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Summary

  • GM's history of poor design and execution are a thing of the past.
  • The large dividend pays you to wait for the multiple to expand to a reasonable level.
  • GM is currently priced for earnings contraction over the medium term.

General Motors (NYSE:GM) is a source of perpetual controversy surrounding its famed bailout as a result of decades of mismanagement, a ridiculous cost structure and terrible designs that consumers simply didn't want. I have looked down upon GM my entire adult life due to those factors, but no more. For the first time, I am a GM bull and in this article, I intend to explain why. The valuation of GM has simply become too compelling to ignore, with shares currently priced for an Armageddon scenario where GM forgets how to sell cars.

To figure out what I think GM is worth and what the market is currently pricing it for, I'll use a DCF-type model that you can read more about here. In essence, it uses inputs such as earnings estimates, a discount rate and other basic metrics, such as book value and dividend payouts in order to determine a discounted present value for the company's future operations and a fair value of today's business.

For this exercise, I used 2014 and 2015 earnings estimates from Yahoo! Finance. I then used the company's present dividend of $1.20 per share and estimated 5% per annum growth in the payout. The discount rate I chose was 10%, as I believe that represents a fair assessment of risk and allows for a margin of safety in the analysis. Finally, I chose 3% as the perpetual growth rate. All of these estimates are just that, and you may not agree, but I believe them to be reasonable.

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

Prior-Year earnings per share

$3.18

$3.67

$4.87

$4.81

$4.75

$4.69

x(1+Forecasted earnings growth)

15.40%

32.70%

-1.25%

-1.25%

-1.25%

-1.25%

=Forecasted earnings per share

$3.67

$4.87

$4.81

$4.75

$4.69

$4.63

Equity Book Value Forecasts

Equity book value at beginning of year

$26.33

$28.80

$32.41

$35.90

$39.25

$42.49

Earnings per share

$3.67

$4.87

$4.81

$4.75

$4.69

$4.63

-Dividends per share

$1.20

$1.26

$1.32

$1.39

$1.46

$1.53

=Equity book value at EOY

$26.33

$28.80

$32.41

$35.90

$39.25

$42.49

$45.58

Abnormal earnings

Equity book value at beginning of year

$26.33

$28.80

$32.41

$35.90

$39.25

$42.49

x Equity cost of capital

10.00%

10.00%

10.00%

10.00%

10.00%

10.00%

10.00%

=Normal earnings

$2.63

$2.88

$3.24

$3.59

$3.93

$4.25

Forecasted EPS

$3.67

$4.87

$4.81

$4.75

$4.69

$4.63

-Normal earnings

$2.63

$2.88

$3.24

$3.59

$3.93

$4.25

=Abnormal earnings

$1.04

$1.99

$1.57

$1.16

$0.76

$0.38

Valuation

Future abnormal earnings

$1.04

$1.99

$1.57

$1.16

$0.76

$0.38

x discount factor(0.1)

0.909

0.826

0.751

0.683

0.621

0.564

=Abnormal earnings disc to present

$0.94

$1.64

$1.18

$0.79

$0.47

$0.22

Abnormal earnings in year +6

$0.38

Assumed long-term growth rate

3.00%

Value of terminal year

$5.46

Estimated share price

Sum of discounted AE over horizon

$5.03

+PV of terminal year AE

$3.08

=PV of all AE

$8.11

+Current equity book value

$26.33

=Estimated current share price

$34.44

What I've shown here is a close approximation of what I believe the market is pricing into GM shares today. With shares trading at $34.53 as of this writing, I believe that negative earnings growth is priced into shares in the out years, namely 2016 and beyond. If we assume for a second that analyst estimates are correct, and they are normally pretty close, GM will actually need to decrease its EPS in each year from 2016 to 2019 in order to justify today's price. That sounds pretty nonsensical to me, as you could reasonably expect GM to grow earnings at 2% or so, based simply on inflation of prices and efficiencies gained. In other words, I don't believe priced-in expectations have any basis in reality.

On the plus side, having the legendary investor on your side is nice. Warren Buffett owns 40 million shares of GM, or roughly 2.5% of the company. We all know his holding period is "forever", and with a valuation like what we've just seen, who can blame him? Meanwhile, he's collecting ~$50 million a year in dividends on his position.

More importantly, one reason GM was so far behind the foreign manufacturers is that it built cheap, unattractive cars that nobody wanted. GM doesn't do that anymore, and it has this to thank for its resurgence. Moves like investing in the cars that will drive profitability in the future, like the Volt and Opel's new all-electric, show me that GM management gets it and that it will not rest on its laurels, as it did in the past. While the Volt has been a disappointing seller so far, there is promise in not only the Volt, but what it could represent in the future. An affordable electric car will become commonplace at some point, and GM is laying the groundwork for that now, gaining expertise in designing and building such cars.

The obvious black eye right now is the ignition switch disaster, with which GM has shot itself in the foot. If claims are true that GM knew about this and didn't do anything about it, that is an abhorrent act and penalties should be levied. However, this too shall pass, as it always does, and the ADD attention span of the general populace will move on to focus on something else. Anyone remember the unintended acceleration problems at Audi and Toyota? Didn't think so, neither does anyone else. GM will move past this and it will be a faint memory at some point, so I'm not overly concerned about it. Lawsuits and fines will be handed down, but GM will pay them, apologize and we will all move on.

So what is GM worth then, if my claims are true? Analysts have GM growing earnings at around 15% per year over the term of 2016 to 2019, but I'm not willing to go that far. If that ends up being the case, then GM will be the investment of the century, but let's be a bit more conservative here. If I price in 5% EPS growth for the 2016 to 2019 period, holding constant this and next year's EPS with our example above, I get a current fair value for GM of $44.49, or 29% upside from here. Keep in mind also that this number represents a fair value, not a price target, meaning that the price target is actually much higher. The $44.49 represents the price at or below which GM shares should be bought today given the expectations of future profit growth. In other words, the margin of safety is gigantic on this one.

And in case you needed another reason to be bullish, GM's dividend, which I haven't touched on much, is a very nice 3.5% at present, offering you nearly twice the market yield for waiting for expectations to catch up to reality. The bottom line is that GM represents a rare opportunity to own a turnaround stock with a gigantic yield and an enormous margin of safety to boot. This former GM hater is backing up the truck.

Source: General Motors - Priced For Earnings Contraction