General Dynamics Corporation (NYSE: GD), an industrials business with a market capitalization of $67.1 billion, currently trades at a P/E multiple of 23.0x which is above the sector’s median multiple of 22.8x. Although this makes GD look unattractive, investors may change their mind after reviewing the assumptions behind the P/E ratio. In the post below, I explain how to apply P/E multiples and what to watch out for.
How To Utilize GD’s PE Multiples
A multiples valuation, also known as a comparable companies analysis, determines the value of a subject company by benchmarking the subject’s financial performance against companies deemed to be similar. We can then determine if a company is undervalued or overvalued relative to its peers by comparing metrics like growth, profit margin, and valuation multiples.
A P/E Ratio is a valuation metric that indicates the multiple of earnings investors are willing to pay for one share of a company:
P/E Ratio = Stock Price ÷ Earnings Per Share
The P/E ratio by itself is not very helpful at all. It is only useful when comparing it to other companies that are considered similar to the subject company. The basic idea is that companies with similar characteristics should trade at similar multiples, all other things being equal. Therefore, we can come to a conclusion about the stock if the ratios are different. In the chart below, I compare GD’s P/E ratio to its peer group that includes Raytheon Company(NYSE: RTN), Lockheed Martin Corporation (NYSE: LMT), Northrop Grumman Corporation(NYSE: NOC) and Textron Inc. (NYSE: TXT).
Since GD’s P/E ratio of 23.0x is lower than the median of its peers (38.2x), it means that investors are paying less than they should for each dollar of GD’s earnings. As such, our analysis shows that GD represents an undervalued stock. Furthermore, finbox.io’s P/E Ratio Model calculates a fair value of $353.65 per share which implies big upside.
I selected a fair multiple of 36.2x in my analysis by averaging GD’s current P/E ratio with its peer group.
The P/E Ratio’s Flaws
While this approach typically provides a reasonable valuation range, it is important to understand that our conclusion rests on some important assumptions. The first being that the selected peer group actually contains companies that truly are similar to GD. The second important assumption is that the selected peer group stocks are being fairly valued by the market.
If the assumptions above do not hold to be true, then the difference in P/E ratios could be due to a variety of factors. For example, if you accidentally compare GD with higher growth companies, then its P/E multiple would naturally be lower than its peers since investors reward high growth stocks with a higher price.
source: P/E model
On the other hand, if the second assumption does not hold true, GD’s lower multiple may be because our selected comparable companies are being overvalued by the market.
What To Do Next
As a current investor, you may have already conducted fundamental analysis on the company and its stock so its current undervaluation could signal a potential buying opportunity to increase your position in GD. But keep in mind the P/E ratio’s potential flaws when applying this valuation approach. It is important to note that there are a variety of other fundamental factors that I have not taken into consideration in this article. I highly recommend that you continue your research on GD by taking a look at the following:
Valuation Metrics: what is GD’s EBITDA less CapEx multiple and how does it compare to its peers? This is a helpful multiple to analyze when comparing capital intensive businesses. View the company’s EBITDA less CapEx multiple here.
Risk Metrics: what is GD’s asset efficiency? This ratio measures the amount of cash flow that a company generates from its assets. View the company’s asset efficiency here.
Efficiency Metrics: is management becoming more or less efficient in creating value for the firm? Find out by analyzing the company’s return on invested capital ratio here.
As of this writing, I did not hold a position in any of the aforementioned securities and this is not a buy or sell recommendation on any security mentioned.