Is Caterpillar Overvalued?

Jan.18.11 | About: Caterpillar Inc. (CAT)

Caterpillar (NYSE:CAT) has been one of the best performers during the recovery from the financial crisis. Since March 2009, the stock has gained 333%, which equates to a cumulative return 247% greater than the S&P 500 over the same period. Can this outperformance continue, or is CAT due for a decline?

The most basic metric most investors consider when determining if a stock is cheap or expensive is the price to earnings ratio (P/E). This does have some merit, but absolutely cannot be the sole determinate when arriving at a final conclusion — especially for cyclical stocks. Using earnings from the most recent four quarters, CAT’s P/E is just under 31. The chart below shows the P/E over longer periods and how reversion to the mean could adversely impact the share price. The highlighted cells are the various price points for earnings per share of $3.97. This is the projected full year 2010 earnings per share, which I calculated by simply adding the mean analyst estimate for Q4 earnings plus actual earnings for the first three quarters of fiscal year 2010.
10-Yr Avg P/E
5-Yr Avg P/E
3-Yr Avg P/E
1-Yr Avg P/E
Current P/E
15.47
17.14
19.02
32.12
30.82
3.90
60.32
66.83
74.18
125.27
120.20
3.91
60.47
67.01
74.37
125.59
120.51
3.92
60.63
67.18
74.56
125.91
120.81
3.93
60.78
67.35
74.75
126.23
121.12
3.94
60.94
67.52
74.94
126.55
121.43
3.95
61.09
67.69
75.13
126.87
121.74
3.96
61.25
67.86
75.32
127.20
122.05
3.97
61.40
68.03
75.51
127.52
122.36
3.98
61.55
68.21
75.70
127.84
122.66
3.99
61.71
68.38
75.89
128.16
122.97
4.00
61.86
68.55
76.08
128.48
123.28
4.01
62.02
68.72
76.27
128.80
123.59
4.02
62.17
68.89
76.46
129.12
123.90
4.03
62.33
69.06
76.65
129.44
124.20
4.04
62.48
69.23
76.84
129.76
124.51
4.05
62.64
69.40
77.03
130.09
124.82
Click to enlarge
This chart would seem to signal that the P/E is near a peak and is too expensive. The widely held axiom is that stocks with a low P/E are “cheap” and offer a better probability of upside price appreciation. However, this can be misleading when buying cyclical stocks because the P/E relationship is quite different. A high P/E ratio could actually be an indication that earnings are primed to accelerate. As earnings grow at a quick clip, the P/E comes back down to earth. Conversely, a cyclical stock with a low P/E could be prepared for a fall because the earnings have caught up with the share price. As earnings decline again with the business cycle, the P/E is taken higher as the ratio’s denominator shrinks. For example, from July 2002 to April 2006, CAT gained 300% while the P/E dropped from 26x to 16x.
The logic behind this explanation makes sense, but few things in the stock market are absolute. This inverse P/E relationship for cyclical stocks does not always hold. For example, the prolonged fall from October 2008 to March 2009 left CAT with an incredibly low P/E of 6.96x. Based on the previous paragraph, that should have signaled that the earnings had likely peaked and the share price was due to fall. This is an example of why it is important to consider all contributing factors. March 2009 was an anomaly and an investment opportunity that might not ever occur again in the investment lifetime of anyone reading this article. The share price of CAT was unrealistically low and the market was putting a higher risk premium on the shares because of the uncertainty of CAT Financial and the impact that a prolonged global recession could have on heavy machinery sales. For those investors wise enough to recognize the overly pessimistic price quoted by the market, a great deal of profit was made.
This deeper examination shows that exclusively looking at CAT’s P/E is inconclusive. Further analysis must be done before drawing a conclusion on the value of the shares.
The next method involves normalizing earnings by using return on equity (ROE). This is a multistep process that begins with mapping out the historical ROE by year. This can simply be done by dividing net income by average equity. This information can easily be found by looking at 10-K filings on sec.gov.
Year
ROE
2010
46.03%
2009
12.07%
2008
47.17%
2007
44.67%
2006
46.26%
2005
35.90%
2004
30.05%
2003
19.03%
2002
14.40%
2001
14.36%
2000
19.03%
1999
17.86%
Click to enlarge
