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Introduction

The automobile sector is getting attention as the sector has not truly recovered from the multiple macroeconomic setbacks it has experienced in the last few years, such as the subprime crisis and earthquake in Japan. This article evaluates three of the largest companies in the sector -- Ford Motor Co (F), Volkswagen (OTCQX:VLKPY) and Toyota (TM), which have had their share of economic jolts in the last few years. Our argument makes a largely statistical case for suggesting which stock is the best bet for now.

Analysis

Volkswagen is currently selling at a low P/E ratio of 2.2, which is way below the industry average of 25. This metric alone is interesting enough to warrant a serious evaluation of Volkswagen as a bargain purchase. The article compares Volkswagen to two other major automobile companies selling at relatively low valuations, Ford and Toyota. The P/E ratio of Ford is 9.5 and for Toyota it is 20.2. From such numbers one would expect Toyota to be the most profitable and Volkswagen to be the least.

A measure of profitability is the owner's earnings. Owner's earnings are defined as Net income + Depreciation & Amortization - All Capital Expenditure (including working capital expenditure). This metric represents the money the company is making as a business for the shareholders. It is a better metric than net income or CFO, as it takes into account the internal investments that the company will have to keep on making to sell more products. Two automobile companies may have similar Net Incomes or CFOs over a period of five years, but they may have made vastly different investments in plants and inventory over the same period. As the table below shows, Volkswagen seems to performing better than Toyota and Ford as far as owner's earnings are concerned. It had only one year of negative owners' earnings, and its ttm measure of negative owner earnings is close to the best numbers in the last five-year period, which were seen in the year 2009-10.

Owners Earnings

2007-08

2008-09

2009-10

2010-11

2011-12

ttm

Toyota

-282,685

2832,908

-1057,425

383,999

-12501,866

-12,168

Ford

-6,539

-14,424

10,479

29,224

-136,697

5,381

Volkswagen

11,581

3,442

12,018

29,203

-89,635

10,661

Volkswagen seems to be doing even better than the other two companies on one metric, the return on invested capital (measured as Net Income/ Total Assets). The better profitability is largely due to the higher margins for Volkswagen, which have been consistently better than the other two competitors. The turnover of the three companies has fluctuated in the past and Ford currently is the best in this category. Thus, the profitability numbers are almost the opposite of what we expected from the P/E multiples. Volkswagen, which is selling at a cheap share price, seems to be doing the best, if one considers the fundamental numbers of profitability.

ROIC

2007-08

2008-09

2009-10

2010-11

2011-12

Toyota

5.29%

-1.50%

0.69%

1.37%

0.93%

Ford

-6.72%

1.39%

3.98%

11.33%

2.97%

Volkswagen

2.83%

2.83%

0.54%

3.43%

6.08%

ROIC = margin *turnover

2007-08

2008-09

2009-10

2010-11

2011-12

Toyota

Margin

6.53%

-2.13%

1.11%

2.15%

1.53%

Turnover

80.99%

70.64%

62.44%

63.70%

60.63%

Ford

Margin

-10.03%

2.30%

5.09%

14.83%

4.22%

Turnover

67.00%

60.72%

78.30%

76.40%

70.45%

Volkswagen

Margin

3.78%

4.18%

0.91%

5.39%

9.67%

Turnover

74.92%

67.78%

59.37%

63.63%

62.82%

Return on Earnings (ROE), the more commonly analyzed metric of profitability, however, favors Ford more that Volkswagen.

ROE

2007-08

2008-09

2009-11

2010-11

2011-12

Toyota

14.47%

-4.34%

2.02%

3.95%

2.69%

Ford

84.76%

-34.74%

-974.89%

134.50%

35.52%

Volkswagen

12.93%

13.58%

2.72%

14.87%

26.78%

If we do a simple credit analysis of the three companies, Volkswagen again seems to be the best positioned among all the three companies. Volkswagen has been generating enough cash from its operations to pay back the interest due to its creditors (although Toyota seems to be doing even better). However Volkswagen seems to be much better placed if we consider the other metrics that are a better indicator of credit quality, the ratio of average market value of the firm and debt on the balance sheet. If the value of any collateral (for the creditors of Volkswagen, it is the value of the company itself) is 26 times more than the money that is due to you, then you can breathe easier.

Toyota

Ford

Volkswagen

Debt / Equity

0.6

4.5

0.8

Interest Coverage Ratio (Average CFO / Interest Paid)

44.704

0.885

2.819

Average market value of firm / debt ( on balance sheets )

0.094

0.647

26.171

Given that the analysis so far (high profitability for low P/E stocks and good creditworthiness of the companies) points toward potential value stocks, we have used the valuation criteria put forward by Benjamin Graham (author of Intelligent Investing and Security Analysis) for identifying value bargains. We assumed similar interest coverage ratios and a conservative measure for the interest rate on debt issued by the three corporations. The interest that can be readily serviced by the companies from Cash flow operations is calculated as average CFO for the past five years divided by the assumed interest coverage ratio. The amount of the debt the company can readily service is calculated as interest that can be readily serviced divided by the typical interest rate on the debt issued by corporations (we have assumed 10% for all three, which is very conservative for them). The value of the company (according to the Graham rule) should be at least 175% of this debt capacity plus the surplus cash on the balance sheet.

Toyota

Ford

Volkswagen

Typical interest coverage ratio in the sector

4

4

4

Maximum Interest Paid in Last 5 years

46882

10437

4197

Average Cash flow from Operations [CFO]

2095854.8

9233.8

11831.4

Interest rate on debt issued by corporation

10%

10%

10%

Last five year average CFO / Typical Interest Coverage ratio (Interest that can be readily serviced)

523963.7

2308.45

2957.85

Debt service capacity (Interest that can be readily serviced/ Interest rate on debt)

$ 5239,637.00

$ 23,084.50

$ 29,578.50

Value of business ( 175% debt capacity + Surplus cash)

$ 11463,910.75

$ 79,857.88

$ 68,489.38

Value of business ( 175% debt capacity + Surplus cash) as percentage of market capitalization

69.82%

191.04%

94.16%

Bottom Line

The calculations represented in the table above suggest that Ford is the most undervalued among three. However, given that the fundamental numbers of Volkswagen have been consistently better than Ford, a diversified investment in both the stocks is recommended for the investor.

Source: Ford, Volkswagen And Toyota: Which Is The Best Bet For Now?