General Electric (NYSE:GE) is one of the most reputable conglomerates in the world. The company is best described as a diversified mixture of financial and industrial enterprises. In addition to its financial arm, General Electric produces high-tech engines, industrial systems, and construction and power equipment. The size of the company is so big that just about anything that happens around the world has an effect on it. It's obvious that a conglomerate of General Electric's size is too big to fail. Surely, the company's financial arm is a great concern for dividend investors.
However, the company is going through a substantial reorganization and is reducing its stake in financial businesses. As Morningstar suggests, the power infrastructure business is booming on a global scale. Since General Electric is the leader in this field, this segment is likely to form the backbone of the company's future growth. General Electric's earnings increased by about 7% this year, and the year-to-date return of 8% is in the positive territory.
As of the time of writing, General Electric stock was trading at $19 with a 52-week range of $14-$22. It has a market cap of slightly above $200 billion. Trailing 12-months (TTM) P/E ratio is 14.6, and the forward P/E ratio is 10.8. P/B, P/S, and P/CF ratios stand at 1.7, 1.4, and 6.3, respectively. Operating margin is 11.5%, and net profit margin is 10.5%. The company has some debt issues due to its exposure to financial markets. The debt/equity ratio is 2. General Electric is a nifty dividend payer. Based on the latest dividend of $0.17, projected yield is 3.5%.
General Electric has a four-star rating from Morningstar. Out of three analysts covering the company, two have buy ratings and one has a hold rating. Wall Street has diverse opinions on General Electric's future. For this year, top-line growth estimate is 80%, whereas the bottom-line growth estimate is 23%. Average five-year annualized growth forecast estimate is 12.5%. While this might seem like an overly bullish estimate, it is possible as long as the recovery keeps going.
What is the fair value of General Electric given the forecast estimates? We can estimate General Electric's fair value using the discounted earnings plus equity model as follows.
Discounted Earnings Plus Equity Model
This model is primarily used for estimating the returns from long-term projects. It is also frequently used to price fair-valued IPOs. The methodology is based on discounting the present value of the future earnings to the current period:
V = E0 + E1 /(1+r) + E2 /(1+r)2 + E3/(1+r)3 + E4/(1+r)4 + E5/(1+r)5 + Disposal Value
V = E0 + E0 (1+g)/(1+r) + E0(1+g)2/(1+r)2 + … + E0(1+g)5/(1+r)5 + E0(1+g)5/[r(1+r)5]
The earnings after the last period act as a perpetuity that creates regular earnings:
Disposal Value = D = E0(1+g)5/[r(1+r)5] = E5 / r
While this formula might look scary for many of us, it easily calculates the fair value of a stock. All we need is the current-period earnings, earnings growth estimate, and the discount rate. To be as objective as possible, I use Morningstar data for my growth estimates. You can set these parameters as you wish, according to your own diligence.
Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate. In order to smooth the results, I will also take the average of TTM EPS along with the mean EPS estimate for the next year.
E0 = EPS = ($1.22 + $1.76) / 2 = $1.49
Wall Street holds diversified opinions on the company's future. While analysts tend to impose subjective opinions on their estimates, the average analyst estimate is a good starting point. Average five-year growth forecast is 12.5%. Book value per share is $11.32. The rest is as follows:
Fair Value Estimator
Fair Value Range
Download the FED+ Fair Value Estimator here.
I decided to add the book value per share so that we can distinguish between a low-debt and debt-loaded company. The lower boundary does not include the book value. According to my five-year discounted earnings plus book value model, the fair value range for General Electric is between $24 and $35 per share. At the current valuation, General Electric is undervalued.
Click to enlarge image.
Looking at the graph above, one can see that the General Electric stock is trading well below its pre-crisis valuation. The stock was trading as high as $40 prior to the Lehman failure. Recently, General Electric announced that it has entered into a $900 million investment plan in Turkey. The investment will focus on local infrastructure and innovation. That is an interesting move from General Electric. Back in 2010, the company sold its stake in Turkiye Garanti Bank (OTCPK:TKGBF) for a deal worth about $5 billion. Given the initial purchase price of $1.8 billion in 2005; the transaction was a highly profitable one for General Electric. Apparently, this time the company is back for an industrial investment.
In fact, General Electric is going through a significant transformation. The company is downsizing the finance unit, while returning back to its industrial roots. General Electric recently made a bold move into the natural gas business. In cooperation with Chesapeake Energy (NYSE:CHK), the company will engage in establishment of several modular compression stations. It is expected that 250 modular stations will be provided by the second half of 2012. As natural gas is currently trading at an almost 50% discount to retail gasoline, the collaboration could be highly lucrative for both companies.
My FED+ valuation suggests that the future growth is not yet implemented in the stock price. A modest earnings growth of 12.5% suggests that the stock is undervalued by at least 20%. It has substantial potential to reach my fair valuation range. Oppenheimer also agrees with me. The company has an upgraded target price of $24 on General Electric. Besides the nifty dividends, that is another reason to consider General Electric for the long term.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.