Deere & Co. (NYSE:DE) had a small pop on 4th quarter (FYE 10/31) earnings, gratifying as I had just opened a position. As a cyclical, investing in Deere requires a long-term view on valuation: specifically, use of 5-year average earnings is extremely helpful in developing a realistic appraisal of the situation.
This article focuses on valuation, and then covers a brief checklist of fundamental strengths. For investors who want a full picture of the company's merits, Tim McAleenan recently presented a capable and balanced discussion.
Projected 5-Year Average EPS
Ben Graham suggested the use of 5 or 7-year average EPS as a measure of value, sometimes abbreviated as PE5 or PE7. My contribution to this procedure is to include forward earnings, to reduce the problems associated with using a backward looking metric. The resulting metric, for purposes of this article, is forward PE5.
Here's how I do the math on Deere:
With forward PE5 at 12.2, the next step is to compare that to a historical average on that metric. I develop an average for Deere of 14.8, looking back to 2003. 14.8 X $6.96 = $103 as an estimate of fair value at the end of the company's fiscal 2014 year. Here's the spreadsheet:
Typically, high quality companies trade at a multiple of 20. However, Deere is cyclical and moves to the drumbeat of agricultural markets. As such, the historical average at 14.8 reflects the reduced multiples frequently accorded to cyclical stocks.
Forward PE5 is a relatively stable metric, while Deere, with a beta of 1.5, is volatile. During six of the past seven years, it was possible to buy the company at a forward PE5 of less than 14.8. The exception was 2007. At some point during each of these seven years, the stock could be sold above the 14.8 average multiple.
Buy low and sell high will work here. Attempting to quantify high and low, the spreadsheet includes a percentile table, to give an idea of where the current share price falls on a relative basis. It's on the low side, at about the 35th percentile, by this line of thinking.
I recently changed the selection criteria on the Synthetic Dividend Growth Portfolio to include consideration of capex and accept higher beta than previously. After closing positions I consider overvalued, I added companies that have a 5-year history of increasing dividends and a two-year history of capex in excess of depreciation. I want companies that are investing in themselves on a fundamental basis.
Deere meets both tests, not that common.
- Dividend - yields 2.41%, 9 consecutive yearly increases, payout ratio is 29% on a conservative forward earnings estimate
- Buybacks - 5-year average share count decrease is 2.5% annually
- Current ratio 2.3
- Long-term debt stable at 37.2% of Total Liabilities and Equity
- Capex well in excess of Depreciation