The shares of Ford Motor Co. (F) have been hit hard since the start of the new year – losing around 20% since 2016 trading started. Is this share price decline justified, or does it represent the opportunity of a lifetime? (This article is a digest version of a longer report available to IOI subscribers.)
As I discuss in my book and teach in our training classes, there are only a few things that drive the value of a stock: revenue growth, profitability, and investment level and efficacy. Let’s look at each of these drivers to build a good estimate of what Ford’s stock is really worth.
We looked at Ford in April of 2014 and projected that revenues would grow at 3% over the next five years in a best-case scenario and would shrink 1% per year in a worst-case scenario. So far, Ford’s actual results have ended up just about in the middle of that range, as you can see in figure 1.
Our present model is a bit more bearish – we are keeping 3% annualized growth as a best-case scenario, but dropping our worst-case projection to an annual fall of around 2%.
While revenues at Ford have been ho-hum, profitability has been extremely high – near our best-case margin projection of 7% (we use a proprietary profit metric called Owners’ Cash Profit or “OCP”). Our 2014 estimates plotted against the profits Ford actually generated are shown in figure 2.
We think that profitability is likely to remain good as the company consolidates platforms, closes unprofitable regional offices, and cuts costs in Europe. As such, we are keeping our profitability projections as is: best-case OCP margin of 7%, worst-case OCP margin of 2%.
The next valuation driver is the crucial one – investments. Unlike many analysts who conceive of investments only as expenditures for new equipment we view investments as any cash outflow that is taken to boost future profitability, including loans made to JVs, cash spent on acquisitions, and the cash value of stocks issued as “currency.”
We were surprised to see that the main form of investment spending made by Ford is not in retooling their factories, but in making loans to clients in an attempt to spur demand. While most people do not think of loans to clients as a form of “investment,” if you agree with our definition above, you must agree that Ford’s lease program is an investment – it is a cash outflow taken to boost future profitability.
Ford is lending out so much money, that the cash outflow actually eats through its owners’ profits in every year with strong sales. The best years for Ford’s owners in terms of free cash flow were actually in 2009-2010 thanks to a combination of asset sales and no loans being made to clients (see figure 3).
Ford’s investments are efficacious – loans to its customers succeed in spurring demand, keeping factory utilization high, and eventually boosting profits. The problem is that owners only get access to a share of those profits if very generous assumptions are made about normalized free cash flow margin levels. Even assuming that Ford’s medium-term cash flows will grow at a very fast annualized clip of 8%, our fair value estimates are still low, as shown in figure 4 below.
IOI’s valuation range for Ford is wide – $5 per share worst-case, $17 best-case, and $11 split right down the middle – because its operational and financial leverage have the potential to create huge swings in profitability in different economic environments.
The good news is that if Ford can maintain its recent high profitability levels, its fair value is likely closer to the upper end of our range than the lower. The 5.1% dividend yield also makes the shares attractive to income investors, but considering the valuation uncertainty, we cannot recommend an investment in the shares at this price level.
To Learn More about IOI’s Valuation Framework, Contact Us