With an average analyst rating of buy, Eaton is clearly an analyst favorite. But the analysts could be wrong. Is ETN overvalued at today's price of $195.9? Let's take a closer look at the fundamentals to find out.
The first step in determining whether a stock is overvalued is to check its price to book (P/B) ratio. This is perhaps the most basic measure of a company's valuation, which is its market value divided by its book value. Book value refers to the sum of all of the company's assets minus its liabilities -- you can also think of it as the company's equity value.
Traditionally, value investors would look for companies with a ratio of less than 1 (meaning that the market value was smaller than the company's book value), but such opportunities are very rare these days. So we tend to look for company's whose valuations are less than their sector and market average. The P/B ratio for Eaton is 4.47, compared to its sector average of 3.78 and the S&P 500's average P/B of 2.95.
Modernly, the most common metric for valuing a company is its Price to Earnings (P/E) ratio. It's simply today's stock price of 195.9 divided by either its trailing or forward earnings, which for Eaton are $6.39 and $9.32 respectively. Based on these values, the company's trailing P/E ratio is 30.7 and its forward P/E ratio is 21.0. By way of comparison, the average P/E ratio of the Industrials sector is 20.49 and the average P/E ratio of the S&P 500 is 15.97.
The problem with P/E ratios is that they don't take into account the growth of earnings. This means that a company with a higher than average P/E ratio may still be undervalued if it has extremely high projected earnings growth. Conversely, a company with a low P/E ratio may not present a good value proposition if its projected earnings are stagnant.
When we divide Eaton's P/E ratio by its projected 5 year earnings growth rate, we obtain its Price to Earnings Growth (PEG) ratio of 2.47. Since a PEG ratio between 0 and 1 may indicate that the company's valuation is proportionate to its growth potential, we see here that ETN is overvalued when we factor growth into the price to earnings calculus. One important caveat here is that PEG ratios are calculated on the basis of future earnings growth estimates, which may turn out to be wrong.
If a company is overvalued in terms of its earnings, we also need to check if it has the ability to meet its financial obligations. One way to check this is via the so called Quick Ratio or Acid Test, which is the sum of its current assets, inventory, and prepaid expenses divided by its current liabilities. Eaton's Quick ratio is 0.824, which indicates that that it does not have the liquidity necessary to meet its current liabilities.
One last metric to check out is Eaton's free cash flow of $1.94 Billion. This represents the total sum of all the company's inflows and outflows of capital, including the costs of servicing its debt. It's the final bottom line of the company, which it can use to re-invest or to pay its investors a dividend. With such healthy cash flows, investors can expect Eaton to keep paying its 1.7% dividend.
Analysts are bullish on Eaton, but we are concerned they may be missing the clouded growth picture, as expressed by the stock's elevated PEG ratio. In addition, many of its valuation metrics point to a stock with an inflated value. We will keep following ETN to see whether the analyst community was right.