Caterpillar Is 1 of the Largest Industrials Companies by Market Cap. But Is It a Buy?

Key Points

• Caterpillar stock has surged in recent months and is one of America's biggest industrial giants.

• Melius Research recently upgraded Cat stock to a buy based on artificial intelligence power needs.

• But a closer look at Caterpillar's valuation shows that the stock costs a lot -- probably too much.

• 10 stocks we like better than Caterpillar ›

In a recent June report, Motley Fool researchers identified Caterpillar (NYSE: CAT) as one of the three largest (specifically, the third largest) industrial stocks by market capitalization in the U.S.

Valued at $162 billion last month, the stock now costs more than $192 billion. Caterpillar generates more than $63 billion in sales annually, and turns $22.5 billion of this into gross profit. On the bottom line, Caterpillar earned net profit of $9.9 billion over the last 12 months, and the company generated $7.9 billion in positive free cash flow.

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Impressive statistics all. But are they good enough to make Caterpillar a buy today?

Image source: Getty Images.

Wall Street's take on Caterpillar

Wall Street seems to think so. According to a S&P Global Market Intelligence survey of 25 sell-side analysts who follow Caterpillar stock, 14 of them agreed the stock is a buy. Just last week, that number increased by one when Melius Research upgraded Caterpillar stock to buy and assigned the industrials stock a $500 price target.

As Melius commented in a write-up on The Fly, a financial news site, 2027 sales at Caterpillar are likely to grow "materially" as the power demands from artificial intelligence (AI) data centers drive increased need for power from multiple sources, including engines manufactured by Caterpillar. Caterpillar's role in this "power explosion," says Melius, is turning out to be surprisingly big, and gives the analyst reason to recommend Caterpillar stock even after it has already outperformed the S&P 500 significantly over the last 52 weeks, rising more than 21% in price.

And yet, just because Melius says Caterpillar stock is a buy doesn't necessarily make it so.

All of Caterpillar is divided into three parts

Caterpillar's business is made up of three main areas: construction, resource industries (primarily mining), and energy and transportation. The engines business falls within this last category, and it's undeniable that this segment is doing best of all at Caterpillar. Over the past five years, revenue from energy and transportation has surged 30% in total, versus growth of only 20% in resource industries and 13% in construction.

To this extent, Melius is right to point out that the engines business is a big revenue driver for Caterpillar. Unfortunately for Melius, and other Wall Street analysts recommending Caterpillar, it turns out that engines aren't a great driver of profits for Caterpillar. Despite its surging revenue, over the past 12 months, the energy and transportation segment has earned just 19.9% operating profit margin for Caterpillar.

The slower-growing resource industries and construction businesses, in contrast, earned operating profit margins of 20.4%, and 25.2%, respectively.

Is Caterpillar stock a buy?

What does this mean for investors? In dollars and cents, it breaks down as follows. After surging in price over the past year, Caterpillar now boasts a $192 billion market capitalization. On the one hand, that's only 19.4 times trailing earnings, which doesn't sound too expensive. But the devil's in the details here.

Caterpillar carries nearly $36 billion in net debt on its balance sheet, lifting its debt-adjusted market cap (its enterprise value) to nearly $228 billion. The company also generates significantly less free cash flow than it reports as net income -- just $7.9 billion over the past 12 months. As a result, the stock's enterprise value-to-free-cash-flow ratio is nearly 29, or roughly 50% more expensive than the stock's P/E ratio might suggest.

Factor in only a modest 1.5% dividend yield, and a projected 4.5% long-term earnings growth rate (according to the same analysts who recommend buying Caterpillar), and I can only conclude that this stock, so highly valued by investors, is in fact much too expensive to buy right now.

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Rich Smith has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.