Caterpillar Stock Upgraded: What You Need to Know

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Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

Caterpillar (NYSE: CAT) investors had an incredible 2017, watching their stock rise 64% over 12 months of trading. 2018 is off to a pretty nice start as well, with shares tacking on another 8% so far in January (and the month isn't even over yet).

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What's got Caterpillar stock jumping lately? Well, Wall Street analysts for one thing -- they've been keen on Caterpillar all month long. Last week alone saw Caterpillar win a new buy rating, a hike to earnings estimates, and two raised price targets, according to reports from StreetInsider.com. And this week, Caterpillar won yet another upgrade, when New Orleans-based investment bank Seaport Global announced it is raising its rating on Caterpillar stock to buy and assigning a $195 price target.

Here's what you need to know about that.

Why Wall Street loves Caterpillar

Last week, analysts at Citigroup raised their price target for Caterpillar stock to $185, and Credit Suisse hiked its price target to $192. Investment banker Berenberg went even further, announcing a buy rating and a $200 price target on Caterpillar stock, stating, "Just as the mining downturn was more severe than expected, we believe the amplitude of the current upturn is underappreciated... CAT's mining original equipment (OE) and aftermarket revenues are depressed beyond normal and are set to grow at 25% CAGR through 2020 to make up for five years of under-investments."

Even with Caterpillar stock trading at an extremely pricey-seeming P/E ratio of 115 (based on trailing earnings), that prospect of multiyear, 25% annualized earnings growth was bound to attract some attention. You just don't see that kind of growth rate come around often in a $100-billion-plus market cap company like Caterpillar.

Seaport jumps aboard

It certainly caught Seaport Global's attention. Taking its own closer look at Caterpillar this morning, Seaport didn't come away quite as enthusiastic as Berenberg -- but was still pretty impressed.

Acknowledging the "strong run the stock has had recently," Seaport still thinks Caterpillar has "room to run." The analyst notes that after conducting "dealer checks" among sellers of earth-moving equipment, it's come away with the impression that "new-equipment inventories are still too low," and that Caterpillar should enjoy "high-single-digit if not double-digit revenue growth in 2018" as it manufactures new equipment to fill the gap between demand and supply. (What's more, because there is demand, chances are that those sales will enjoy high profit margins.)

Seaport sounded out Caterpillar management to confirm its suspicions. Unfortunately, management declined to give it "a pinpoint full-year outlook" for 2018. Turning next Caterpillar competitor Deere & Co. (NYSE: DE), though, Seaport was able to confirm that Deere is anticipating "strong growth rates ... for much of the year," with sales of construction and forestry products expected to grow 15%.

Granted, Deere is not Caterpillar, and vice versa. Still, given how closely these two companies compete, it's likely that if Deere is promising a good year in 2018, then Caterpillar should prosper similarly.

The most important thing: Valuing Caterpillar stock

Now as I mentioned at the outset, there's still the question of whether things will go good enough for Caterpillar to justify analysts' price targets. It behooves us, therefore, to say at least a few words on valuation.

At $101.7 billion in market capitalization, Caterpillar stock currently sells for 115 times its trailing-12-month profits. That sounds pricey. After all, Deere stock only costs 25.5 times earnings. Still, analysts surveyed by S&P Global Market Intelligence agree, on average, that the rebound in commodities is likely to drive Caterpillar's profits up 53% this year (to $7.63 per share), then another 24.5% in 2019 (to $9.50 per share), before slowing to a more leisurely 13% pace in 2020 ($10.77 per share). Add it all up, and that averages to a bit more than the 25% short-term earnings growth rate that Berenberg projected last week.

Sure, that still sounds pricey relative to a P/E of 115. But consider: If Caterpillar's free cash flow grows in tandem with earnings growth, well, Caterpillar threw off $4.4 billion in cash profits over the last 12 months. Its $101.7 billion market cap is only 23 times that figure. At 25% growth, I can see how a price-to-free-cash-flow ratio of 23 would look pretty attractive to investors.

Throw in a modest 1.8% dividend yield for good measure, and Caterpillar stock just might be worth buying.

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.

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