Analysts can't seem to agree on how much Ford (NYSE:F) and General Motors (NYSE:GM) are worth. The target price estimates on Ford range from $12 to $23 (with some online articles and blog postings suggesting share prices as high as $30) and the price estimates on GM range from $33 to $55 (with some online articles and blog postings suggesting share prices as high as $100). Why is it so difficult for analysts to determine a fair valuation for these well-established companies that are in highly cyclical and predictive industries?
Currently, Ford is trading for 10.06 times its earnings (in the last 4 quarters) while GM is enjoying a high P/E of 37.90. Keep in mind that GM's earnings has a lot of one-time items due to the company's recent recall activities and this may not reflect a normal. Also, keep in mind that Ford's extraordinarily low P/E in 2012 reflects a one-time tax benefit which gave the company a temporarily low P/E at the time.
If we look at normalized figures, Ford is enjoying a P/E of 11.50 and GM's P/E falls to 20.20. Still, by looking at this metric alone, it looks as if Ford is at least twice as cheap as GM.
What if we look at price-to-sales ratios of the two companies? Currently Ford is trading for 0.45 times its annual sales while GM is trading for 0.36 times its sales. These figures look ridiculously cheap compared to some other companies; however, both figures are in line with these companies' historical valuations. Then one has to ask why these two companies get such low price-to-sales ratios.
At the end of the day, it all comes down to margins. While it is important for a company to generate healthy amounts of revenues, what matters at the end of the day is how much of that revenue stays home with the company. American car companies tend to have dangerously low margins, which puts their survival into question every couple decades. Currently, Ford's gross margin is 13.62% and GM's gross margin is 10.61%. Keep in mind that we are not looking at operating or net profit margins, we are looking at gross margins. When a company's gross margin is in low-teens, it will end up selling for about 0.3-0.4 times its revenues. Notice that GM's gross margin is a little more volatile than Ford's. In fact, the company enjoyed negative gross margins not long ago.
When we look at operating margins, things get even scarier. I am throwing in two Japanese carmakers, Toyota (NYSE:TM) and Honda (NYSE:HMC), in the mix just for reference points. Currently, Ford's operating margin is 4.0% and GM's operating margin is 2.33% while Toyota's operating margin is 8.94% and Honda's operating margin is 6.32%. Compared to their Japanese peers, the American carmakers are not keeping much of their revenues in their pockets.
In the car industry, cash flow is as important as margins. In the last 4 quarters, Ford and GM generated roughly the same amount from their operations. GM generated $13.79 billion while Ford generated $12.45 billion from operations in the last 4 quarters. For GM, the figure was the highest ever since the company's bankruptcy, while Ford saw better figures back in 2010. Yet, we can't blame Ford fully because the company has been investing heavily in China for growth; while, both companies were also spending a lot of money to reduce their capacities in Europe where sales have been less than impressive for the last 5 years or so.
Compared to their cash flow generation, GM seems like a better value as the company currently trades for 4.1 times its cash flow from operations against Ford's 5.2 times its cash flow from operations.
Currently both Ford and GM have a lot of net cash. Ford's balance sheet was helped with Alan Mulally's cost-cutting measures which improved the company's profitability and cash reservation greatly while GM's balance sheet took a great push from the government and a bankruptcy which effectively erased many of the company's liabilities. Currently Ford trades for 2.37 times its book value while GM trades for about 1.38 times its book value.
In the next 2 years, both Ford and GM are expecting their revenues to improve, helped by the improvements in the European economy as well as the continued uptrend in the US vehicle market. Both companies are particularly hopeful about selling more pick-up trucks to take advantage of an improving housing market.
Keep in mind that both companies operate in a highly-fragile industry with relatively low margins. A large recall or a slowdown in the global economy can hurt both companies' profitability greatly.
Historically speaking, American car companies enjoyed average P/E of 11-12, average price-to-sales ratio of 0.25, average price to operating cash flow of 5 and average price-to-book value of 2.0. In other words, if we look at the long-term history, the American carmakers seem fairly valued at the moment. If we ignore the historical trends, both Ford and GM look deeply undervalued but this is just how these companies have always been due to the nature of their industry. We really can't expect American carmakers to trade for 20-25 times their earnings in the long term, unless they are newcomers like Tesla (NASDAQ:TSLA).
Many analysts ignore the past trends and industry averages and they simply compare car companies with companies in other industries. For example, currently the average P/E ratio of the market is 19 and the carmakers look grossly undervalued compared to the market average; however, when we look at the historical averages and the highly cyclical nature of the car industry, it makes sense that these companies have lower valuations than the rest of the market.
Does this mean you should avoid car companies? Absolutely not. You should just be aware of the realities of the car industry and not get caught up in a game where analysts get a little sensationalist in order to make the headlines. Ford could increase its sales as well as profitability in Europe and Asia and, GM could cut costs in Europe while minimizing recalls, and both companies could enjoy higher stock prices over time. Both companies still have a lot of opportunities and a lot of room to improve things. For example, once Ford catches up on its pension payments, it will have more money to return to its shareholders. Similarly, if GM's recall drama comes to an end, the company's investors will enjoy more buybacks and higher dividends. These things will take time and will not happen over time.
If investors want to see exceptionally strong stock price appreciations (like 50-100% in a year), the well-established American carmakers might not be the place to look at. On the other hand, if the investors are looking for fairly valued companies with strong dividends and a decent amount of safety, Ford and GM will both offer some value to those investors.
Disclosure: I am long F. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.