3 Industrial Strength Dividends

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

If investors are looking for a segment that will benefit from the slow improvement of the economy, companies in industrial production seem like a logical fit. This is why I recently ran a screen on The Motley Fool CAPS Screener looking for industrial companies that paid at least a 3% dividend and were rated highly among CAPS members. There were several companies to choose from, but three stuck out in particular for their strong brand names and earnings growth. The three companies I chose to do some more research on were Eaton (NYSE: ETN), Emerson Electric (NYSE: EMR), and General Electric (NYSE: GE). While each of these companies could be attractive investments on their own merits, what I wanted to know was which one would be the best value at today's prices?

Each of these three companies should benefit from an improving economy in slightly different ways. Eaton for example, should benefit from the impending jump in new vehicle sales due to the pent-up demand that has been built over the last several years. The companies focus on power management, and specifically power-train systems are directly affected by the strength of the economy. Emerson Electric, on the other hand, should benefit from continued investments in the oil and gas industry, as well as their expertise in control, measurement, and safety systems in multiple industries. General Electric's largest revenue contributor is their Energy Infrastructure unit. If the economy continues to recover, many companies will continue to invest in new energy technologies. A stronger economy would also benefit GE Capital, as this division would see less loss provisions and better earnings. As you can see, there are good reasons that each company's earnings should grow over the next few years. To begin to figure out the best value, let's look at the current valuation of each stock relative to their expected earnings growth.

<table> <tbody> <tr> <td> <p><strong>Name</strong></p> </td> <td> <p><strong>P/E on '12 Earnings</strong></p> </td> <td> <p><strong>Growth Expected</strong></p> </td> <td> <p><strong>PEG</strong></p> </td> </tr> <tr> <td> <p>Eaton</p> </td> <td> <p>10.74</p> </td> <td> <p>9.20%</p> </td> <td> <p>1.17</p> </td> </tr> <tr> <td> <p>Emerson Electric</p> </td> <td> <p>14.26</p> </td> <td> <p>8.50%</p> </td> <td> <p>1.68</p> </td> </tr> <tr> <td> <p>General Electric</p> </td> <td> <p>14.35</p> </td> <td> <p>12.27%</p> </td> <td> <p>1.17 </p> </td> </tr> </tbody> </table>

Of the three companies, General Electric has the highest expected growth rate, but the highest P/E ratio as well. Eaton is being valued similarly to GE, but at a lower growth rate and P/E multiple. Emerson Electric seems overvalued relative to its two competitors with the lowest expected growth rate, but second-highest multiple. Though General Electric has the highest P/E ratio, the company's higher growth rate makes it a relatively better value than Eaton. Though both companies have the exact same PEG ratio, this higher growth rate would bring the PEG ratio down more quickly. (Eaton – 2, Emerson Electric – 1, General Electric – 3)

When it comes to a company's earnings, one thing that I routinely look at is the company's history versus analyst estimates. General Electric is the clear leader with no earnings misses and three times beating estimates in the last four quarters. In fact, the company also has the highest average earnings beat at 2.08%. The second best performer is Eaton, which has beaten earnings twice, missed once, and overall has an average beat of 1.25%. This leaves Emerson Electric as the laggard with two misses, two beats, and an overall average miss of 3.4% per quarter. (Eaton – 2, Emerson Electric – 1, General Electric – 3)

Knowing that earnings can be manipulated, many investors have turned to free cash flow as a better way to define a company's ability to return cash to shareholders. The problem is that if investors are comparing companies of different sizes, unless you use an apples to apples comparison, the cash flow numbers don't mean very much. What I use is a comparison of free cash flow per $1 of sales. This gives us an idea of which company is the most efficient at turning its sales into cash flow. By this measure, Emerson Electric is the leader with $0.11 of free cash flow per $1 of sales in their most recent quarter. The second most effective company is General Electric, which produced $0.10 of free cash flow per $1. This leaves Eaton in third place, with a still respectable $0.08 of free cash flow using the same measure. In theory, the company that produces the most free cash flow for each $1 of sales, should be able to return a relatively larger amount of cash to their shareholders through dividends and share buybacks. (Eaton – 1, Emerson Electric – 3, General Electric – 2)

Since all three companies pay a dividend of at least 3%, some investors would ignore this measure of comparison completely. However, a good yield is only worth the company paying it. If that company's free cash flow is insufficient to cover the payout, the dividend may not be continued. This was a hard lesson that General Electric investors had to learn during the Great Recession, as the company was forced to cut its payout. At this time, all three companies have reasonable payout ratios, but Eaton and Emerson Electric seem to offer a better deal than General Electric. Both Eaton and Emerson Electric have dividends yields of about 3.3%. In addition, both companies have a payout ratio in the high 30% to the low 40% range. General Electric on the other hand, pays a yield of just over 3%, but its payout ratio is higher at about 48%. Given these factors, we will call it a tie at the top between Eaton and Emerson Electric with General Electric falling behind. (Eaton – 3, Emerson Electric – 3, General Electric – 2)

The totals are: Eaton – 8, Emerson Electric – 8, General Electric – 10. It's not too hard to understand why General Electric would come out on top. The company has the highest growth rate and a still reasonable valuation. In addition, investors get a good yield covered by the second-highest free cash flow production per $1 of sales. While the company's payout ratio is just a bit higher than the other two, it still is not excessive. While I believe either Eaton or Emerson Electric could be attractive investments on their own, across the board General Electric offers the best combination of traits at the current time.

Interested in Additional Analysis?

For GE, the recent financial crisis struck a blow, but management took advantage of the market's dip to make strategic bets in energy. If you're a GE investor, you need to understand how these bets could drive this company to become the world's --infrastructure leader--. At the same time, you need to be aware of the threats to GE's portfolio. To help, The Motley Fool offers comprehensive coverage for investors in a premium report on General Electric, in which their Industrials analyst breaks down GE's multiple businesses. You'll find reasons to buy or sell GE, and you'll receive continuing updates as major events unfold during the year. To get started, click here now.

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