Thinking About Investing In GE? Read This First

February 7, 2018

Thinking About Investing In GE? Read This First

  • I’ll give a simple overview of what investing in GE means now, what the risks and rewards are.
  • Depending on what your required returns are, GE might be an attractive investment.
  • However, a lot of bad things can still happen.



Introduction

General Electric (NYSE: GE) was one of the worst performing stocks in 2017 and the situation hasn’t changed in 2018.

Figure 1: GE’s stock price in the last 5 years. Source: CNN Money.

However, GE is a blue chip stock, has a strong brand, and probably a positive long term outlook, so when a decline hits such a stock, it’s important to see what the intrinsic value of the company is, and whether the decline is due to temporary headwinds that represent an opportunity or due to structural problems.

Let’s start with the value, conclude with the outlook, and investment thesis.

GE’s Intrinsic Value

Where I differ from most analysts is that I use a range of values to estimate the intrinsic value of a company. There are simply too many moving parts to put everything into a fixed number. As Buffett would say, “I’d rather be vaguely right than precisely wrong.”

Therefore, I’ll go through some tools out of my arsenal that fit GE as a stock and offer you GE’s range of intrinsic values from various perspectives that will help you make an investing decision.

Present Value Of Future Cash Flows

There have been a series of negative things that have hit GE lately, and the latest of which was a $9.5 billion insurance charge where the total expected contribution would be around $15 billion. Nevertheless, a long-term perspective will allow us to see what GE can offer, but we always have to keep an eye open for more potential ghosts coming from GE’s past.

If we look at GE’s cash flows from operating activities, they were $29.9 billion in 2016 and only $11 billion in 2017, or $3.39 and $1.25 per share, respectively. The 2018 guidance for free cash flows is between $6 and $7 billion, or between $0.68 and $0.79 per share. If I attach a cash flow valuation of 10 to those values, I get an intrinsic value between $6.8 and $7.9 where those values double if I use a more appropriate market valuation of 20. Intrinsic value is very personal and depending on what your required return rate is, 10% or 5%.

But The Question Is, How Will Those Cash Flows Evolve In The Future? 

GE is in sectors that will do well in the future: power, renewables, healthcare, and aviation.

Figure 2: GE’s operations have short term issues but should do well in the long term. Source: GE.

So we really could expect good things in the long term but before investing, one must understand the complexity GE brings with it.

Apart from the good sectors, there are also issues that could plague the company further in the future. A Bloomberg analyst expects a write-down of the assets acquired from the 2015 Alstom acquisition as GE’s assumptions for the power market proved too optimistic.

Figure 3: GE’s power market assumptions. Source: Bloomberg.



In the Alstom case, investing returns were expected to be around 15% but the reality is more an unfortunate single digit. So there’s expectation that GE will be forced to write down some of its goodwill which could trigger debt and refinancing issues. More about that later as goodwill impairments don’t impact cash flows.

So GE had its share of problems this past year, from power sector profitability issues to the latest GE capital shock. However, this also means that the company is addressing its issues and if we see any kind of improvement in 2018 and after, GE might be worth much more but it mostly depends on how the market will feel about GE, its valuation, and risk.

If GE manages to bring its free cash flow up to $15 billion in the next few years, the price to cash flow would be 10 at current prices and the intrinsic value around the current price. However, if interest rates increase,—and accordingly required returns from equities—GE’s stock price doesn’t have to move even if GE does well. In an environment that is seeing increased volatility, it’s better to be conservative and expect lower valuations.

So I would say that GE’s intrinsic value derived from cash flows is in the range of $8 to $16. Therefore, there is more downside than upside for the conservative investor. If GE gets a market valuation for its cash flows, then the intrinsic value would be from $16 to $32. So it is up to you and your investing style to decide which range to use.

Margin Of Safety In The Book Value

Following on what I mentioned above, a lot of GE’s value is intangible and in the form of goodwill.

Figure 4: GE has been piling up its goodwill through acquisitions. Source: Bloomberg.

If we remove the goodwill from GE’s balance sheet, the actual shareholder equity would be negative. $104 billion in goodwill dwarfs the $64 billion in equity which means that there could be much more trouble if creditor sentiment weakens and GE finds it costly to refinance the $81 billion it has in direct loans, which exclude GE capital.

Figure 5: GE’s balance sheet. Source: GE.

So there’s no margin of safety in the book value of the company. This might be irrelevant for the current GE situation, but is useful for comparative purposes. If you find a company that has similar valuations and future prospects as GE and has significant book value, pick the other.



Return On Invested Capital

According to Morningstar, GE has had an average return on invested capital of 3.77% over the last 5 years and when things go well, the return is around 4.5%. Therefore, this is also the long term return you can expect from investing in GE and the lower the starting point, the better where the actual book value of $8.78 would be the best point to start.

Conclusion & Investment Thesis

Whether you should invest in GE or not depends on the risk you wish to take. From a relative perspective, GE has much more upside than downside as despite all the bad things that have happened, there is still operating profitably. So if margins improve alongside a fair valuation, you could see GE at $30 as was the case just a year ago.

On the negative side, if there are more impairments and concerns about GE’s debt, you could see the stock fall to $8 which would then make GE an attractive investment also from the perspective of the investor who demands investment returns of above 10% per year, not from the stock, but from the underlying business one invests in. A thing that could further push GE lower is the recent SEC investigation that could lead to more accounting questions and impairments.

So GE is a speculative bet at the moment, perhaps not the smartest bet to take if we are on the verge of a correction or bear market.