GE's Valuation: Is It A Buy As A Bank Or As An Industrial Giant?

| About: General Electric (GE)

General Electric (NYSE:GE) is a multinational conglomerate, operating in four segments: Energy, Technology Infrastructure, Capital Finance and Consumer & Industrial. So, GE is a combination of a massive industrial conglomerate and a major bank, the GE Capital Corp., which still generates over 33% of sales and more than 40% of profits. However, the company aims to gradually ecrease GE Capital's share on profits to 30%, and deploy the cash it extracts to accelerate growth in its industrial businesses and return more cash to the shareholders through buyback and dividends.

First, let's explore some of GE's most pressing current issues, and then we will dive into how to calculate the fair price-to-earnings ratio of GE to determine whether it is a good long-term value investment at its current price.

Issues with GE

Having a bank as part of its business generates many specific issues for GE and its investors. For the company, it causes GE serious problems in terms of risk management and also in terms of the stock's attractiveness for investors.

For the long-term value investors, the main issues are how to fairly value GE as a whole, as well as its industrial and banking parts, and what risks the banking arm poses to the company.

For the dividend growth investors, the sharp dividend cut illustrates the pains of how the banking part weighted on GE's financial position and reputation during the 2008-2009 financial crisis.

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Besides these issues, many long-time GE investors also have a historical aversion toward GE's CEO Jeff Immelt due to GE's stock price and dividend still being substantially lower than at the heights of 2007, also expressed through a class action lawsuit for misleading investors in 2008.

Banking business risk

GE's ownership of GE Capital Corporation puts a major obstacle in the way of a straightforward valuation of GE's total business, because most investors value banks and industrial conglomerates very differently and assign a different fair price-to-earnings ratio and a very different risk to these two disparate types of businesses, with industrial conglomerates generally trading at much higher valuations than banks.

Even if the financial arm amounts to just 30% of profits in the future, it still makes GE a more volatile and riskier stock compared to other large-cap dividend-paying stocks, because if the financial arm gets in trouble, it could not only contribute zero profit or a loss, but if it really got into trouble, it could incur a loss amounting to multiples of its asset value due to being leveraged like every bank. And, if GE group wanted to keep it and not let it go bankrupt (for example, to keep its reputation, or to keep the business for future profits), it could be liable to pay more than the entire GE group can afford.

So unlike in the case of pure banks, where they simply go bankrupt and the owners lose whatever money they put in, but they don't need to pay anything more, in the case of GE, the entire GE equity could be at risk.

Essentially, the banking business downsizing will just decrease positive effects of the higher-than-average profit margins, while higher volatility and risks of a total capital loss will prevail, even though they will be slightly lower.

Deconstructing GE's overall valuation

The current total forward P/E of GE is 12.81. If we are willing to assign a forward P/E of just 9 to the banking business (10 being the average valuation most big banks trade at) knocking off 1 from the P/E due to GE's plans to downsize its banking business, which will result in falling earnings in the future, the calculations reveal that the current GE price assigns a forward P/E of 15.35 to the non-banking business of GE. (Calculation: 0.4x9+0.6x?=1x12.81; therefore 0.6x=12.81-0.4x9=9.21; hence ?=15.35).

So, if investors are willing to assign the GE Capital financial arm a forward P/E of 9, then at current GE stock price, they are paying a 15.35 forward P/E multiple for the non-banking business of GE.

If we compare this figure with its Industrial goods/Diversified machinery peers, such as Siemens (SI), United Technologies (NYSE:UTX), Honeywell (NYSE:HON), Danaher (NYSE:DHR) and Illinois Tool Works (NYSE:ITW), we see that GE is not a bargain, although it's not trading anywhere near an overvalued territory, either. But, there are better options in terms of P/E in the group at the moment, such as Siemens, pressured by having headquarters and part of its sales in the EU, or United Technologies.

Company Forward P/E
GE non-banking part 15.35
Siemens 10.77
United Technologies 13.4
Honeywell 13.89
Danaher 15.91
Illinois Tool Works 14.85

Naturally, if some investors have a different opinion about what valuation should be assigned to GE's banking part, this will change the valuation of the non-banking business. The lower the banking part P/E, the higher the non-banking part P/E. For example, if the banking business was priced at a corresponding forward P/E ratio of 8, the forward P/E of the non-banking divisions would be 16, and if the banking business is priced at forward P/E of, say, 11, GE's non-banking forward P/E would show as 14.

As a side note, it is interesting that the 3D systems company (NYSE:DDD) is listed in the same group of Diversified tools companies as GE. Obviously, we would not expect a growth stock like 3D to trade at similarly low P/E valuations as GE.

Key takeaways

When we look at GE's banking and non-banking businesses separately, and estimate a fair value of its banking business at a corresponding forward P/E ratio of 9, we see that GE's non-banking business currently trades at a forward P/E of 15.35. This figure alone is at the higher end of the range where its industry peers trade.

Moreover, considering the fact that GE is currently extracting extraordinarily high amounts of cash from its banking business to downsize it, it is reasonable to expect slower earnings growth and dividend increase once this bank-downsizing phase is finished in a few years.

Furthermore, GE's downsizing of the banking unit to 30% of profits will not eliminate the risk of the entire company bleeding cash due to problems solely in its banking business. Rather, the downsizing will just decrease the positive impact of above-average banking profit margins on the overall GE conglomerate.

A complete spin-off of GE's banking business would be a more interesting option for shareholders, as it would unlock the stock to additional long-term dividend growth investors and investment funds who were reluctant until now to invest in GE due to its more volatile banking sector exposure.

GE is definitely not overpriced. However, there are other companies with either a much more interesting price and slightly higher risks, such as Siemens, or companies with similar risks and same or better growth prospects that trade at lower valuations, such as United Technologies or Honeywell.

Lastly, for investors looking for a bank, I recommend Wells Fargo (NYSE:WFC), which generated a total return of 8.15% in the past ten years; or, an insurance business such as Travelers (NYSE:TRV) that is a member of the DJIA returning 11.15% on average over the past decade, could be a smart choice. For those searching for an industrial conglomerate, I recommend another DJIA company - 3M (NYSE:MMM), which I wrote about, but Siemens or United Technologies could also be an interesting choice.

Disclosure: I am long WFC, MMM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.