One of the reasons our members love us is that we tell the story through the numbers. Every income statement says something; every balance sheet has a history; and every cash flow statement reveals a firm's true intrinsic value. The numbers talk--and we think every investor should listen to them. Let's see what they say about General Motors (GM).
At Valuentum, we think a comprehensive analysis of a firm's discounted cash-flow valuation and relative valuation versus industry peers is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index (click here for an in-depth presentation about our methodology), which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors (we like firms that fall in the center of the diagram below). More interest = more buying = greater likelihood price increases to fair value.
If a company is undervalued both on a DCF and on a relative valuation basis, it scores high on our scale. General Motors posts a VBI score of 4 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its attractive relative valuation versus peers, and very bearish technicals. We compare General Motors to peers Ford (F), Honda (HMC), and Toyota (TM).
• General Motors is back. The firm put up a solid 2012, with four of its five business units showing profits. Its fixed costs have been reduced by roughly 25% since 2007, putting it on much more solid footing.
• General Motors has significantly improved its break even point. On an EBIT-adjusted basis, break-even is roughly 10 million total US industry units (a level not reached in more than 20 years). During the past three years, the auto maker has posted an EBIT-adjusted margin of roughly 7.4% (not bad).
• Though there will be hiccups along the way, we don't think GM is finished expanding operating margins. Its intermediate-term goal is for EBIT-adjusted margins to be greater than 10% as it continues to reduce fixed costs and improve efficiency.
• China will eventually become the world's largest vehicle market, and GM has used its first-mover advantage to become one of the dominant players in the highly-fragmented country.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital - ROIC - with its weighted average cost of capital - WACC. The gap or difference between ROIC and WACC is called the firm's economic profit spread. General Motors' 3-year historical return on invested capital (without goodwill) is 6.3%, which is below the estimate of its cost of capital of 11.3%. As such, we assign the firm a ValueCreation™ rating of POOR. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
The estimated fair value of $50 per share represents a price-to-earnings (P/E) ratio of about 13.5 times last year's earnings and an implied EV/EBITDA multiple of about 22.3 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 4.6% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 13.3%. Our model reflects a 5-year projected average operating margin of 7%, which is above General Motors' trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 0.7% for the next 15 years and 3% in perpetuity. For General Motors, we use a 11.3% weighted average cost of capital to discount future free cash flows.
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 $50 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 General Motors. We think the firm is attractive below $35 per share (the green line), but quite expensive above $65 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 General Motors' fair value at this point in time to be about $50 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 General Motors' 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 $72 per share in Year 3 represents our existing fair value per share of $50 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
Additional disclosure: F is included in the portfolio of our Best Ideas Newsletter.