Is Barron's Right about Eaton Corp?
History indicates they are over optimistic
The March 16, 2015, issue of Barron’s says diversifed industrial company Eaton (ETN, Financial) is primed for a nice rise from last week’s $66.63 closing quote.
Columnist Jack Hough’s teaser blurb made that assertion while correctly noting Eaton’s attractive 3.3% dividend.
Much of his rationale for owning ETN came via its relative valuation versus some of its industrial competitors. When looked at in that way Eaton comes across as the second highest, to Emerson Electric (EMR), yielder and with a clearly lower P/E than all the others.
The presumption appears to be that ETN deserves to trade at a higher multiple than the indicated 13.3x forward P/E listed on the chart. Mr. Hough said Eaton can go to about $80 based on that reasoning.
“Look for the stock to rise 20% over the next year as earnings grow and the valuation moves back toward its historical level.”
I’m not sure where he is getting his reference numbers.
Exclude the company’s elevated 2009 P/E reading, high due to recesssion-ravaged profits rather than the stock’s popularity, and ETN averaged 13.2x its current years’ earnings since the start of 2008 (source: Value Line).
Apply that normalized multiple to his $5.00 estimate for the next four quarters, through early 2016, and you’ll arrive at a $66 price target. The stock already reflects realtively good news that hasn’t yet occurred.
The few times when Eaton has crept higher than 14x (red starred on chart) have proven to be excellent occasions for profit taking. Buy-and-hold types regretted not exiting near 2008’s pinnacle of $49.10. They suffered through almost a 70% draw down by March of 2009. It ended up taking more than four years to permanently break through $50.
Momentum chasers at 2011’s peak, at a P/E of 14.4x, experienced a 41% drop within months and needed around 18-months to break even.
Eaton got downright pricey, based on its own history, not quite one year ago. At last spring’s $80 peak Eaton commanded an unsustainable 17.1x forward multiple. Not surprisingly, it has retreated almost $14 per share since then despite nothing but positive quarterly comps.
The best returns on this solid company were garnered by those who ventured in when Eaton’s valuation was clearly below normal (green stars on chart). Each of those times came with higher than typical dividends along with those sub-normal P/Es.
Today’s slightly above average yield is nice but is largely attributable to an expanded payout ratio. The current $2.20 per share dividend rate equals about 44% of 2015’s projected earnings versus a payout ratio as low as 29% back in 2008.
Buying Eaton now and longingly counting on P/E expansion is not a predictable reason to expect a 20% gain over the next 12-months.
Option savvy traders who favor Eaton should consider selling some ETN Jan. 2017, puts at $65 or $70 strike prices. Collecting $9.40 per share for the $65 strike would make for a worst-case, ‘if exercised’ net price of just $55.60.
ETN has not changed hands as cheaply as $55.60 since April of 2013. That dip proved to be a very fleeting experience. ETN was then on the road to $80.
Maximum profits of $940 per contract will be realized as long as ETN holds at $65 or above on the Jan. 20, 2017, expiration date. The shares are already north of that price. Barring unexpected bad news, that best-case scenario seems likely to play out.
Disclosure: Short ETN puts
