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Is CAT a bargain right now?

I’ve been following Caterpillar (CAT) closely the past few months looking for a good opportunity to initiate a position. I’ve been searching for high quality dividend stocks to add to my portfolio to provide an income stream and reduce volatility. CAT has been beaten down from its recent high just shy of $100 in February to around $83 as of this morning’s trading. That’s a 17% drop, and I believe it opens the door to position entry. In fact, I initiated a position this morning at $83.37 on the dip at the open due to the lackluster US jobs report. Following are my reasons why.

Caterpillar is in the business of heavy mining & construction equipment, engines, and turbines. Visit virtually any industrial site and you’re virtually guaranteed to see some of their equipment in use. CAT is a $55B worldwide company, headquartered in the US but with a large focus on growth regions such as China more recently. General consensus is that the stock has underperformed as of late due primarily to uncertainties in some of the company’s key markets. With the price of gold plummeting, mining companies are becoming more cautious with their capital investments. Demand in China is showing signs of uncertainty as well. I prefer to look at the long term picture though rather than short term fluctuations. Long term there will be an ongoing demand for heavy machinery, and CAT is well positioned to supply that demand. For that reason I am treating this dip in share price as an opportunity rather than a cause for concern.

CAT is currently trading just North of $83/share at a PE ratio of just under 10. The company pays an annual dividend of $2.08 which works out to a yield of around 2.4%. Better yet, CAT has increased dividends every year for the past 19 years and with a payout ratio of just 25%, looks capable of continuing this policy in the future. Stock performance itself has lagged the rest of the market due in part to the reasons I’ve outlined above, with share prices down nearly 20% from a year ago and 5% YTD. CAT has a debt/equity ratio currently of 1.58, and appears capable of meeting it’s near term obligations per it’s current ratio of 1.43.

I have used several valuation techniques in an attempt to ascertain what a reasonable price to pay for Caterpillar stock would be as follows:

  • EPS Growth Capitalization: Using a future PE of 13 and a projected EPS growth of 9.4% over the next five years, I arrived at an intrinsic value of $98.14 which is 17% above today’s trading price using a 12% discount rate.
  • Discounted Cash Flow (DCF): Using an initial revenue growth rate of 15%, declining to 3% over the forecast period, a terminal growth rate of 3%, and a 12% discount rate, my discounted cash flow analysis resulted in an intrinsic value of $105.34 which is 19.5% higher than today’s price.
  • Dividend Discount Model: Based on a current dividend of $2.08/yr, a long term dividend growth rate of 5.2% (3-yr avg.) and a 12% discount rate, fair value for CAT works out to be just $30.91 using the dividend discount model. Clearly what this is saying is that we must rely on capital appreciation in addition to dividend distributions if we are willing to pay today’s prices for this stock. Also dragging this number down was my choice to use the 3-yr average in an attempt to be conservative. The 1-yr and 5-yr dividend growth rates for example are circa 9% and would result in a fair value of $66 if used.
  • Graham Number: Based on earnings of $8.49 over the past 12 months, and a current BVPS of $26.86, the Graham Number equates to $71.63, or about 18% lower than today’s price.
  • Other multiples: Using historical PE analysis, PB analysis, and dividend yield analysis, fair value appears to be $155.18, $98.51, or $83.74 respectively.

Throwing away the two extremes (high and low), the fair value range for CAT looks to be between $71.63 and $105.34. The average valuation is $91.47 and the median is $89.80. Based on this, it would appear that Caterpillar is trading within it’s fair value range, but erring to the low side approximately 9% below the mean. As stated above, I am taking this opportunity to initiate a position despite the low margin of safety.

Disclosure: I am long CAT.

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