Can General Electric Company (GE) Really Increase Its Return on Equity?

By Markets Fool.com

General Electric Company's 3.5% dividend yield is attracting a lot of income seekers, but will the company be able to grow the dividend in the future? In a recent article, I highlighted the importance of the company's need to grow earnings and improve productivity to do so. The question now is whether General Electric really can improve productivity. Or is it stuck in an era of productivity decline because of its size and scale?

Continue Reading Below

Return on equity matters
In the previous article, I outlined why return on equity, or ROE, matters for dividend growth. Simply put, ROE is a measurement of how well a company can generate income from what shareholders own in the company.

I've produced the following table so you can better see how a high ROE affects dividend growth. According to this analysis, peers such as United Technologies and Honeywell International will be capable of paying out a much larger dividend in the future, despite starting from a lower base.

Company Market Cap (Billions) 10-Year ROE Average Payout Ratio Theoretical Dividend Growth Rate, g=ROE*(1-D/P) Theoretical Dividend in 10 Years Theoretical Yield in 10 Years' Time
General Electric

$260

13.3% 58.9% 5.3% $1.5 5.8%
Honeywell International $81 23.6% 34.6% 15.4% $7.8 7.6%
United Technologies $110 21.5% 34.6% 14.1% $8.8 7.3%

Source: company presentations. Theoretical yield is based on current stock price.

On the other hand, these figures are based on quantitative analysis that assumes ROE in the next 10 years will average out the same as in the past 10 years. Moreover, there is an argument that a company's ROE will be harder to increase in time as it grows larger.

Continue Reading Below

General Electric Company versus peers: the long view
To shed some light on these questions, let's look at ROE during the past two decades for these companies. Incidentally, the three companies will always be associated following GE's collapsed takeover of Honeywell in 2001, a bid that saw it trump United Technologies in the process.

GE Return on Equity (TTM) Chart

GE Return on Equity (TTM) data by YCharts

Honeywell International's ROE has increased notably since the 2002 recession and is approaching levels seen before the 2009 recession -- an indication that scale is not necessarily an impediment to growing ROE.

United Technologies' ROE has been relatively range-bound since both recessions. It's likely that its ROE dipped after the acquisition of Goodrich, and as the company's Pratt & Whitney segment has increased its investment in getting its geared turbofan engine into service. Nonetheless, United Technologies has good growth prospects -- demonstrating that ROE is sometimes determined by long-term strategic decisions.

In short, both companies have outperformed General Electric, whose ROE has declined notably after both recessions. The results of the differences in productivity can be seen in returns to shareholders, with General Electric the laggard:

GE Total Return Price Chart

GE Total Return Price data by YCharts

A return to form
A look at each company's ROE has to be accompanied by some qualitative commentary. In that vein, General Electric's ROE performance over the past 20 years isn't necessarily an inexorably declining metric. Another view sees it, at least partly, as a consequence of being hit by one macro-headwind after another.

If it wasn't rising oil prices, it was the 9/11 attack and its impact on aerospace. If it wasn't sluggish utility spending from 2000 to 2005, affecting its core power and water sales, it was the overexposure to credit markets during the financial crisis through GE Finance. I've discussed these issues more length elsewhere, so suffice it to say that they all added up and reduced the potential for earnings growth and ROE.

In truth, you can't just look at ROE in isolation from the company's end markets. Still, prospects look good for General Electric in the next few years. The renewed focus on power that comes with the acquisition of Alstom's energy assets allows management to generate earnings growth in its core market. Meanwhile, management believes that EPS from its overall industrial business will grow by double digits in 2015.

The takeaway
All told, General Electric can increase its ROE in future years, and investors shouldn't be too downbeat, based on the previous 10 years' performance, although the company needs help from its end markets and good execution with the integration of Alstom's energy assets. Again, it's important to note that ROE is partly contingent on a company's trading environment.

Clearly, the company needs to improve ROE because more of the same probably won't be good enough to satisfy most investors. In other words, don't just look to the company's dividend, because it might not be enough to support the stock price if General Electric doesn't improve ROE in the future. If current ROE trends continue, then Honeywell International and United Technologies are a better value.

The article Can General Electric Company (GE) Really Increase Its Return on Equity? originally appeared on Fool.com.

Lee Samaha has no position in any stocks mentioned. The Motley Fool owns shares of General Electric Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.