Editor's Choice

One Simple Metric Proves this Blue Chip is Massively Undervalued

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

General Electric (NYSE: GE) is arguably the best-run company in the world. Known for its celebrity CEOs and legendary management training program, GE is a leader in every market in which it competes. The company is enormous -- with $146 billion in sales over the last four quarters -- but is an efficient operator. It is also well-diversified, with operations in aviation, transportation, consumer finance, healthcare, energy infrastructure, and home & business solutions.

Lately, however, investors have lost patience with the conglomerate. GE's sales have declined over the last few years as it shed underperforming businesses and made investments in new ones like energy infrastructure. The company's dividend policy has also turned off some investors who were hoping for a bigger dividend in 2012.

However, the market is focusing on details when it should be valuing the long-term earning power of the firm. GE's first-class operations produce tens of billions worth of free cash flow each year. But, more impressively, it reliably converts close to 19% of sales into free cash flow.


<img src="/media/images/user_13490/ge-fcf-margin_large.png" />

From 2002 to 2011, GE averaged a free cash flow margin of 18.69%. The free cash flow margin had a coefficient of variation of 0.17. If you think back to your introductory statistics course, the coefficient of variation is the standard deviation divided by the mean; it's essentially a measure of volatility. GE's coefficient is extremely low. By comparison, Deere & Co (NYSE: DE), a mature industry leader, has a coefficient of 0.47. Consumer electronics giant Apple's (NASDAQ: AAPL) is 0.48. And integrated oil giant Exxon Mobil's (NYSE: XOM) is 0.35. Deere, Apple, and Exxon are all industry leaders that produce a ton of free cash flow each year, yet GE still does it better than they do. Microsoft (NASDAQ: MSFT), on the other hand, has a variation coefficient of 0.16. Microsoft is a mature free cash flow cow that, at least in the past, had a predictable business. You will rarely find a company that converts a more reliable percentage of sales into free cash flow than Microsoft and GE.

A low coefficient of variation makes it easy to predict how much free cash flow the company will earn in the future. Since we can be pretty sure that GE will convert about 18.7% of sales into free cash flow, all the investor has to do is determine the future sales level. LTM sales are $146 billion; $146 billion x 18.7% = $27 billion in free cash flow. A diversified world leader like GE deserves a 15x free cash flow multiple; 15 x $27 billion = $409 billion, or $38.77 per share.

Of course, the value changes at different levels of sales. GE's energy infrastructure segment is expected to drive the company's growth over the next 5-10 years, which should offset slow sales growth in other lines. This chart shows the value per share at different levels of sales:


<img src="/media/images/user_13490/ge-value-per-share_large.png" />

Final Thoughts

The market is not giving GE credit for its outstanding predictability and unmatched industry leadership. The company is worth at least $30 per share, and is worth closer to $40 if it can leverage a housing rebound and domestic exploration and production of fossil fuels to boost the top line. There will always be countless metrics for investors to peruse and use to add color to their investments, but sales conversion into free cash flow is the only one that really matters for GE.

titans8904 owns shares in Deere & Company and ExxonMobil. The Motley Fool owns shares of Apple, General Electric Company, Microsoft, and ExxonMobil. Motley Fool newsletter services recommend Apple and Microsoft. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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