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I have recently taken a bullish stance on Ford (NYSE:F) and expect the stock to perform well through the rest of 2012 and in 2013. While it's true that Ford has struggled for much of 2012, I think the stock is finally beginning to turn around, and investors are noticing. Those who focus on fundamentals, but do not have a thorough understanding of it, get hung up on one key statistic: Ford's current P/E ratio is a mere 2.5. Many investors look at this and do not fully understand why, something this article will attempt to shed some light on.

Among other reasons for being bullish, I picked Ford for several key reasons. First, Ford has done an exceptional job selling cars in the U.S. and China, helping planned losses from Europe, which is now expected to be $1.5 billion for 2012. Aside from strong domestic sales fighting European losses, Ford has already planned ways to help keep costs lower and further reduce the effects of Europe.

I also think the recent decision allowing Alan Mulally to remain Ford's CEO until at least 2014, will greatly increase the odds that Ford does more than just scrape by for the next few years. Mulally was able to steer Ford clear of government bailouts in 2008, when other U.S. automakers had to resort to such actions. Mulally was able to keep Ford afloat and eventually reinstated its dividend in early 2012.

Finally, I think Ford has a beautiful chart and personally, I think technical analysis plays a vital role in a stock's behavior. Over the long-term, fundamentals may tell the story, but I think it's important to use both fundamental and technical analysis together in order to make sound investment decisions. Aside from the reasons listed above, reading my previous article on my bullish stance includes a more in-depth analysis, as well as how I plan to play the pending upward move in Ford.

(click to enlarge)

Source: Stockcharts.com

But if Ford is looking so good, why is the valuation so low? In essence, A very high P/E ratio would potentially indicate that the stock is rather pricey. On the other hand, a very low P/E ratio would indicate that the stock is being discounted quite a bit. The actual definition of P/E ratio, from the investment website InvestorGuide.com, goes as follows:

"fundamental analysts use the price-to-earnings ratio, more commonly known as the P/E ratio, to figure out how much the market is willing to pay for a company's earnings. You can calculate a stock's P/E ratio by taking its price per share and dividing by its EPS. For instance, if a stock is priced at $50 per share and it has an EPS of $5 per share, then it has a P/E ratio of 10. P/E can be calculated for the previous year ("trailing P/E"), for the current year ("current P/E"), or for the coming year ("forward P/E"). The higher the P/E, the more the market is willing to pay for each dollar of annual earnings. Note that last year's P/E would be actual, while current year and forward year P/E would be estimates, but in each case, the "P" in the equation is the current price."

The average P/E ratio for the S&P 500 is between 12-15. Using only the above information, we would come to the conclusion that Ford is extremely, extremely cheap. But the market wouldn't likely discount a stock so drastically unless something was affecting the information that dictates the P/E ratio. Lets take a closer look at some of these components.

Looking at the chart below, we can see how Ford recently traded with a P/E ratio between 8 and 10 in 2010, before collapsing in 2011. The chart displays the P/E ratio (blue line) and the price of Ford (orange line) simultaneously, over a 2.5 year time span:

(click to enlarge)

Source: Ycharts.com

So what exactly caused this sudden drop in the P/E ratio? The answer involves how companies can and do manipulate earnings figures. When Ford reported its fourth quarter results in 2011, it posted a gain of $20.2 billion. Of that $20.2 billion, only $6.6 billion was from actual auto-related earnings, while adding approximately $12.4 billion back onto its books in previous tax losses.

Portions of old tax losses can be considered corporate assets, because they can applied to current taxes. Assuming the company becomes profitable eventually, these tax losses can come onto the books, and in Ford's case, did so in a rather drastic manner. This accounting "trick" occurred in January 2011, and as you can see on the chart above, weighed heavily on the stock price.

Despite the alteration, the $6.6 billion in profit was a welcome change to the struggling company. Ford, which has now been profitable for the last three years, felt that it was appropriate to welcome the tax losses back on the books. Below is a chart of the previous 12 years, where you can see Ford struggled mightily between 2006-08, before turning things around in 2009.

(click to enlarge)

Now back to the P/E ratio and how it became distorted. Below I'll show two different scenarios, the first, if Ford only posted the $6.6 billion gain and the second, the actual $20.2 billion gain posted by Ford in its 4Q earnings report and how it would effect the current P/E ratio in 2011:

P/E Ratio = Price / Earnings Per Share = $16 / 1.79 = 10.05

P/E Ratio = Price / Earnings Per Share = $16 / 4.94 = 3.24

The difference in earnings is the equivalent of what the tax losses added back onto the books. As you can see in the example, as well as on the first chart above, this crushed the P/E ratio from 10, all the way down to the current ~2.5 P/E ratio Ford now has. Because the P/E is shown from the trailing 12-months, the P/E ratio remains remarkably low. With such a low share price and so much "profit" from 2011, the earnings, which is the "E" in P/E, severely alters the ratio.

Now when you look to adjust the P/E ratio for what it should be, you'll see Ford doesn't look that strange after all. Below is the projected PE ratio for Ford, based on what it is projected to earn for 2012, which is $1.34 per share:

PE Ratio = Price / Earnings Per Share = $11.10 / 1.34 = 8.28

So if Ford's true P/E ratio is 8.28, why does it display 2.5 instead? Well, like we discussed above, the P/E ratio is typically displayed for the trailing 12-month period. When you divide price by earnings per share, or EPS, it is also for the trailing 12-months. In Ford's case, the trailing 12-month EPS is 4.42 and with Ford only trading for $11, that's quite a bit of profit. Below is the equation showing how Ford's P/E ratio becomes distorted, and is the one typically displayed by most financial news sources:

PE Ratio = Price / Earnings Per Share = $11.10 / 4.42 = 2.51

As you can see, this is how Ford's numbers can be misleading, especially when you just take them for granted. Once you dig into some of these numbers and really figure why they are what they are, better investment decisions can be made. While Ford's current PE ratio is not 2.5, but closer to 8 or 9, it still suggests the automaker is relatively cheap for the current share price.

Ford has beat each of its last three earnings estimates, despite bearish shareholders and dim outlooks. Although 2012 has been a rough ride for this automaker, the bulls are coming out and analysts are lightening up. Ford currently has an average price target of $14.67 among 22 analysts, with zero "Sell" or "Underperform" ratings. I think Ford is undervalued on a fundamental basis, while maintaining strong price action, which is why I remain long and bullish.

Source: Ford's P/E Is 2? A Deeper Look At This Automaker's True Valuation