Ford (F) has been in the news quite a bit as of late.
On January 8, we learned that Ford’s sales in China rose an impressive 19% to 1.114 million vehicles in 2014. As followers have come to expect, the automaker is executing well and gaining ground in the country, a central part of our thesis. That same day we also received word that Ford raised its dividend 20%, to $0.15 per share on a quarterly basis. That’s nearly a 4% annual dividend yield based on current prices! Though the firm’s dividend is not as safe as those in the Dividend Growth portfolio on the basis of its Dividend Cushion ratio, we do view the dividend as icing on the cake with respect to Ford’s overall investment thesis. On January 13, the executive suite at the Detroit Auto Show mentioned that its launch of the 2015 F-150 remains on track. The F-150 is Ford’s bread-and-butter truck and promises to be more efficient than previous models thanks to more aluminum content. The new F-series represents a key source of earnings upside, in our view.
We continue to value Ford’s shares at $20 each, implying material upside from its share price at the moment. We like the company a lot and may re-consider adding it back to the Best Ideas portfolio at the right price (under the low end of the fair value range, or under $14 per share). We’re being patient, however. We exited at $14.82 per share in September of last year.
Ford’s Investment Considerations
Investment Highlights
• Ford has been around since the turn of last century and produces and sells automobiles. The company also engages in other businesses, including financing vehicles. Recent performance has been its best since 2006, setting records for Fiesta, Fusion and Escape. Sales in China have also been fantastic as of late, though global economic concerns will always be present.
• Ford’s earnings outlook has been muted due to expected product investments, but the automaker continues to please investors who not only have seen increased dividends but also have witnessed the firm effectively capture pent-up demand caused by the Great Recession.
• Ford continues to implement its ‘ONE FORD’ plan successfully and accelerate development of new vehicles customers want. The company continues to have success driving operating margin improvement and has reduced North America’s structural costs by more than $9 billion since 2005.
• Though Ford has seen turnaround expert and former CEO Alan Mulally leave, we think COO Mark Fields is highly capable of running the automaker as the next chief executive. The middle of the decade is looking quite bright for Ford Motor. Market share in China and sales of the F-150 are worth watching closely.
• We like the firm’s ability to generate strong automotive cash flow while reducing pension obligations. Ford now boasts an investment-grade credit rating and expects to maintain it through the course of the economic cycle.
Business Quality
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Ford’s free cash flow margin has averaged about 3.3% during the past 3 years. As such, we think the firm’s cash flow generation is relatively MEDIUM. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Ford, cash flow from operations decreased about 34% from levels registered two years ago, while capital expenditures expanded about 54% over the same time period.
Valuation Analysis
Our discounted cash flow model indicates that Ford’s shares are worth between $14-$26 each. The margin of safety around our fair value estimate is driven by the firm’s MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. All of a firm’s value is based on the future, and the future is unpredictable. This is why we use a margin of safety in our process. If the future were known with certainty, then value estimation would be precise. Obviously, value is not precise, but a range of probable fair value outcomes.
The midpoint of the range is our estimated fair value of Ford, or $20 per share. Our model reflects a compound annual revenue growth rate of 4% during the next five years. Our model reflects a 5-year projected average operating margin of 7.6%, which is above Ford’s trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3.6% for the next 15 years and 3% in perpetuity. For Ford, we use a 10.4% weighted average cost of capital to discount future free cash flows.
We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers — those that drive stock prices — pay attention to a company’s price-to-earnings (PE) ratio and price-earnings-to-growth (PEG) ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. We think Ford’s PEG ratio is particularly attractive.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm’s fair value at about $20 per share, every company has a range of probable fair values that’s created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn’t see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Ford. We think the firm is attractive below $14 per share (the green line), but quite expensive above $26 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Ford’s fair value at this point in time to be about $20 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm’s current share price with the path of Ford’s expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm’s shares three years hence. This range of potential outcomes is also subject to
change over time, should our views on the firm’s future cash flow potential change. The expected fair value of $24 per share in Year 3 represents our existing fair value per share of $20 increased at an annual rate of the firm’s cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
