It's not easy writing this article, not least because it runs contrary to an investor's intuitive sense. Investors always want to take an interest in high-quality companies with exceptional management, but there's a difference between a great company and a great stock to buy. Illinois Tool Works (NYSE:ITW) is definitely the former, but is it the latter? Let's take a closer look.

Illinois Tool Works valuation looks stretched compared to peers

In a nutshell, the valuation of the company isn't adequately compensating investors for the risk involved in holding the stock. The company has strong potential to recover from the COVID-19 pandemic, and its management continues to do a great job of expanding operating underlying margin in the face of difficult end markets, but all of the goodness appears to be baked into the price already.

Person holding up trophy on hill

Illinois Tool Works is one of the best-run companies in the industrial sector. Image source: Getty Images.

Let's start with the valuation. The best way to compare companies with different debt loads is to look at enterprise value (market cap plus net debt), or EV, compared to earnings before interest, taxation, depreciation, and amortization, or EBITDA. As you can see below, Illinois Tool Works' valuation is significantly higher than many of its peers.

For reference, Illinois Tool Works is a diversified industrial conglomerate operating out of seven different segments. It's a pretty balanced company, with each segment contributing no more than 20%, and no less than 10%, of operating income in 2019. The companies in the chart have all been named as peers in each of its segments.

ITW EV to EBITDA (Forward) Chart

Data by YCharts

Pricey on a historical basis too

Not only is this company looking expensive relative to its peers, but it's also looking pricey compared to its historical trading ranges. The following chart compares its current and forward EV/EBITDA multiple with its historical range, and has another major diversified industrial, 3M (NYSE:MMM), included by way of comparison.

Furthermore, even if you argue that 2020 is a trough year which has been artificially taken down due to the COVID-19 pandemic, it's still hard to justify Illinois Tool Works' valuation. For example, Wall Street analysts estimate it won't be until 2022 that the company's EV/EBITDA gets down to 17.4 times, compared to a forecast for 3M to get to 11.9 times in the same year.

ITW EV to EBITDA Chart

Data by YCharts

Why Illinois Tool Works trades at a premium

Naturally, there's a reason why Illinois Tool Works is being given a valuation premium. That largely comes down to the excellent, and relentless, work its management has been doing to improve operating margin over the years. The chart below shows the remarkable improvement made by highly respected CEO Scott Santi since his appointment in 2012. Again, the company's performance compares very favorably to 3M.

ITW Operating Margin (TTM) Chart

Data by YCharts

Santi's transformation of Illinois Tool Works has been undertaken using the 80/20 principle (80% of business tends to be done by 20% of customers) in order to guide how to reshape the company to focus on its most profitable product lines and customers. Over time, Santi has simplified the company's businesses, pruned unprofitable product lines, improved the supply chain, and focused businesses for growth.

These so-called "enterprise initiatives" have yield at least 100 basis points of margin expansion for the company for a number of years, even as end markets have sometimes negatively contributed to margin -- note the big drop in margin during the second quarter of 2020. For reference, bp is basis points, so 100 bp is 1%.

Illinois Tool Works margin expansion.

Data source: Illinois Tool Works. bp = basis points, where 100 bp=1%.

However, it's not all about cutting costs and restructuring. Indeed, in the middle of the pandemic, when others were laying off staff right, left and center, Santi took a different approach. Quoting from Santi on the second-quarter earnings call, "[W]e are going to lean in hard to the upside by remaining invested in staff to support anticipated demand two to three quarters out, so that we have ample cushion to fully support our customers as their businesses reaccelerate."

It was a decision that proved prescient as the company's organic revenue growth bounced back nicely in the third quarter.

Illinois Tool Works organic revenue growth.

Data source: Illinois Tool Works presentations.

Why Illinois Tool Works is not a buy

There's a lot to love about the stock, and a lot to admire about its management, but it's worth noting that the industrial environment remains uncertain. The recovery is in place for now, but it's hard to know where the economy will go in 2021. 

As such, it becomes difficult to buy a stock like Illinois Tool Works trading on an enterprise value of 18.6 times forecast EBITDA in 2021. And it becomes very difficult if you consider that those estimates appear to assume an ongoing recovery in the economy. On a risk/reward basis, there are other investment options out there, even if they are in companies not as well run as Illinois Tool Works.

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.