General Electric's (GE) most recent quarterly report was terrific virtually across the board. Among others, some of the highlights included industrials profit up 11%, total orders up 19% and the company's famous order backlog increasing yet again to $229 billion. After the report, analysts were quick to praise the results and offer their insights, including Citi which thinks GE could see some multiple expansion as the company gets closer to its stated goal of a 70/30 mix of earnings from the industrial business and banking business, respectively. That prompted me to take a look at what that could mean for the company's earnings multiple and the consequences for the stock over the near and medium terms; we'll take a look at what it would mean for GE shares now.
To start, GE's current forward earnings multiple, based on Yahoo! Finance's 2014 earnings data, is 14.5. This implies that GE's earnings multiple has actually already moved up fairly substantially in just the past year as GE's forward multiples used to reside in the low double-digit range. In fact, this chart, from YCharts, shows that GE's trailing PE multiple, which is a close enough proxy for this exercise, has risen close to its five-year high.
Understanding we aren't using trailing PE as the metric of choice, this chart is still very instructive as it shows GE's multiple of earnings the market is willing to pay has increased materially in just the past 18 months or so. Now, this has been well deserved as GE has been firing on all cylinders and is executing the downsizing of its banking unit just as it had promised. But the point stands; GE's multiple has already expanded a lot prior to the analyst commentary stating such following the Q3 call. So where does that leave us?
GE has a few competitors, although none of them directly compare since GE is massive in size and a hugely complicated business with many disparate components. However, I think a peer group of Honeywell (HON), United Technologies (UTX), 3M (MMM) and Siemens (SI) can offer some clues as to what GE's industrial business should be valued at.
Honeywell is a good proxy for GE's industrial business as it competes in transportation, automation and controls, performance materials and aerospace. Honeywell currently trades for 15.8 times next year's earnings and the stock is making new all-time highs almost every day.
UTX also provides industrial services, building systems and aerospace products, so it is also in similar businesses to GE. UTX shares are within a couple of points of their all-time highs also and currently trade for a forward earnings multiple of 15.7.
3M is a bit of a different company from GE but still competes in many of the same segments. These include transportation, industrials, healthcare and technology. 3M shares are also trading at all-time highs and the company's forward earnings multiple is currently 16.8.
Siemens is one of the best peers to compare GE in my view as it operates in the energy, healthcare and infrastructure businesses. SI is trading at 52-week highs and sports a forward earnings multiple of 14.1.
So to sum it up, the peer group I've selected has respective forward earnings multiples of 15.8, 15.7, 16.8 and 14.1. If we just take a simple average of these, we are left with a peer group multiple of 15.6 on next year's earnings. Recall that GE's current forward earnings multiple is 14.5 and if we simply assume GE will receive the peer group multiple, which I'd argue is more than fair, we could see GE shares move up almost 8% just because of a revaluation by the market.
There are some reasons why GE may not receive the market multiple and the main one is the company operates an enormous bank in addition to its industrial business. I'd argue the peer group selected is more representative of pure play industrials whereas GE was once a bank with an industrial business on the side. That is no longer the case as management has made a point to downsize the banking business and focus on the industrial and services business in the wake of a disastrous financial crisis. However, with GE's industrial business showing itself to be best of breed and the banking business not only downsizing but making billions of dollars in the process, GE likely deserves a premium to its peer group.
The bottom line is that even though GE has benefited from a large multiple expansion in the past year-and-a-half, there is still room to move up. In addition, GE's industrial business is the best in the world and likely deserves a premium to the company's peer group. Thus, I think we will see GE shares gradually move up to and past the peer group multiple over the next year or two as GE's bank is downsized further and the company becomes a more pure play industrial company again. A forward earnings multiple of 16 or 17 would not be out of the question and if we apply that to 2015's earnings estimates, we get a price target of $31 to $33 irrespective of any profitability improvements that materialize between now and then.