Shipbuilding and services specialist Huntington Ingalls (HII 2.25%) was spun off from Northup Grumman in early 2011. General Dynamics (GD 2.77%) is roughly six times larger and offers a far more diversified list of products and services that includes submarines, aircraft, and armored vehicles, among other things. Both, however, provide key products and services to the U.S. military. That's normally a fairly consistent business driven by large and often very long contracts. With a supportive administration in the White House, it would seem like now is a good time to take a look at this pair of stocks. But which of these two military-industrial companies is a better buy? Using a Benjamin Graham lens, the answer may not be what you want to hear.
Valuation is key
It's important to look at two factors when looking at these stocks: price and value.
Value investor Benjamin Graham is often considered the father of securities analysis, having helped to mold Warren Buffett during the Oracle of Omaha's early years. One of Graham's most important concepts is that price is what you pay, but value is what you get. To put it a different way, even a great stock can be a bad deal if you pay too much for it. Thus, to compare General Dynamics and Huntington Ingalls, you'll want to step back from the current environment for military spending, regardless of your opinion of the future, and consider a few key valuation metrics.
A little bit of ratio analysis
One of the first measures investors examine when looking at valuation is the price-to-earnings ratio. Huntington Ingalls' is roughly 25, which is higher than that of General Dynamics, which has a P/E of around 23. On that score, the latter looks cheaper, but those numbers in isolation don't provide the full picture here.
The market's P/E is roughly 21, which means both of these defense contractors are expensive relative to the market. Equally important, if not more so, both are expensive relative to their own histories. General Dynamics' average P/E over the past five years is 17.5, and Huntington Ingalls' average P/E over that span is a little under 18.
Looking at a company's valuation, however, should be something of an ensemble approach. This is because one metric may not provide a full picture. One year's earnings, for example, may not be indicative of a company's true earnings power because of one-time items or temporary market conditions. That could, in turn, skew the P/E ratio.
Which is why another important valuation metric to look at is price to sales. Although sales figures don't provide a good indication of a company's ability to generate profits, this is valuable metric because sales tend to be more consistent over time than earnings. Huntington's P/S ratio is currently around 1.6. General Dynamics' P/S ratio is roughly 2.2. The market's P/S ratio, meanwhile, is roughly 2.1. Here, the equation is reversed, with General Dynamics looking like the more expensive of the two stocks and Huntington appearing cheap relative to the market, as well. However, both companies have P/S ratios that are above their five-year averages. Huntington's P/S ratio over that period is roughly 1, while General Dynamics' is around 1.5. So, yes, Huntington Ingalls wins on this metric, but it's hard to suggest, based on the company's history, that it's cheap today.
Price to book value is another important valuation tool. In this case, you are examining a company's market price relative to the value of its underlying assets, or its book value. Book value doesn't show you how well a company is putting its assets to work, only what those assets are worth. You are basically moving from valuing a company using its income statement to valuing a company using its balance sheet.
Huntington's P/B ratio is roughly 6.7 today, while General Dynamics' is 5.8. The market's P/B ratio is well below both of these numbers at roughly 3.1. And, following the above trend, Huntington Ingalls' five-year average P/B of 4.5 and General Dynamics' average of around 4 are both below their current P/B ratios. Once again, neither company comes up looking like a great deal today.
Rounding this out to a quartet of valuation metrics is price to cash flow. This time you are looking at a company's valuation using the cash flow statement. The cash a company generates is the lifeblood of its business, which is why this is a great metric to consider. However using it in isolation would be a mistake because, like earnings, one-time items can cause temporary cash flow peaks and valleys. Which again highlights the importance of taking an ensemble approach to valuation ratios.
Huntington Ingalls' P/CF ratio of nearly 15 is above the market's roughly 14 and its five-year average of a little more than 11. Not a particular surprise there. However, while General Dynamics' P/CF ratio of 17.5 is above the market's level, it is below its five-year average on this metric of around 18. That said, although General Dynamics looks relatively cheap compared to its own history here, it's still more expensive than Huntington and the market. Once again, no clear valuation winner.
Stay on the sidelines for now
There's nothing particularly wrong with General Dynamics or Huntington Ingalls as companies. However, a good company isn't always a good investment. And when you step back and look at valuation, neither of these military contractors seems to be trading hands at bargain prices today. If you believe, as Graham did, that price is what you pay and value is what you get, then you'd be better off avoiding this pair for now.
Editor's note: A previous version of this article stated that Huntington Ingalls was spun off from General Dynamics -- it was spun off from Northrup Grumman. The Fool regrets the error.