Who Wants to Be a Railroad Tycoon? Union Pacific Stock Rated a Buy

By Markets Fool.com

At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." Today, we'll show you whether those bigwigs actually know what they're talking about. To help, we've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.

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Who wants to be a railroad tycoon?

This morning, analysts at U.K.-based brokerage Atlantic Equities announced a seriesof new ratings for American and Canadian railroad stocks. According to the ratings watchers at StreetInsider.com, CSX (NASDAQ: CSX), Kansas City Southern (NYSE: KSU), and Norfolk Southern (NYSE: NSC) received only neutral ratings from the analyst. On the other hand, Union Pacific (NYSE: UNP) and, a bit to the north, Canadian Pacific (NYSE: CP), both won overweight ratings from the analyst.

Why?


Investing in railroads is not a straightforward process. Image source: Getty Images.

No straight line to an answer

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That's an excellent question. Unfortunately, no one seems to know the answer. I've checked all my usual sources in the mainstream media, but so far, the most I've been able to dig up is that Atlantic has set a $114 price target on Union Pacific (which costs $92 and change today), assigned a $104 target to Norfolk Southern (which currently costs about $88), prices Kansas City at $113 (current price: $96.58), and thinks CSX is worth about $31 a share -- 11% more than it currently sells for, but apparently still only good enough for a neutral rating.

As for how the analyst justifies these ratings, however, we know almost nothing -- and that's OK.

Your guess is as good as theirs

After all, it's not as if Atlantic Equities is some stock-picking star, with special insight into the stock markets that you and I lack. To the contrary! According to our data on Motley Fool CAPS, Atlantic Equities ranks only in the bottom half of investors we track, with ratings accuracy that's similarly sub-40%. Surely you can crunch numbers well enough to beat that record, right?

So let's get started.

Crunching the numbers on North American railroad stocks

Drawing data from my favorite free stock screening tool, finviz.com, here's how these five stocks stack up today:

Railroad Stock

P/E

5-Year Projected Growth Rate

Dividend Yield

Total Return

Canadian Pacific

19.4

8.7%

1.1%

9.8%

CSX

15.3

5.3%

2.6%

7.9%

Kansas City

21.0

9.6%

1.4%

11%

Norfolk Southern

16.6

10.8%

2.7%

13.5%

Union Pacific

18.0

7.4%

2.4%

9.8%

Data source: Finviz.com.

As you can see, in choosing to initiate coverage of the railroad industry, Atlantic Equities isn't exactly diving deep for value. While it's true that the five stocks named above all sell for less than the current 25.3 P/E ratioon the S&P 500, their growth rates are rather low, and their dividend yields only average for the industry.

As a result, not one of these five stocks sports a P/E ratio lower than its percentage expected total return (profits growth, plus dividend payments). Norfolk Southern comes closest to passing this value test, with a total return ratio of 1.2 -- but even there, it's about 20% too expensive to be considered a true value stock. Canadian Pacific and Union Pacific, the two stocks Atlantic has picked to outperform the market, both sell for total return ratios of roughly 2.0 (as do CSX and Kansas City Southern).

So given all this, why would Atlantic Equities favor overpriced Union Pacific and Canadian Pacific over cheaper Norfolk Southern? The most likely answer is "return on equity." According to finviz's data, Union Pacific and Canadian Pacific both boast returns on equity that far outpace their peers -- 21.3% and 32.2%, respectively, versus an average of 13.7% ROE for their peers.

Pick your valuation poison

Personally, I'm a fan of investing based on total return -- and by that metric, none of these five railroad stocks passes the test. But I will say this: Choosing stocks based on superior returns on equity, rather than on the more variable metric of growth rate expectations combined with dividend yield, is a perfectly valid way to invest in stocks. Atlantic is not necessarily wrong when it says Canadian Pacific and Union Pacific are better bargains than Norfolk Southern for example.

The only caution I'd give, should you choose to follow Atlantic Equities' advice and buy one of the two Pacifics, is this: Beware of debt.

As we've explained before, some companies use excessive debt to jack up their returns on equity. Problem is, "earnings generated from debt financing [can be] higher risk than earnings generated from equity financing ... Whereas a company that is completely equity financed can normally ride out a downturn, a company with a large portion of debt financing is unfortunately not quite so well equipped."

With this in mind, if choosing between Canadian Pacific and Union Pacific as an investment, I'd be inclined to go with Union Pacific and its debt-to-equity ratio of 0.7, rather than Canadian Pacific with its ratio of 1.8. If you're going to risk buying an overvalued stock, at least make sure it's the one with the lighter debt load.

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Fool contributorRich Smithdoes not own shares of, nor is he short, any company named above. You can find him onMotley Fool CAPS, publicly pontificating under the handleTMFDitty, where he currently ranks No. 308 out of more than 75,000 rated members.

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