Even a great company can make a bad investment at the wrong price, and with the stock market now in its sixth year of a strong bull market, the S&P 500 is now trading at a P/E ratio of 19.49, 34% higher than its median valuation since 1871.
Investors may be wondering if this is a good time to initiate a position, or add to one, in certain high-quality industrial dividend growth stocks, such as Parker-Hannifin Corporation (PH -0.74%)
(PH -0.74%)After all, Parker-Hannifin has outperformed the market over the last five years, and if the market is getting over heated, does that mean investors should necessarily avoid Parker?
PH Total Return Price data by YCharts
Is Parker-Hannifin stock overvalued?
Here at The Motley Fool we believe that long-term buy-and-hold investing is the key for nearly anyone to build wealth. However, as my Motley Fool colleague Morgan Housel pointed out in his excellent article on the subject, "buy-and-hold doesn't mean you can buy with abandon at any price."
| Company | 21-Year Historic P/E Ratio | Current P/E Ratio | Premium | 21-Year Historic P/CF | Current P/CF | Premium |
|---|---|---|---|---|---|---|
| Parker-Hannifin | 15.2 | 15.8 | 3.90% | 9.9 | 11.9 | 20.20% |
| General Electric | 21.9 | 16.3 | (25.60%) | 11.8 | 11.1 | (5.93%) |
| Honeywell | 18.6 | 17.1 | (8.10%) | 12.4 | 14.8 | 19.40% |
| Eaton | 15.2 | 14.7 | (3.90%) | 10 | 13.5 | 35% |
| Emerson Electric | 19.7 | 16.9 | (14.20%) | 12.4 | 12.4 | 0% |
| 3M | 19.9 | 19.5 | (2%) | 13.8 | 15.2 | 10.10% |
| Average | 18.42 | 16.72 | (8.32%) | 11.7 | 13.2 | 13.13% |
| S&P 500 | 14.56 | 19.49 | 34% |
Source: S&P Capital IQ.
As this table shows, Parker-Hannifin doesn't look that overvalued when compared to its industrial, dividend growth peers 3M Co. (NYSE: MMM), General Electric Company (NYSE: GE), Honeywell International Inc (NYSE: HON), Emerson Electric Co. (NYSE: EMR), and Eaton Corp PLC (NYSE: ETN).
For example, Parker-Hannifin is currently trading at 15.8 times earnings, but what does that really tell us? By looking at the company's peers as well as its historic valuations, we can see that Parker-Hannifin is trading slightly below the P/E ratio of its peers and substantially below that of the current market, yet slightly above its 21-year historical P/E ratio.
However, the P/E ratio is not the be all, end all of valuation. Earnings can often be affected by one-time events, tax loopholes, or accounting shenanigans. Price-to-cash flow is also worth noting, and here too we see that Parker-Hannifin seems cheaper than its competitors, but overvalued based on its own historical norms.
Other valuation metrics that matter
| Company | Avg. 5-Year Yield | Current Yield | Premium | PEG Ratio |
|---|---|---|---|---|
| Parker-Hannifin | 2% | 1.70% | 15% | 1.53 |
| General Electric | 3.30% | 3.50% | (5.1%) | 2.14 |
| Honeywell | 2.50% | 2% | 20% | 1.61 |
| Eaton | 2.70% | 2.90% | (7%) | 1.32 |
| Emerson Electric | 3% | 2.70% | 10% | 1.82 |
| 3M | 2.40% | 2.40% | 0% | 1.63 |
| Average | 3% | 2.53% | 5% | 1.675 |
| S&P 500 | 1.89% | 1.55 |
Sources: Yahoo Finance, S&P Capital IQ.
Dividend yield may not at first seem like a valuation metric, but it does if you realize that another way to think about a P/E ratio is as an earnings yield. For example, a P/E of 20 means that a company's current earnings will pay for the original purchase price in 20 years, a 5% earnings yield. Similarly, a 5% dividend yield means that, assuming constant dividends, the investment will pay for itself in 20 years.
