The sequester: When Congress imposed mandatory cuts on government defense spending on March 1, 2013, America's defense contractors were supposed to wither on the vine.
At least, that's what many investors expected. But as owners of Northrop Grumman (NYSE:NOC) stock know, that's not how things played out -- not by a long shot. In fact, no sooner had the calendar flipped over to March 1, 2013, than Northrop Grumman stock was off to the races -- shooting up more than 80% to today's levels ...
... and up 35% over the past year alone.
And yet, gratifying as shareholders may find these paper profits, they do pose a difficult question for investors today: Has Northrop Grumman stock already run as high as it will go, or is there still time to buy the stock and perhaps ride it a bit higher?
That's what we're going to try to figure out today.
Valuing Northrop Grumman stock
Priced at 12.8 times earnings today (according to S&P Capital IQ), but expected by most analysts to grow these earnings at only about 8.3% annually over the next five years (likewise), Northrop Grumman doesn't exactly look like a cheap stock.
If "value investors" prefer to buy stocks at PEG ratios of 1.0 or less, then Northrop Grumman's valuation of more than 1.5 seems a bit on the high side. Consider further that only about $1.9 billion of the company's $2.1 billion in reported net income show up on its cash flow statement as free cash flow -- cash profits. Given the 9% gap between real cash profit and reported net income, a conservative investor could be forgiven for worrying that Northrop Grumman stock might be even pricier than it looks. Granted, the company does pay a tidy dividend yield of 2.3%.
But still -- that makes for a total return ratio of just 10.6% on a 12.8 P/E (or 14.1 P/FCF) stock. It's certainly not an obvious bargain.
Valuing Northrop Grumman stock in context
Another thing worth mentioning: Historically, aerospace and defense stocks in the U.S. tend to sell for valuations of roughly one times sales. (That's not a hard-and-fast rule -- just something I've picked up on from following this industry during the past decade or so). Fast growers, which are projected to grow at better than 10% annually, tend to fetch somewhat more than one times sales. Strong profit producers -- greater than a 10% net profit margin -- likewise receive higher valuations.
And how have Northrop Grumman's profit margins been faring? It depends on how you look at them. Viewed from one perspective, at least, Northrop's profits margins -- gross, operating, and net as well -- have all been on a gradual uptrend for years:
And yet, relative to our 10% goal, Northrop Grumman is still neither a particularly strong profits producer, nor a fast profits grower either. Fact is, the company's net profit margin of 8.6% falls a bit short of the mark, while its projected growth rate (again, 8.3% according to S&P Capital IQ estimates) is likewise subpar. Both of which facts suggest that in a perfect world populated with appropriately priced stocks, Northrop Grumman stock should sell for a bit less than one times sales.
In fact, it sells for 1.1 times sales.
Foolish final thought
Speaking of sales, Northrop Grumman has experienced three straight years of declining sales, is heading for a fourth, and has depended entirely on improving profit margins and share buybacks to keep its per-share profits growing lo these past few years.
For the time being, this combination of cost- and share- count-cutting has sufficed to keep the business above water, and the price of Northrop Grumman stock growing. All that I grant. But after a steep run-up, Northrop Grumman stock now sells for unattractive P/E and price-to-free cash flow ratios, and for a price-to-sales ratio above historical norms for the aerospace and defense industry to boot.
Lacking a clear argument in favor of the stock selling at a discount to intrinsic value, I see no compelling need to buy Northrop Grumman stock today.
Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of Northrop Grumman. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.