In light of recent news that GE may be looking to acquire French firm Alstrom, we are highlighting the firm's Valuentum Buying Index rating of a 9, one of the highest ratings on our stock-selection system and equivalent to a "we'd consider buying" rating. In assessing General Electric's (NYSE:GE) intrinsic value, we think there is material upside to shares. Let's review our thesis on GE and our valuation approach.
But first, a little background to help with the understanding of some of the terminology in this article. We think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.
Our process is rather simple -- we like to find stocks that we think are generally underpriced and are just starting to go up (stocks that are adored by value, growth, GARP, and momentum investors, all the same). We liken stock-selection to assessing the qualities that the judges (money managers) of a beauty contest use to select the contestant (stock) that they think will win. The contestant that is liked the most by the judges will win. In a similar respect, the stock that is soon to be liked by the most money-managers will win. We think GE is starting to gain the attention of money managers across the spectrum from value through momentum (hence, its high rating).
At the methodology's core, if a company is undervalued both on a discounted cash-flow basis and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale (it is liked by a variety of judges/money managers). As we mentioned previously, General Electric posts a Valuentum Buying Index score of 9 on our scale, which reflects our 'undervalued' DCF assessment of the firm, its attractive relative valuation versus peers, and bullish technicals. Probably to no surprise, GE is a holding in both the Best Ideas portfolio and Dividend Growth portfolio.
Our Report on General Electric
- General Electric's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively.
- GE is one of the largest and most diversified industrial and financial firms in the world--with products and services ranging from aircraft engines, power generation, water processing, and household appliances to medical imaging, business and consumer financing and industrial products.
- GE has strong liquidity, a large backlog, and major cost programs underway to deal with anything the economic environment has to throw at it. The firm has a balanced capital allocation strategy with significant cash returned to shareholders in recent years. Emerging market growth and infrastructure investments are key sources of expansion.
- Reduced reliance on GE Capital Corp (GECC) remains a sound trajectory. Not only do we think that increased transparency and potential monetization of a portion of its far-reaching financial operations is a prudent idea, but the move also frees up the executive suite to focus on driving top-notch performance at its industrial operations.
- GE boasts a very nice dividend yield, and its Dividend Cushion score is solid. The firm has paid an amazing ~$150 billion in dividends since 1970. It is one of our top ideas.
General Electric has taken a number of steps to position itself for future success, and reduced reliance on GE Capital Corp (GECC) remains a sound trajectory. Not only do we think that increased transparency and potential monetization of a portion of its far-reaching financial operations is a prudent idea (particularly given the recent lessons learned from the Financial Crisis), but the move also frees up the executive suite to focus on driving top-notch performance at its industrial operations. Clearly, we're already seeing the potential of this "new GE," and we like it very much.
GE recently reported excellent first-quarter results. One of the most important indicators of GE's industrial business potential is the trend in backlog of equipment and services. Since 2010, the trend in backlog has been ever-higher, and we like that the company posted increases in every business segment over the year-ago period. Industrial segment organic revenues jumped a better-than-expected 8% during the period, while growth market revenues advanced 7%. Equipment revenue jumped 12%. We find it quite remarkable that a company of General Electric's size is growing at a pace that is 2-3 times healthy global GDP numbers, and it posted double-digit growth in five of nine growth regions.
GE's industrial segment profits rose 12% thanks to segment margins improving 50 basis points over the prior-year period. 'Simplication' and efficiency initiatives continue to be the key margin drivers, accounting for a large portion of the profitability improvement. Excluding the 2013 NBCUniversal impact and other restructuring items, operating earnings per share increased 9% from the year-ago period. GE Capital's earnings were flat, and the division posted a solid Tier I common ratio (Basel I) of 11.4% and a strong net interest margin of 4.9%. Both of these numbers are better than some of the largest money center banks, including JP Morgan, Wells Fargo, and Citigroup. Cash from operating activities totaled $1.7 billion during the period, and the industrial giant ended the quarter with $87 billion of consolidated cash and equivalents.
GE's 2014 operating framework remains on track, and the company is expecting all key metrics for the year to move in the right direction. We're also huge fans of GE's ongoing focus on removing structural costs. Its 'simplication' goals, for example, helped to reduce industrial structural costs in the first quarter by $254 million, and the company remains on track to achieve $1 billion in savings. This is needle-moving efficiency improvement.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. General Electric's 3-year historical return on invested capital (without goodwill) is 22.4%, which is above the estimate of its cost of capital of 8.4%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. General Electric's free cash flow margin has averaged about 12.5% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information about our investment services, please visit our website at Valuentum.com. At General Electric, cash flow from operations decreased about 8% from levels registered two years ago, while capital expenditures expanded about 6% over the same time period.
Our discounted cash flow model indicates that General Electric's shares are worth between $27-$37 each. Shares are trading at $26.60 at the time of this writing. Since they fall below the low end of our fair value range, we consider the company to be undervalued on a discounted cash-flow basis. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $32 per share represents a price-to-earnings (P/E) ratio of about 21.7 times last year's earnings and an implied EV/EBITDA multiple of about 14.1 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 1.8% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -0.9%. Our model reflects a 5-year projected average operating margin of 22.3%, which is above General Electric's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.4% for the next 15 years and 3% in perpetuity. For General Electric, we use a 8.4% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $32 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for General Electric. We think the firm is attractive below $27 per share (the green line), but quite expensive above $37 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate General Electric's fair value at this point in time to be about $32 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart to the right compares the firm's current share price with the path of General Electric's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $40 per share in Year 3 represents our existing fair value per share of $32 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
GE continues to simplify its business by shedding non-core financial assets as its industrial operations fire on all cylinders. The company boasts a solid annual dividend yield of 3.4% at the time of this writing, and dividend growth investors should expect increases year-after-year. Management has learned from the Financial Crisis, and as evidenced by the coming initial public offering of its North American Retail Finance division, it's not interested in needless risk-taking for growth. We continue to expect upside in shares, and the company remains a holding in the actively-managed portfolios. In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score, as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.
Image Source: Valuentum
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
Additional disclosure: GE is included in both of Valuentum's newsletter portfolios -- the Best Ideas portfolio and Dividend Growth portfolio.