The share price of General Electric (NYSE:GE) has gained 12% over the past 12 months, which is fairly in line with a 13% return for the S&P 500 Index. At ~$26, I believe investors should consider adding positions, as there is a fair level of safety margin on the share valuation and dividend growth prospects continue to look bright.
From a relative perspective, GE now trades at 14.4x forward 2015 P/E multiple, which is 2% below the same multiple of S&P 500 at 14.7x (see chart below). I view this relative valuation level to be attractive because 1) GE's current consensus long-term EPS growth estimate at 8.9% is fairly close to the average growth estimate of 9.0% for S&P 500 companies; 2) the stock offers a 3.3% dividend yield, which is notably above S&P 500's average at just 1.9%; and 3) GE management is committed to return capital to shareholders, and has repurchased $9.9B value of shares over past 4 quarters, in addition to dividend payout. In fact, GE's forward P/E traded at an average of 4% premium above that of S&P 500 in the past 10 years.
On an absolute basis, GE's valuation also looks very reasonable. Based on a current annualized dividend of $0.88 per share and 11.5% cost of equity (supported by the CAPM model, which uses 3% risk-free rate, 6% equity risk premium, and GE's 5-year beta of 1.4), the Gordon growth dividend discount model suggests that the current share price of ~$26 implies a dividend growth rate of approximately 8.0% (see chart below).
Now the question is whether GE has the capacity to support that level of dividend growth going forward. Looking at current consensus estimates, the market now expects GE's free cash flow to rise from $12B-$14B in 2014 to $16B-$18B in 2016. Based on total dividend payment of $7.8B in 2013, annual dividend payment would need to reach about $11B in order to achieve a 10% dividend growth. Given that GE's future free cash flows significantly exceed the dividend commitment, I expect the annual 8% dividend growth is completely achievable and even conservative. It is noted that the cash surplus after paying dividend can be used for cash acquisitions and share buybacks. Assuming no changes in my annual dividend payment assumptions ($11B by 2016), actual growth in dividend per share would be greater than 10%, owing to lower share count as a result of the buyback. As such, GE's valuation appears very secured from a dividend income perspective.
Looking at the historical trend of GE's dividend yield, the yield rarely exceeded 3.8% in the past 5 years (see chart below). Assuming an investor buys the shares now and quarterly dividend will grow by 8% from $0.22 to $0.24 per share in the next dividend cycle, the share price will need to drop to ~$25 in order for the dividend yield to climb to 3.8% within one year. At this level, I believe GE's high yield would attract a large demand, and thus, share price should stabilize at that level. As such, the investor who holds the shares would incur a total loss of just 2.5%, after factoring in the 3.3% dividend income throughout the 1-year holding period, implying a solid margin of safety on the share price.
In terms of fundamentals, GE's recent development has been very positive. The company recently announced a binding offer to acquire a few energy assets from Alstom (OTCPK:ALSMY) for $16.9B. I view this transaction to be a long-term positive given that 1) acquisition price at 0.7x trailing 12-month revenue does not seem very expensive; 2) the integration of Alstom's energy assets will accelerate GE's portfolio transformation by adding scale in new power generation businesses; and 3) the deal is expected to have immediate accretive impact by adding an incremental EPS ranging from $0.04 to $0.06. The transaction is expected to close in 2015, and the main risks in the process are due to potential competing offers and government rejection.
In conclusion, given GE's robust free cash flows and secured dividend prospects, I believe a floor for the share price would be at around $24, which implies conservative assumptions, including 8% dividend growth in the next cycle and 4% dividend yield. Hence, investors are recommended to accumulate shares at this level, as downside risk is limited and notable upside will be driven by continued organic and acquisitive growth.
All charts are created by the author, and data used in the article and the charts is sourced from S&P Capital IQ, unless otherwise specified.
Disclosure: I am long GE. 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.