Is Caterpillar Stock a Buy?

It's never easy to value a cyclical company like Caterpillar (CAT 1.22%). It's easy to get caught up buying stocks when everything is going great only to find out you overpaid when their end markets start to turn down.  Often, the best time to buy them is when everything looks grim, and the valuation (based on current earnings) is very high. That said, let's try and take a balanced look at Caterpillar stock. Here's what you need to know before buying the stock.

Caterpillar's valuation

Investment articles usually end with valuation appraisals rather than starting with them. However, bear with me because the following chart is critical to understanding the investment case for Caterpillar.

Image source: Getty Images.

Readers can see the cyclicality in its earnings before interest, taxation, deprecation, and amortization (EBITDA) chart below. You can also see a commonly used valuation metric, namely enterprise value, or EV (market cap plus net debt) to EBITDA.

Note that when EBITDA peaks, the valuation is very low, and when EBITDA hits a trough, the valuation is very high. Given that earnings swing so vehemently, it's often the case that the best time to buy a cyclical stock is when its valuation is high, and earnings are just about to surge. This is contrary to the usual investing maxim of only buying on a low valuation and selling on a high one. It can sometimes make sense to buy on a high valuation and sell on a low valuation with a cyclical stock.

Data by YCharts

Caterpillar's valuation

To value Caterpillar, it's a good idea to consider its earnings and cash flow through the cycle. During the company's investor day presentation in 2019, management outlined its targets for profitability and free cash flow (FCF) generation through the cycle. The forecast operating margin and FCF ranges are shown below.

Data source: Caterpillar presentations.

Of course, these projections were made long before the first case of coronavirus appeared. Indeed, there were fears that Caterpillar's FCF would dip below the range due to the slump in sales caused by the pandemic. Fortunately, as so often happens with cyclical stocks, the upswing in its sales has been sharper than expected. Caterpillar's retail sales (the company sells through independent dealers) have turned positive again on a year-over-year basis.

Data source: Caterpillar presentations. YOY = year over year. Chart by author.

The improvement is such that Wall Street analysts are now forecasting that Caterpillar's FCF will trough at $5.2 billion in 2021. For valuation purposes, you could argue that Caterpillar's actual FCF range through the current cycle will be $5.2 billion to $8 billion. The midpoint is $6.6 billion.

Given that a reasonable valuation for a mature industrial is around 20 times FCF, you could take the midpoint FCF through the cycle (in this case, $6.6 billion) and calculate a fair value for Caterpillar of 20 times that, or around $132 billion.

That's pretty much what Caterpillar trades on right now.

Potential upside?

What about the company's prospects? Is there reason to believe the $5.2 billion to $8 billion range is too conservative or overly optimistic?

The bearish argument is that the industrial stock is enjoying a typical cyclical recovery characterized by an initial strong recovery phase. However, when dealers replenish inventory, and end-market sales start to naturally slow, then Caterpillar's sales will moderate. Moreover, the bears are concerned about the state of governments' finances in the wake of the pandemic -- something that might constrain infrastructure spending. 

Image source: Getty Images.

In contrast, the optimist sees Caterpillar in the early innings of a multi-year recovery in mining-capital spending -- not least because mining-commodity prices are improving and the industry is coming out of a period of relatively low investment. Similarly, Caterpillar's oil and gas-related sales should receive a boost with the price of oil above $60 a barrel. Throw in the possibility of an infrastructure bill in the U.S. and ongoing spending in China, and Caterpillar is well placed for an extended recovery.

Is Caterpillar a buy?

All told, the stock looks fairly valued, so the investment decision boils down to your level of confidence in the bullish recovery scenario. If you believe Caterpillar is set for an extended period of growth, then the stock doesn't look like a great value. After all, based on the calculations above, Caterpillar is fairly priced right now, so there's no value gap to close.