Today we will consider three companies in the Industrial Goods sector: General Electric Co. (GE), Siemens (SI) and ABB. Each of these electronics and electrical engineering companies have been competing and pushing their strategies in order to get ahead of the competition. Let us find out which company is leading among these three when it comes to an investment, and which is pushing down the Industrial Goods sector.
Deep Finance Expertise
The investment valuation on GE, SI and ABB will be based on the Pricing Model, which is prepared in a very simple and easy way to value a company for business valuation purposes. This valuation adopts the investment style of Benjamin Graham, the father of value investing. My basis of valuation is the company's last five years of financial records: the balance sheet, income statement and cash flow statement. In my valuation, first I will calculate the enterprise value because this is a great measure of the total value of a firm and is often a great starting point for negotiation of a business.
1. The Enterprise Value Approach
The enterprise value is the present value of the entire company. It measures the value of the productive assets that produced its product or services, and both the equity capital (market capitalization) and debt capital. Market capitalization is the total value of the company's equity shares. In essence, it is a company's theoretical takeover price because the buyer would have to buy all of the stock and pay off the existing debt, pocketing any remaining cash. This gives the buyer solid grounds for making an offer.
Going forward, let us walk through the table below as a summary for the calculation of the enterprise value:
The table shows the market value and the enterprise value for APC, APA and CHK, as well as their total debt and cash and cash equivalents. The enterprise value was greater than the market capitalization because it takes into account the equity capital and the debt capital.
The market capitalization for GE was increasing at an average rate of 9%, while the market capitalization for SI was erratic in movement, averaging 9%. The same is true with ABB showing erratic movement, averaging 10%. It shows that the enterprise value was greater than the market capitalization due to its total debt. The average total debt was 85%, 27% and 12% for GE, SI and ABB, respectively, while its cash and cash equivalents were 24%, 19% and 19% of the enterprise value for GE, SI and ABB, respectively. Moreover, GE was highly leveraged.
Purchasing the entire business of GE, SI and ABB, an investor will be paying 39% equity and 39% total debt, 92% equity and 8% total debt, and 100% equity and zero total debt, respectively.
The buying price for the entire business to date of this writing was $482 billion, $99 billion and $54 billion at $45.64, $113.06 and $23.46 per share for GE, SI and ABB, respectively. These are what the businesses are worth if sold today. Moreover, the market price to date was $23.04, $106.09 and $22.14 per share for GE, SI and ABB, respectively.
2. The Net Current Asset Value Approach
Benjamin Graham's Net Current Asset Value (NCAV) method is well known in the value investing community. Graham was looking for firms trading so cheap that there was little danger of falling further. The concept of this method is to identify stocks trading at a discount to the company's Net Current Asset Value per Share, specifically at two-thirds or 66% of net current asset value.
The table above shows that the market price was greater than the 66% ratio for GE, SI and ABB. The percentage of the 66% ratio against market price was 89%, 7% and 13% for GE, SI and ABB, respectively. This indicates that the price was overvalued because the stock was trading above the liquidation value of the company.
3. Benjamin Graham's Margin of Safety
The Margin of Safety is the difference between a company's value and its price. Value investing is based on the assumption that two values are attached to all companies - the market price and the company's business value or true value. Graham called it the intrinsic value. Value investing is buying with a sufficient margin of safety.
The question is, how large of a margin of safety is needed to be considered sufficient? Graham considers buying when the market price is considerably lower, a minimum of 40 percent, than the real or true value of the stock. When can we say that the margin of safety is sufficient?
Going forward, let us find out if the stocks of GE, SI and ABB can be candidates for a buy.
The average margin of safety was 0%, 29% and 46% for GE, SI and ABB, respectively. It is shown that the enterprise value was greater than the true value of the stocks of GE and SI. It indicates that the stock of GE and SI cannot be a candidate for a buy as far as the concept of Benjamin Graham's Margin of Safety is concerned. Moreover, ABB's enterprise value was less than the true value of the stock, telling us that the stock is a good candidate for a buy. This means buying a security at a discount compared to its underlying true value.
Going forward, let me show you the formula for the intrinsic value or the true value of the stock, as it factors into the calculations for the margin of safety.
The formula for intrinsic value is:
Intrinsic Value = EPS * (9 + 2G)
The explanation of the calculation of intrinsic value is as follows:
EPS -- the company's last 12-month earnings per share;
G -- the company's long-term (five years) sustainable growth estimate;
9 -- the constant, which represents the appropriate P/E ratio for a no-growth company as proposed by Graham (Graham proposed an 8.5, but I changed it to 9);
2 -- the average yield of high-grade corporate bonds.
Furthermore, here is the summary of the results of the calculations for growth:
As shown above, ABB produced a higher sustainable growth, annual growth and a return on equity than GE and SI. While SI produced a higher earnings per share at $6.58 against $1.27 for GE and $1.25 for ABB, the average payout ratio was 53%, 43% and 46% for GE, SI and ABB, respectively. This represents the percent of a company's earnings per share, which is paid out in dividends.
The Sustainable Growth Rate shows how fast a company can grow using internally generated assets and not issuing additional debt or equity. The return on equity measures the profitability of the company by the profits it generates with the money invested by common stock holders.
4. Relative Valuation Methods
The Relative Valuation Methods for valuing a stock is to compare market values of the stock to the fundamentals (earnings, book value, growth multiples, cash flow, and other metrics) of the stock.
The 'P/E*EPS' indicator determines whether the stock is undervalued or overvalued by multiplying the P/E ratio by the company's relative EPS and then comparing it to the enterprise value per share. The P/E*EPS valuation tells us that the stock was overvalued for GE because the P/E*EPS ratio was less than the market price, while, for SI and ABB, it shows that their stock prices were undervalued because the market price was less than the P/E*EPS ratio.
On the other hand, the EV/EPS valuation is used to separate price and earnings in the enterprise value. The EV/EPS valuation tells us that the price (P/E) that was separated from the enterprise value was 80% and the remaining was the earnings per share (EPS), which is at 20% for GE, while, for SI, the price (P/E) was 17% and the EPS was 83%. Lastly, for ABB, the price (P/E) was 81% and the EPS was 19%.
The EV/EBITDA valuation tells us that it will take 8, 13 and 11 times the cash earnings of GE, SI and ABB, respectively, to cover the costs of buying the entire business. In other words, it will take 8, 13 and 11 years to recover the costs of buying.
Overall, indications are that the stock price of GE was overvalued and there was zero margin of safety. SI tells us that its stock price was undervalued, but also that it has no sufficient margin of safety. On the other hand, the stock of ABB was undervalued and has a sufficient margin of safety. Therefore, I recommend a HOLD on the stock of General Electric Co. and Siemens AG ADR, while I recommend a BUY on the stock of ABB, Ltd. ADR.