Caterpillar (CAT 2.72%) is a top-five holding of the Bill & Melinda Gates Foundation Trust, and it's also a stock up 83% over the last three years and 176% over the last five. But what can investors expect for the year ahead for this member of the Dow Jones Industrial Average stock index? Does it make sense to follow the Bill & Melinda Gates Foundation Trust and buy the stock? Here's what you need to know.

Caterpillar's cyclicality

As always with Caterpillar, investors should be mindful that it's a cyclical company, so its sales tend to oscillate according to a trend. Its main end markets are construction, resource industries (encompassing mining machinery and aggregate machinery), and energy and transportation (oil and gas equipment, power generation equipment, transportation, and industrial machinery).

Many of these end markets have been in good health in recent years, with commercial construction solid, infrastructure spending receiving bipartisan support, and mining and energy equipment supported by good commodity prices, encouraging capital investment. In addition, a newfound discipline among energy and mining companies encourages the view that capital spending in those industries is set for a long, moderately growing supercycle, rather than the boom and bust of previous decades.

Caterpillar's management acknowledges the cyclicality and outlines financial targets with it in mind. For example, in the current year, management estimates that its machine, energy, and transportation (ME&T) free cash flow from trough to peak will range from $5 billion to $10 billion.

With this in mind, there are three factors that investors need to consider before buying Caterpillar stock.

1. Caterpillar's valuation

Based on management's estimates, Caterpillar appears to be at the top of the cycle in terms of FCF. The chart below shows the evolution of its FCF, and management's guidance for 2025 FCF is a figure in the "top half" of its annual target range -- in other words, a figure between $7.5 billion and $10 billion.

Data source: Caterpillar SEC filings. Chart by author.

It would be simple to put in the midpoint of the 2025 guidance ($8.75 billion), multiply it by 20 (a typical price-to-FCF multiple), and get a target market cap for Caterpillar of $175 billion. That figure suggests a 6.5% upside potential from the current market cap.

However, suppose this is the top of Caterpillar's cycle. In that case, it makes sense to be cautious and price the stock at the midpoint of the $5 billion to $10 billion cyclical range, meaning $7.6 billion in FCF and $150 billion market cap, again assuming a 20 times FCF multiple.

2. Caterpillar's services growth

There are a couple of other reasons to be cautious about Caterpillar. The first comes from its services growth. Caterpillar generated $64.8 billion in sales in 2024, of which $24 billion came from services -- a 4% increase from 2023.

Image source: Getty Images.

Services are essential to Caterpillar; they help reduce the cyclicality of its earnings (services are more sticky in a weak economic environment), create a margin expansion opportunity for the company, and offer a long-term income stream.

They are a key part of management's growth plans, which aim to double services revenue from $14 billion in 2016 to $28 billion in 2026.

With $24 billion in services revenue in 2024, Caterpillar needs to grow services revenue by 8% a year through 2026 to hit its target. That looks like a tall order, given that management expects its total sales to be slightly lower in 2025 than in 2024. Indeed, it's noticeable that CEO Jim Umpleby referred to the target as "aspirational" on the recent earnings call.

Image source: Getty Images.

3. Caterpillar can't rely on price realization

Price realization is the ability to achieve a product's listed selling price. Not all products sell at the selling price, partly due to promotions or discounts. The best way to think about it is to consider that a positive trend in price realization indicates more substantial pricing power and vice versa.

Going into 2024, Caterpillar's growth in price realization (which drops straight into profits) was more than offsetting sales volume declines, but as you can see in the chart, that's no longer the case. In fact, price realization turned negative in the fourth quarter of 2024.

Data source: Caterpillar presentations. Chart by author.

This suggests Caterpillar's pricing environment is weakening, and pricing is catching up with year-over-year sales volume declines.

A stock to buy?

Caterpillar doesn't look like an outstanding value stock right now. That might change if the economy enters a supercycle for commodities (Caterpillar has exposure to mining and energy and the infrastructure needed to harness it) or if the impressive improvement in FCF in recent years is structural.

However, given the trend in price realization, service revenue growth, and sales volumes, Caterpillar has likely already passed the peak in the current cycle. It's one for the watch list for now, and it looks like the Bill & Melinda Gates Foundation Trust has already made easy money on the stock.