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General Electric (GE) is one of the largest conglomerates in the world. The company has a wide range of products and services: aircraft engines, power generation, water processing, household appliances, business and consumer financing, and industrial products. The company is ranked sixth based on revenues in Fortune's U.S. 500 list. While the stock has suffered badly due to the recent financial crisis, it performed pretty well since its dip of $5 in 2008.

As of Sept. 18, 2012, GE stock was trading at about $22, with a 52-week range of $14.02 to $22.37. It has a market cap of about $232 billion. The trailing 12 months P/E ratio is 17.8, whereas the forward P/E ratio is 12.8. P/B, P/S, and P/CF ratios stand at 1.9, 1.6, and 7.2, respectively. The operating margin is 11.2%, while the net profit margin is 8.4%. The company has significant debt issues as the debt/equity ratio of 1.9 is far above the market average.

GE pays solid dividends; the trailing yield of 3% is approximately the same as the forward one. Upcoming dividends are expected to amount to 17 cents per share in Q4 2012, which is half as much as the dividends paid before financial crises. However, since 2009, the quarterly dividend amount has soared from 10 cents to 17 cents.

GE has a four-star rating from Morningstar. Out of the three analysts covering the company, two have a "buy" rating and one has an "outperform" rating. This is good reason to suppose that Wall Street holds positive opinions about the company's future. The average five-year annualized growth forecast estimate is 12.5%. What is the fair value of GE given the forecast estimates? We can determine GE'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 intimidating 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.

Valuation

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 trailing 12 months EPS along with the mean EPS estimate for the next year.

E0 = EPS = ($1.24 + $1.73) / 2 = $1.49

Wall Street holds diverse 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 $11.38. The rest is as follows:

Fair Value Estimator

V (t=0)

E0

$1.49

V (t=1)

E0 (1+g)/(1+r)

$1.51

V (t=2)

E0((1+g)/(1+r))2

$1.53

V (t=3)

E0((1+g)/(1+r))3

$1.55

V (t=4)

E0((1+g)/(1+r))4

$1.57

V (t=5)

E0((1+g)/(1+r))5

$1.59

Disposal Value

E0(1+g)5/[r(1+r)5]

$14.44

Book Value

BV

$11.38

Fair Value Range

Lower Boundary

$23.65

Upper Boundary

$35.03

Minimum Potential

7.29%

Maximum Potential

58.90%

(You can 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 GE is between $24 and $35 per share. At a price of about $22, General Electric is trading at a deep discount. The stock has at least 7% upside potential to reach its fair value.

Peer Performance

While there are many companies in the market segments in which GE operates, Siemens AG (SI) is probably the closest competitor of GE. At the current valuation, Siemens is also undervalued. The stock is trading at a relatively low forward P/E ratio of 12. Siemens has rather reasonable debt philosophy; shareholders' interests are better protected against a business decline. While both companies offer respectable dividends, SI currently does have a substantially better outlook in terms of both profitability and financial stability.

General Electric

Siemens AG

United Technologies

Trailing P/E

17.8

14.8

17.2

Forward P/E

12.2

12

12.3

Yield

3%

2.74%

2.4%

Debt/Equity

1.9

0.5

0.9

Return on Equity

9.8

14.1

19.0

Another competitor, United Technologies Corp. (UTX) is also trading at attractive valuations. The stock supports a forward P/E ratio of 12.3. However, similar to General Electric, the company has a serious debt issue, which is a red flag for company's financial health.

Current Economic Outlook

Since the new CEO Jeffery Immelt has taken over, much of the company's businesses have been streamlined and reallocated for better use. The company holds products and operations in several key industry segments, which is expected to growth along with the rest of the economy. Furthermore, since the GE name can be found on the back of everything from jet engines to toasters, the company is well positioned for growth outside the U.S.

Summary

GE has finally focused its business model on its industrial divisions. Accordingly, the company has plans to sell several assets of GE Capital. In the past, the company has suffered from inorganic growth and excessive acquisitions, which did not benefit the company much.

Nevertheless, according to historical valuation metrics, GE's stock is slightly undervalued with at least 7% potential to reach its fair value. Notably, GE stock has gained 38% over the last 12 months. Based on the strength of its operations and the company's future prospected in emerging markets, I expect the company to be an outperformer. Particularly, I expect continued growth of dividends along with nifty capital returns for long-term investors.

Source: General Electric Is Primed For A Leap