Caterpillar's Power Generation Business Is Nearly as Big as Its Construction Segment. Here's What That Shift Means for the Stock's Multiple

Investors mostly know Caterpillar (NYSE: CAT) as a maker of bulldozers and backhoes, and construction equipment is still a huge part of its business, to be sure.

What was only an ancillary part of its business mix, however, is quickly becoming an important profit center for the company. This new center is Caterpillar's power generation unit, which offers conventional combustion-power generators, gas turbines, and even some solar power solutions.

This shift -- or perhaps more precisely, the reason for this shift -- is affecting the stock's valuation in a way the market is likely to support for the foreseeable future.

Image source: Caterpillar Inc.

Another company capitalizing on the AI revolution

It's never been a bad company. With only a handful of predictable exceptions, however, the slow-moving, single-digit-growth nature of the construction business has kept Caterpillar shares priced below the S&P 500's modern-era average price/earnings ratio of around 20.

As is the case with plenty of other related companies, though, the advent of artificial intelligence (AI) is changing how investors value this one.

It's true! While the construction of data centers requires heavy-duty bulldozing and the like, Caterpillar's biggest and most unexpected growth engine of late is the aforementioned power-generation equipment. Starved for electricity, data centers are now utilizing this company's conventional combustion-powered generators for auxiliary and even primary power. For customers willing and able to make the larger upfront investment, Caterpillar is even supplying natural gas power turbines.

And this demand is making a measurable impact on its top and bottom lines. Last quarter, Caterpillar's power and energy unit's revenue grew 17% year over year to more than $8.2 billion, nearing company-leading construction-related sales of just over $8.3 billion. Moreover, power and energy's operating profit of a little more than $2 billion eclipsed construction's profit of just under $2 billion, underscoring the power arm's margin-widening pricing power in this environment.

Look for more of the same, too, and for the same reason. The company's order backlog now stands at $72 billion, growing 92% year over year for the three months ending in June.

The thing is, this future growth appears to already be priced into the stock. CAT shares have soared nearly 90% over the past 12 months due to AI-driven growth, pumping the stock up to a frothy forward-looking price/earnings ratio of a little more than 30. For perspective on this figure, that makes Caterpillar shares more expensive than Microsoft's, Alphabet's, and Nvidia's.

Just get used to it for a while.

Probably not a short-term fluke

Only time will tell how long investors are willing to support such a premium valuation. But, given the amount of money already earmarked for investment in AI infrastructure and how quickly that money is intended to be deployed, it's conceivable this could be the new valuation norm for several more years.

Analysts seem to think so anyway. Indeed, most of them are saying Caterpillar shares still aren't fully valued. The analyst community's current consensus price target of $991.21 is more than 20% above the ticker's current price, allowing room for an even richer valuation.

James Brumley has positions in Alphabet. The Motley Fool has positions in and recommends Alphabet, Caterpillar, Microsoft, and Nvidia. The Motley Fool has a disclosure policy.