Don't Give Up on GE

My colleagues and I have documented at length the pall that is weighing on the stocks of high-quality companies. One of the companies suffering from that phenomenon is General Electric (NYSE: GE), which the market severely penalized during the credit crisis for the scale and exposure of its lending activity. If we look forward a few years rather than backwards, do we find an opportunity here for patient investors, and what would it take for that opportunity to materialize?

The Rodney Dangerfield of stocks
Here's an example of the lack of regard the market has shown GE: On the 15th of this month, General Electric announced earnings per share of $0.29 in the third quarter, $0.02 ahead of the consensus estimate. For its trouble, GE shares lost 5% on a day the broad market was essentially flat.

Moreover, there appears to be something more going on here than the "high-quality" discount alone. Witness, for example, how GE's share valuation stacks up against those of some of the companies in its peer group, several of which are also blue-chip companies:

*Median value.
**The peer group also includes Leukadia National, Loews, Philips Electronics, and Siemens. Source: Capital IQ, a division of Standard & Poor's.

That's right -- GE is trading at a discount to every single one of these companies on the basis of its price-to-earnings multiple.

What's going on here?
That discount stands in the face of performance that the market usually welcomes. Following is a graph of the company's quarterly earnings-per-share surprises (the percentage difference between the actual earnings and analysts' consensus forecast), from 2009 through the most recent quarter.

That's an impressive record of consistency -- at least seven "beats" in a row! Surely the market should be ready to award a company that kind of performance with a premium. So what's the problem here?

Here's one factor that may help to explain things. Following is the equivalent graph for revenue surprises.

That gives us a very different picture! With regard to revenue, GE also displays strong consistency -- just not the sort that investors are likely to reward. GE has beaten the consensus forecast just once since the beginning of 2009. Let me invert that statement to emphasize the point: GE has missed revenue expectations in six of the past seven quarters.

Why I expect GE shares to outperform
GE's share performance lags behind all of its peers over the trailing three-, five- and 10-year periods, and it's next to last on a year-to-date basis. With the company now boasting share returns and a P/E multiple that are appreciably lower than those of its peer group and its own long-term historical averages, there is reason to believe the tide will eventually turn for GE. Why? Because stock returns are mean-reverting, and so are price-to-earnings multiples. (With mean reversion, below-average values are generally followed by above-average values.)

GE's worth: A sum-of-the-parts valuation
If the market is willing to revisit its opinion on GE, what is the potential upside for investors? One way to quantify this is to estimate the current fair value for GE shares. To do so, I broke GE into two segments: Industrials and GE Capital. To value the Industrials segment, I use the average enterprise value-to-EBITDA multiple of a peer group of industrial conglomerates. Enterprise value (EV) adds net debt to market to assess value from the perspective of an acquirer of the entire enterprise; EBITDA (earnings before interest, taxes, depreciation, and amortization) is a measurement of the company's cash flow.

As far as GE Capital goes, it makes sense to compare it against a peer group of large banks. Here, I looked at the group's average price-to-tangible common equity multiple. Tangible common equity equals tangible assets minus liabilities and is an accounting measurement of a company's worth.

The following table summarizes my results.

*Trailing 12 months.
Source: Author's calculations, GE company filings and Capital IQ, a division of Standard & Poor's.

My conservative valuation produces a fair value for GE shares of $19.34. At that price, shares are currently trading at a 16% discount to intrinsic value. That's not a massive gap, but let's keep in mind that the market rarely offers a meaningful discount on companies of this caliber: Where a 16% discount might not be enough to motivate you to buy the shares of a company in decline or in distress, it appears relatively generous for a stable, high-quality business.

Two catalysts for share appreciation
How long will investors need to wait for a re-rating of GE shares? No one knows, but I can think of two potential catalysts. One or more "beats" on the revenue line would give the market confidence that the business is firmly on a growth path again, but that will depend largely on the speed of the global economic recovery.

A realistic scenario: $20 per share within 18 months
There is a second lever over which GE has more control: Its dividend. If the company were to raise its dividend to $0.15 (from $0.12) -- which it could do without difficulty -- and the annualized dividend yield remained stable at its current level of 3.0%, that would imply a $20 stock. I do expect GE to raise its dividend next year, and I think we could well see the shares reach $20 within the next six to 18 months.