I’ll calculate 2009 ROE as an example. By looking at the bottom line of the Income Statement we see that 2009 net income was $895M. Next we move to the Balance Sheet and see that total equity for 2009 was $8,740M. Since the ROE calculation calls for average equity, we also need 2008 equity, which was $6,087M. Plugging those figures into the equation ($895/(($8,740+$6,087)/2)) yields a ROE of 12.07%.
Finding a full cycle is the next step. This is done by looking at trough to trough ROE. For CAT, the most recent full cycle lasted from 2001-09. From here, simply take the ROE average during the cycle, which was 29.32%. Finally, to normalize the earnings over the full cycle, multiply the equity from the most recent 10-Q ($9,875M) by the average ROE. This leaves us with normalized earnings of $2,896M. This normalized number is far easier to work with than attempting to project earnings into the next quarter or year due to the volatile and unpredictable nature of profits.
The most time consuming part is out of the way, and now all we need to do is apply an earnings multiple. Multiplying the P/E by the normalized earnings gives us a market cap which can then be divided by shares outstanding to give us a per share value. The table below shows a range of earnings multiples and their corresponding value in relation to the current share price.
P/E
Implied Share Price
% Overvalued / Undervalued
30.90
140.97
47.6%
25.68
117.16
22.7%
23.68
108.03
13.1%
23.00
104.93
9.9%
22.00
100.37
5.1%
21.00
95.81
0.3%
20.00
91.25
-4.4%
19.00
86.68
-9.2%
18.39
83.90
-12.1%
16.39
74.78
-21.7%
14.50
66.15
-30.7%
Click to enlarge
As you review the chart, here are a few facts to consider:
  1. The current P/E for the S&P 500 is 23.68, according to Robert Shiller.
  2. The mean P/E since 1881 is 16.39, also calculated by Shiller.
  3. The average P/E over CAT’s most recent full cycle was 14.50.
  4. CAT’s current P/E is 30.90.
  5. Due to CAT’s wide moat, the shares should likely be valued above the market multiple.
Great investors are able to take the available facts and determine which are relevant and appropriate to use. The facts have all been presented, but now the hardest part is using them to make an investment decision. A vast number of assessments can be made from this point based on how the information above is interpreted.
On the low end, I do not think the most recent cycle P/E (or anything below this level) is suitable. The unrealistically low multiples during the end of the cycle, as discussed earlier, distort the figure. On the other hand, I would argue that applying CAT’s current P/E is unrealistic to use in combination with normalized earnings for obvious reasons. Further, I believe the current market P/E of the S&P 500 plus a premium for CAT’s competitive advantages is too high as well. The world has gone through a plethora of transformations since 1881, but markets have an uncanny way of staying consistent. The booms and busts have been happening for centuries. For these reasons I would argue that the multiple used in harmony with normalized earnings should be closer to the historical average with a premium factored in to account for CAT’s wide moat. I think a P/E of 18x–21x is fitting. This signals that CAT is likely overvalued with the best case scenario being that the shares currently trade at intrinsic value.
CAT is very sensitive to the business cycle and is more volatile than the overall market. This can cause the share price to run the gamut from undervalued to overvalued. Savvy investors can take advantage of this volatility by purchasing shares when the market moves the share price below intrinsic value and selling when optimism moves the share price above intrinsic value. While I believe CAT is a strong company with a bright future, investors should avoid the stock at this level. As a value investor, I always like to see a margin of safety. This concept popularized by Graham and Dodd is not currently present in Caterpillar shares and therefore I suggest looking elsewhere for stocks that are undervalued. Phil Fisher once said that even the best companies in the world can be too expensive from time to time.
Note: All calculations above were based on CAT trading at $95.49.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.