Ford Is Motoring Its Way Higher

Sep. 3.14 | About: Ford Motor (F)

Summary

Ford has seen multiple years of strong sales and profit growth.

A strong macro environment for cars and Ford's execution have combined to double shares in the last two years.

Ford has a lot of fundamental momentum and operating leverage that should boost returns going forward.

Shares of Ford Motor Company (NYSE:F) have absolutely exploded over the past few years after falling out of favor with investors following the financial crisis. The company has been busy growing sales and profits and investors have rewarded the company with doubling the share price since the low about two years ago. After this huge run up, are shares expensive or still a good buy going forward? In this article, we'll take a look at Ford shares to see if there is still some upside after the big run.

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To do this I'll use a DCF-type model you can read more about here. The model uses inputs such as earnings estimates, which I've taken from Yahoo!, dividends, which I've set at a steady 10 cents of growth annually, and a discount rate, which I've at the 10 year Treasury rate plus a risk premium of 7%.

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

Prior Year earnings per share

$1.62

$1.33

$1.93

$2.17

$2.43

$2.73

x(1+Forecasted earnings growth)

-17.90%

45.10%

12.23%

12.23%

12.23%

12.23%

=Forecasted earnings per share

$1.33

$1.93

$2.17

$2.43

$2.73

$3.06

Equity Book Value Forecasts

Equity book value at beginning of year

$6.90

$7.73

$9.06

$10.53

$12.16

$13.98

Earnings per share

$1.33

$1.93

$2.17

$2.43

$2.73

$3.06

-Dividends per share

$0.50

$0.60

$0.70

$0.80

$0.90

$1.00

=Equity book value at EOY

$6.90

$7.73

$9.06

$10.53

$12.16

$13.98

$16.05

Abnormal earnings

Equity book value at begin of year

$6.90

$7.73

$9.06

$10.53

$12.16

$13.98

x Equity cost of capital

9.40%

9.40%

9.40%

9.40%

9.40%

9.40%

9.40%

=Normal earnings

$0.65

$0.73

$0.85

$0.99

$1.14

$1.31

Forecasted EPS

$1.33

$1.93

$2.17

$2.43

$2.73

$3.06

-Normal earnings

$0.65

$0.73

$0.85

$0.99

$1.14

$1.31

=Abnormal earnings

$0.68

$1.20

$1.31

$1.44

$1.59

$1.75

Valuation

Future abnormal earnings

$0.68

$1.20

$1.31

$1.44

$1.59

$1.75

x discount factor(0.094)

0.914

0.836

0.764

0.698

0.638

0.583

=Abnormal earnings disc to present

$0.62

$1.01

$1.00

$1.01

$1.01

$1.02

Abnormal earnings in year +6

$1.75

Assumed long-term growth rate

3.00%

Value of terminal year

$27.30

Estimated share price

Sum of discounted AE over horizon

$4.65

+PV of terminal year AE

$15.92

=PV of all AE

$20.57

+Current equity book value

$6.90

=Estimated current share price

$27.47

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What we can see here is that the model produces a fair value for Ford of more than $27, or roughly $10 higher than it trades today. That is a huge discrepancy, so let's take a look at what's driving it.

To begin with, we need to understand what we're looking at. The model produces a fair value and not a price target; in other words, the model is saying that shares are a buy at any price below $27.47 given the inputs I described above. A price target takes an EPS estimate and projects a multiple out into the future whereas the model produces a hard buy/sell price today. The model, in this case, is saying the present value of Ford's earnings stream going forward, adjusted for dividends, is more than 57% higher than shares trade for today.

That would indicate that we should all run screaming to our brokers and buy Ford shares with the mortgage money but before we do that, we should take a look at how the number was arrived at. The model uses a company's book value to determine how efficient management is at using the company's assets to make money. In Ford's case, the company's book value is very low because it uses debt so heavily to finance its operations. Fundamentally, there isn't anything inherently wrong with this practice as long as the business can maintain its income so that it is sufficient to service the debt.

Ford is tipping the scales at a whopping ~$119 billion in debt, a number that goes higher and higher with each successive quarter and also a number that is higher than the company's market cap by nearly a factor of two. I don't care how you slice it, that is a lot of debt. The good news is that Ford's debt is unbelievably cheap with it only costing the automaker around $800 million per year in interest expense. That is very reasonable for Ford to be able to handle and I don't see it as a problem going forward. Yes, that is a lot of money but not in the context of $119 billion and the operating leverage the company enjoys because of it.

However, circling back to the model's valuation technique, this level of debt means Ford has a tremendous amount of operating leverage. When things are good shares will trade up rapidly as earnings on the company's asset base ramp higher. However, things can go south quickly if sales or profits slow as we saw in the last few years. The model rewards companies with high operating leverage if earnings are growing as the very small owned asset base can produce large amounts of earnings by utilizing debt, as Ford has so adeptly demonstrated.

Fundamentally, things are certainly looking up for Ford. Sales have been picking up for Ford for years now and this is not only due to Ford's tremendous execution on new models, but also a strong macro environment for auto sales. A rising tide raises all ships and Ford has certainly benefited from this environment. But make no mistake; Ford has earned its sales growth via exciting new models, like the new Mustang, and refreshes that have kept consumers rolling into dealers.

Ford has a lot of forward momentum fundamentally as it has fully recovered from its brush with bankruptcy during the crisis. Famously, Ford took no government money during the bailout era and its balance sheet took major dents as a result. However, that lack of government funding resonated with consumers and has allowed Ford to build its brand as it pleased, free from the watchful eye of bureaucrats who know nothing about cars.

Apart from its eye-popping debt load that is showing no signs of slowing, I love Ford here. The stock is very cheap and its operating leverage should provide robust earnings growth going forward in excess of revenue growth. I believe Ford can hit 12% earnings growth given its fundamentals and product mix but if things turn south, they will likely turn south quickly. Operating leverage on the scale that Ford employs it is terrific on the way up but dreadful on the way down. I think we're a few years away from that happening but if it does, get out quickly. But until then, enjoy Ford's cheap valuation and nice dividend as you get the magical combination of a strong macro environment for its product and a terrific company that knows how to execute.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.