components of the firm is easily covered with the FFO of the company. Capital expenditures are a vital cash outflow for GE, and the analysis shows that the firm should be able to meet its capital spending requirements through its internally generated funds.
The last metric in the table indicates that the firm is able to meet its interest payments sufficiently. The magnitude of the last ratio shows that, despite high levels of the debt, the firm has no trouble in meeting its interest obligations. However, the interest coverage ratio has deteriorated gradually over the previous three years. GE paid $7.12 billion in cash dividends during 2012 and generated almost $16.2 billion in free cash flows. The dividends of the company are covered adequately through its free cash flows.
In order to determine the fair value of the company, I utilized two different models. The first model is based on the discounted earnings. In this model, I use a discount rate of 11%, and a five-year earnings growth estimate of 12.5% (based on Morningstar estimates). The terminal earnings growth rate is '0' based on the 5-year discounted earnings model. This terminal growth rate suggests a conservative valuation. Based on these estimates, the stock is fairly-priced between $25.8 and $38. Thus, at the current valuation, General Electric has up to 64% upside potential and is undervalued by at least 12%.
The second model utilizes a simple formula, named O-Metrix score. This score is calculated as following
O-Metrix = (Dividend Yield + EPS Growth) / (P/E Ratio) x 5
GE offers a yield of 3.31%, and is expected to grow its earnings by 12.5% over the next 5 years. As the stock has a trailing P/E ratio of 16.5, its current O-Metrix score is 5.47. This score is well above the current market average score. Therefore, we expect General Electric to outperform in the future.
What About Future?
GE stock took a beating after the financial meltdown of 2008, due to its reliance on the financial services division. However, with a dividend yield above 3%, General Electric could be a good long-term investment. I believe the stock has potential to yield significant capital gains. In addition, the dividends of the company look safe with substantial room for growth. Its dividends are well covered through free cash flows, which are increasing thanks to improved operations.
The purpose of this analysis was to gauge the ability of the company to meet its dividends in the future. According to our analysis, the company should not have any trouble meeting its interest obligations, and the debt should not pose any threat to dividends. The company has been increasing dividend payments after regular intervals, which indicates that the company is confident about the future cash flows. Free cash flows and debt metrics of the company are strong, and we believe the company will be able to maintain and increase its current dividends. The stock is also undervalued at the moment, and offers a fair entry point.