Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

Shares of defense contractor Engility (NYSE:EGL), the billion-dollar provider of cyber, IT, engineering, and integration services to the U.S. government, are on a tear this morning. For this, you can thank the intrepid reporters from Reuters, who gave Engility stock an immediate popularity upgrade when they broke the story last night that the company could be in talks to be acquired.

Not everyone on Wall Street is entirely convinced, but just in case there is an acquisition afoot, analysts at Vertical Research Partners announced today they're closing their short recommendation against the stock, and upgrading Engility shares from sell to hold.

Here's what you need to know.

Woman painting wall mural of large fish chasing smaller fish

Larger companies could be in the hunt to acquire Engility. Image source: Getty Images.

What Reuters said

Let's start with the story that sparked the rally. Last night, Reuters cited three sources "familiar with the matter" saying that Engility "is exploring a sale" -- perhaps to CACI International (NYSE:CACI) or Science Applications International Corp (NYSE:SAIC), two peer defense contractors that are both three to four times larger than Engility.

CACI and SAIC are both keeping mum, like Engility, declining to confirm or deny the rumors. But Reuters is citing General Dynamics' purchase of CSRA earlier this year as evidence that there's a "wave of consolidation in the U.S. government services sector" going on, as defense contractors struggle to gain scale so as to be better able to bid on big government contracts expected to roll out under the Trump administration.

Adding to the rumor's credibility, CACI itself tried to buy CSRA out from under General Dynamics, so it could still be in the hunt for an acquisition.

What Vertical said about that

For its part, Vertical Research doesn't seem convinced. In contrast to most analysts who follow Engility, which has an overall buy rating among the seven analysts who follow it, according to S&P Global Market Intelligence, Vertical has been pretty pessimistic about Engility stock in the past. Indeed, alone on Wall Street, it had a sell rating posted on the stock -- up until today.

Now, however, Vertical is pulling that sell rating, even though it believes it still "doesn't think EGL looks attractive," says StreetInsider.com (subscription required). Just because Vertical Research doesn't like Engility stock, after all, "doesn't mean it can't happen." Viewed from the perspective of a defense contractor worried that someone else might snap up the asset and gain scale, Engility might start to look attractive.

How investors should look at the rumors

So how should you, the individual investor, navigate this rumor mill? My advice would be to ignore the rumors, and focus on the valuation. If Engility is a good bargain, it will make any acquirer a more attractive stock for bringing it in-house at a bargain price. Conversely, a good bargain will remain a good bargain even if it remains independent.

On the other hand, an Engility that's too expensive to buy on its own won't do any favors for an acquirer, either. It might add unnecessary debt, lower profit margins, and generally turn into a lodestone around the acquirer's neck. (You can ask General Dynamics about how that works.)

So is Engility stock a good bargain today? After watching Engility report losses for three years running, my first instinct (and ultimate decision) is to answer "no." That being said, I do see that although Engility is reporting GAAP losses, it's been a remarkably consistent producer of free cash flow, generating more than $107 million in cash profit over the last 12 months -- and in fact, generating positive free cash flow in each of the past five years.

At a valuation of 12 times FCF today, the stock doesn't look too awfully expensive. I can see how an acquirer might find the valuation attractive. Additionally, when valued on sales, Engility's $1.3 billion market cap, divided by its $1.9 billion in trailing sales, gives the stock a price-to-sales ratio of only 0.7 -- far below the ratio of 1 that's been the standard for defense companies for more than a decade.

So there are arguments for an Engility buyout as well as against. On balance, I personally see the stock as at best a second-string defense player, and probably not a great investment -- so I won't be joining in today's buying frenzy myself. But that doesn't mean the rumors are wrong. Even if I ultimately conclude that no one should buy Engility, that "doesn't mean it can't happen."

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.