As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In General Electric's (NYSE:GE) case, we think the firm is undervalued. We think it is fairly valued at $27 per share, offering material upside from today's levels.
We think a comprehensive analysis of a firm's discounted cash-flow valuation and relative valuation versus industry peers 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 - the VBI (click here to read our academic white paper), which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors (we like firms that fall in the center of the diagram below). Valuentum subscribers know that more interest in a stock leads to more buying, which leads to a higher stock price.
If a company is undervalued both on a DCF and on a relative valuation basis, it scores high on our scale. General Electric posts a VBI score of 7 on our scale, reflecting our 'undervalued' DCF assessment of the firm and its neutral relative valuation versus peers. We compare General Electric to peers 3M (NYSE:MMM), Honeywell (NYSE:HON), and Tyco Intl (TYC). In the spirit of transparency, we show how the Valuentum strategy has performed below:
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.
• 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.
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 (ROIC) with its weighted average cost of capital (OTC:WACC). 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 34%, which is above the estimate of its cost of capital of 7.2%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
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 14.3% 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 on the differences between these two measures, please visit our website at Valuentum.com. At General Electric, cash flow from operations increased about 34% from levels registered two years ago, while capital expenditures expanded about 47% over the same time period.
Our discounted cash flow model indicates that General Electric's shares are worth between $22.00 - $32.00 each. 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 $27 per share represents a price-to-earnings (P/E) ratio of about 20.4 times last year's earnings and an implied EV/EBITDA multiple of about 12.2 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 1.6% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -6.9%. Our model reflects a 5-year projected average operating margin of 26.5%, 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 2.2% for the next 15 years and 3% in perpetuity. For General Electric, we use a 7.2% 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 $27 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 $22 per share (the green line), but quite expensive above $32 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 $27 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 $33 per share in Year 3 represents our existing fair value per share of $27 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
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.