Benjamin Graham, the Wall Street icon who helped train Warren Buffett, liked to say that even a great company can be a bad investment if you pay too much for the stock. Which is why valuation is so important to consider when you are looking to buy.
Right now, industrial giant Emerson Electric (EMR -0.02%) looks attractive when you examine traditional valuation metrics. However, this Dividend King's yield is surprisingly unattractive from a historical perspective. Perhaps some caution is in order.
Tracking value
When it comes to valuation, most investors default to the price-to-earnings (P/E) ratio. Right now, Emerson Electric's P/E is around 18 times compared to a five-year average of nearly 21 times. That makes the company appear fairly cheap.
But there's one big problem with P/E: Earnings can be very volatile from year to year. This is a notable weakness that suggests other valuation tools might be better or, at the very least, that you should consult other metrics in addition to P/E.
Image source: Getty Images.
Sales and book value tend to be more consistent over time, so the price-to-sales (P/S) ratio and the price-to-book value (P/B) ratio are good additions to the valuation tool box. Emerson Electric's P/S is roughly in line with its five-year average while the P/B is comfortably below its five-year average. At worst, the stock looks reasonably valued to, perhaps, cheap at current prices.
That said, for some companies, dividends are among the most consistent metrics of all. In Emerson Electric's case, it is a Dividend King with 65 consecutive years of dividend increases behind it.
Since boards of directors generally only increase dividends when they believe that a company can sustainably support a higher payment, long streaks like this speak volumes about a company's history and near-term future.
Which is one reason a stock's dividend yield relative to its historical range can be an important valuation tool as well. Emerson Electric's 2.4% yield is toward the low end of the historical range, suggesting the stock is potentially expensive.
EMR dividend yield data by YCharts.
There's a lot going on
Perhaps the most important thing that investors need to understand about Emerson Electric is that there are some big moving parts right now. That's because the company recently agreed to sell a majority stake in its Climate Technologies business to Blackstone.
The deal furthers management ambitions to become a pure-play automation company. This isn't a bad thing, but it has pushed a number of businesses into the "discontinued operations" category and muddied the company's financial statements a little bit, including both the earnings statement and the balance sheet that back the P/E, P/S, and P/B ratios.
This partial divestiture actually continues a longer-term trend, with the company having sold around $18 billion worth of businesses while adding $9 billion since 2021. This is a solid directional shift, since the businesses added are expected to grow 10% annually, compared with the 2% growth that was being achieved at the businesses that were sold.
Moreover, this evolution of Emerson Electric's business model is a positive sign that the company can adjust with the world around it. However, it's in a state of flux right now that complicates the picture for investors. The past might not be the best indicator of the future.
So it's notable that the company's price-to-forward-earnings ratio sits at around 21 times, comfortably above the roughly 19.5 times five-year average for this forward-looking metric that takes into account analyst expectations of future performance.
It's probably best to wait
With Emerson's business remake still ongoing, investors should probably take traditional valuation metrics with a grain of salt for now. Indeed, the price-to-forward-earnings ratio suggests the stock is expensive, as does the dividend yield relative to the company's historical yield trends.
While it might be reasonable to expect a higher-growth stock (which is what Emerson is trying to become) to have a lower yield on an ongoing basis, there's still some work to be done to prove that the company can actually live up to management's goals. For example, the company's fiscal first-quarter 2023 adjusted earnings per share fell short of year-ago levels and the company's own target.
All in, the risk/reward ratio seems tilted in the wrong direction right now.