From the dividend yield perspective, we see that these industrial companies are on average 5% overvalued relative to the last five years. This isn't hard to understand, given that the popularity of dividend stocks in an age of near-zero interest rates has caused investors to bid up quality dividend growth names.
Finally, there's the PEG or price/earnings/growth ratio, which is a good rule of thumb (usually) for whether or not a company is trading at a reasonable valuation relative to its long-term growth potential. Please keep in mind that all valuation metrics are merely tools, and no investment decisions should be based entirely on one metric, (or only metrics at all).
The PEG ratio, which is the basic valuation metric for the "growth at a reasonable price" principle, is based on long-term growth assumptions of analysts, whose models and projections are really just educated guesses. However, this metric can be useful when comparing a particular company to industry peers and the market at large.
What do yield and PEG tell us?
The S&P 500 has had a median PEG ratio of 1.16 since 1990, meaning that current valuations are 33% above this historic level. That may initially seem alarming, given that Parker-Hannifin is trading at nearly the same PEG ratio while its peers trade at even richer levels.
However, before you decide that the market is set to crash and sell all your shares in Parker-Hannifin, one of the best industrial dividend growth stocks of the last few decades, keep in mind that there are one important fundamental investing principles to consider.
Fundamentals matter more
In his 1989 annual shareholder letter, Warren Buffett wrote "it's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
In other words, valuation alone isn't enough to make a smart investing decision. You need to examine the fundamentals of a company to understand whether it's a good long-term investment.
When we examine Parker-Hannifin's fundamentals we see a 96 year old company that has proved itself flexible and adaptable, and a dominant player in industries that are set to profit substantially from several major megatrends in the next few decades.
What Parker-Hannifin has going for it
Parker-Hannifin is a big player in the motion and control industry, which builds control systems for automated systems such as factory robots. In fact its the worlds number one supplier in what is a $120 billion worldwide industry, one that's vitally important to industries such as: oil and gas drilling, food production and packaging, industrial construction, and aerospace.
Why does this make Parker-Hannifin worth considering at today's prices? Well, for one thing investment into the US energy industry is expected to reach $890 billion by 2026, according to analyst firm IHS.
Another major growth catalyst for Parker is the role of its motion control systems in industrial construction for infrastructure projects. For example, according to a new report from the Global Commission on the Economy and Climate, between now and 2030 world wide spending on energy infrastructure alone will reach $89 trillion.
Source: The New Climate Economy Report
Other growth avenues for Parker include its exposure to food production and water filtration systems, which are likely to grow in demand as the world's population grows to 9.4 billion by 2050, according to the US Department of Energy.
Thanks to this kind of global diversification of key growth areas, Parker-Hannifin has been able to achieve 12% annual compound sales growth since 2003,and achieve greater than 10% operating cash flows as a percentage of sales for 13 consecutive years.
More importantly for dividend growth investors, Parker-Hannifin has been able to reward investors with 58 consecutive years of dividend growth.
Given the industrial megatrends that Parker-Hannifin is growing into, I fully believe it will be able to continue its earnings and dividend growth winning streak in the years and decades to come.
Bottom line
When it comes to buying shares of high-quality industrial growth stocks like Parker-Hannifin, one does need to keep valuation in mind. However, unless that valuation is staggeringly outrageous (as it was in 2000 when the S&P 500 was trading at a P/E of 45) long-term, fundamental buy-and-hold investors shouldn't fear dollar-cost averaging or using the favorite Motley Fool principle of "buying in thirds." No one can predict the market, thus it's smart to never go "all in" on a new position, but hold back some cash in reserve, for when the next market correction occurs, as it undoubtedly will. For investors considering companies such as Parker-Hannifin, today's prices still offer a chance of beating the market in the long-term -- if you are patient enough.
