Are Shares of General Electric Priced Right?

Shares are down 6% on the year, but General Electric remains a quality "hold" candidate for investors.

Jul 22, 2014 at 11:31AM

Shares of General Electric (NYSE:GE) attract investors with its valuation and solid dividend yield. Shares are down 6% year to date, after running an incredible 37% in 2013. However, despite that run, I still think shareholders can stay long.  

After several years and billions of dollars, General Electric's increased dependency on its industrial business and decreased dependency on its financial business is starting to pay off. Although today's valuation is higher than its historic average, it makes sense given the change in businesses.

The increase in valuation is warranted
This is what's referred to as multiple expansion. You see, when a company is involved in a low-margin, slow-growing business, it generally receives a low earnings multiple. 

When the company gets out of a slow-growing business (or declining business, in the case of GE Capital), and into a higher-growth, higher-margin business, the earnings multiple expands and allows for the stock to trade with a higher valuation. 

Here is a look at the General Electric's forward and trailing-12-month price-to-earnings (PE) ratio over the past two years:

GE PE Ratio (TTM) Chart

Chart by YCharts

General Electric plans to IPO its credit card business -- Synchrony Financial -- at the end of the month. That's the first step in reducing exposure to its financial business. To show how much more beneficial the industrial business is to GE than the financial business, let's have a look at its recent earnings results:

Business Segment Revenue Growth (yoy) Net Income Growth (yoy) Operating Margins Growth (yoy)
Industrial   7% 9% N/A
  Oil & Gas 20% 25% 0.50%
  Aviation 15% 12% (0.40%)
  Power & Water 10% 4% (1%)
  Appliance & Lighting 0% 23% 0.90%
  Healthcare 0% 1% 0.10%
  Energy Management (6%)  N/A 2.10%
  Transportation (18%) (14%) 0.10%
         
Financial   (6%) (5%) N/A
  GE Capital (6%) (5%) N/A

Source: General Electric's second-quarter earnings presentation (link opens a PDF), chart by author.  

As you can see, not all of the industrial segments are expanding margins or growing revenues and net income. As a whole, however, revenues climbed 7% (5% of which came from organic growth, as per the earnings presentation) while net income grew 9%. Revenue and net income for the financial business slid 6% and 5%, respectively. 

The dividend
Everyone loves a good dividend. With a 3.35% yield, General Electric has one. The company's current payout of $0.22 per share is 120% higher than five years ago, when it was only $0.10. The annual dividend has increased in each of the last five years as well. 

The only downside is General Electric's ability to maintain that payout. The payout ratio -- or the amount of the company's earnings that is paid out in the form of a dividend -- is approximately 60%. While this reading is somewhat high compared to its sector average of 25%, the company should be able to maintain its dividend payments in most economic situations. 

However, shareholders should note that General Electric is no McDonald's or Coca-Cola when it comes to the dividend. These two companies have raised their dividends for each of the last 10 years. General Electric, on the other hand, had to slash its dividend 68% from $0.31 per share in 2008 to $0.10 per share in 2009 due to the harsh economic downturn.

The Foolish takeaway
General Electric was not alone in cutting its dividend in 2008. For the most part, the dividend is relatively secure and a good reason to the own the company's stock. The valuation is not insanely good or bad, which makes it a quality "hold" candidate. 

There's always room for the company's stock to depreciate over the short-term. When coupled with the handsome dividend yield, though, I don't find that a potential decline in GE over the interim is a worthy reason to bail on it at today's levels, given that investors are using a long-term outlook on the company. 

The rotation out of its stagnating financial business and into the more margin-friendly, higher-growth industrial business will also be more beneficial over the long haul. General Electric is a solid "hold" at current levels because of its positive business changes and its current dividend yield.

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Bret Kenwell has no position in any stocks mentioned. The Motley Fool recommends Coca-Cola and McDonald's. The Motley Fool owns shares of General Electric Company and has the following options: long January 2016 $37 calls on Coca-Cola and short January 2016 $37 puts on Coca-Cola. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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