The stock of Deere & Company (DE -0.18%) has been a market darling, beating the S&P 500 and the Nasdaq Composite over the past three years, five years, seven years, and the past decade. That outperformance is arguably well deserved, as Deere is on track to produce a staggering $9.75 billion to $10 billion in net income in fiscal 2023, a fourfold increase in the last five years.
However, a big reason for Deere's impressive bottom-line increase is a growth cycle for agriculture (and, to a lesser extent, construction), which has boosted demand for its machinery and supported price increases that have more than offset inflation.
Deere stock has just an 11.5 price-to-earnings (P/E) ratio compared to a 23.5 P/E for the S&P 500. But the blue chip stock isn't as cheap as it looks. Here's why.
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Cyclical stocks 101
Cyclical stocks like Deere have ebbs and flows in their earnings, which can make them look inexpensive or overpriced depending on the stage of the cycle. This is a far different pattern than with a consumer staples company like Coca-Cola or Procter & Gamble. These companies aren't heavily affected by their business cycle, which reduces the year-to-year seasonality in their earnings.
Even the best cyclical companies aren't able to grow earnings every year. But they are able to capitalize during expansions and have a higher floor during contractions. In this vein, average earnings grow over time, with each downturn landing higher up than the last, and each growth cycle leading to record earnings.
How to value Deere stock
Deere's 10-year median P/E is 17.1. As expected, the current P/E ratio is significantly below the average.
One technique I like to use with cyclical stocks is to take the 10-year median P/E and find out how much net income the company would have to make at its current valuation to have that P/E. In the case of Deere, a 17.1 P/E ratio at its current market cap of $114.4 billion would imply a net income of $6.7 billion, so quite a bit lower than Deere's trailing-12-month (TTM) net income of $10 billion.
The question now is whether $6.7 billion is a realistic expectation. Deere's recent performance says yes, but its historical performance says no.
DE PE ratio data by YCharts.
As you can see in the above chart, Deere had not achieved a 12-month period where net income was above $3.6 billion until 2021. So at first glance, $6.7 billion as an average for the cycle seems like a stretch.
Deere has a bright future
However, there's also the argument that Deere deserves a premium valuation. And even if it doesn't, it could average far higher earnings in the future than in the past. Of course, we don't know where its earnings will settle during a downturn in the cycle or if investors will give the stock a higher multiple. But what we do know is that management has been executing its growth strategy effectively.
Operationally, Deere has done an excellent job forecasting customer demand, managing production lines, and marketing its products to warrant a premium price.
On the financial side, Deere has made strategic buybacks that look brilliant in hindsight given how well the stock has done. It has reduced its outstanding share count by 6.5% in the last three years, 21.5% in the last 10 years, and 39.8% in the last 20 years. Meanwhile, outsize profits have supported a considerable increase in research and development and operational expenses.
The beauty of having a few big years, as Deere has done lately, is that it can accelerate innovation. Some companies will simply boost a dividend or use all the excess cash flow to buy back stock. Deere does pay a growing dividend and repurchase shares, but it also aggressively invests in growth -- arguably more than its peers.
DE Research and Development Expense (TTM) data by YCharts
Ideally, Deere will be able to grow its market share by being a technological leader in precision agriculture and by empowering customers with automation to save them time and money. If it can do that, then it has a clear path toward growing earnings for decades to come, which would make the stock a good value even at its current price.
But if it fails, then the stock could start to look overvalued if earnings decline and stay down, and the next growth cycle falls short of the current one.
Deere stock is at a fork in the road
This is a pivotal time for Deere investors. The stock has done very well. But to keep doing well, and especially to keep being a market-beating stock, the company is going to have to prove that most of its recent earnings boom isn't a one-off success story.
Investors who believe Deere's earnings will fall dramatically and average a lower level in the years to come probably wouldn't be interested in the stock unless it had a meaningful sell-off. But folks who believe that the company is making the right long-term moves are getting the stock at a fairly reasonable price: not too cheap, not too expensive.
Personally, I think the company's next growth cycle will eclipse the highs of this one. And management has proved its ability to execute on its near-term and long-term targets. For that reason, Deere stands out as a great buy. But it's important to understand that buying the stock now is a bold bet on sustained growth and that it is far more expensive than it looks at first glance.
