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Introduction

The automaker Ford Motor Company (NYSE:F) is currently trading at close to a 52 week low, and while I don't believe Ford is exactly a fantastic company (as margins are relatively low), the price you pay for this company is too low given its future expected free cash flow.

Methodology

In this analysis I will value Ford through a discounted free cash flow model. I use the same approach as when I valued Procter & Gamble. I estimate 5 factors:

  1. Future revenue growth
  2. Adjusted operating margin
  3. Tax rate
  4. Sales/capital ratio
  5. WACC

The future revenue growth and adjusted operating margin are estimated by a detailed analysis of the operations of the company, historical growth rates and estimates by analysts and management.

The adjusted operating margin is calculated as: Accounting operating margin + depreciations, as depreciations are purely an accounting number and not particularly relevant in valuation.

To calculate the free cash flow I deduct the capital that the company invests each year from the operating profit. I estimate this amount by assuming an appropriate sales to capital ratio the company will obtain in the future, where capital is calculated as Equity + Debt - Cash + accumulated depreciation.

This ratio tells us how much revenue the company generates in relation to how much capital (both working capital and long-term capital) the company has invested. A capital to sales ratio of below 1 tells us that for each $1 invested in capital, revenue rises by an amount less than $1.

The tax rate is typically set equal to the historical effective tax rate, and WACC is calculated through the CAPM method.

Revenue and operating margin

Click to enlarge.

Sources: Morningstar.com, Annual reports, own calculations.

Sources: Morningstar.com, Annual reports, own calculations.

2012: Revenue declined slightly in Q1 2012. Management has not reported their revenue estimates for 2012, though they expect operating margin to improve slightly. I estimate that revenue will decrease by 1%, and operating margin will improve to 10%.

2013 and beyond: From 2002 to 2012, revenue has decreased by 1.25%. But I am a slightly optimistic, and therefore I assume that they can grow around 4% on a yearly basis. In the terminal period they will grow with the risk free rate of 2.5%.

The historical average operating margin has only been 9.83%. Best case is that they return to pre 2006 margins, though that is relatively optimistic. 9% seems like a decent conservative estimate for 2013-2021 and in the terminal period.

Sales to capital ratio

Sources: Morningstar.com, Annual reports, own calculations.

The capital is calculated as Equity + Debt - Cash + accumulated depreciation. This ratio tells us how much revenue the company generates in relation to how much capital (both working capital and long-term capital) the company has invested.

For 2012 management expects capital investments of $5.5 billion. Depreciation was last year $4.2 billion, and I am assuming a similar amount in 2012 (which means that accumulated depreciations does not change). This is equal to a capital to sales ratio of 1.29

2013 and beyond: The historical average sales to capital ratio is 1.16, and the ratio has actually improved since 2007, as the reported book value of the assets has decreased by a higher rate than the decline in revenue. I assume that the future sales to capital ratio will return to the historical average (of 1.16).

WACC

In the calculation of WACC I make the following assumptions:

  1. Tax rate of 27%
  2. Beta of 2 (Google Finance reports a beta of 2.4 and Yahoo Finance reports a beta of 1.8, but I am using a beta of 2, as I think Ford is a less risky investment today than a couple of years ago).
  3. Interest after tax of 3.12%
  4. Risk free rate of 2.5%
  5. Market premium of 7.7%

This gives me a WACC of 7.94%.

Value of Ford Motor Company

As can be seen in the below table, Ford is undervalued by around 20% according to my estimates. The biggest uncertainty in this valuation is the operating margin. An operating margin of 8.5% (from 2013 to 2021 + terminal period) makes Ford Motor Company fairly priced, and anything below makes it expensive. So even though a margin of safety of 20% seems like a lot, it may not be enough for the cautious investor.

Terminal value145955
PV(Terminal value)64559
PV (CF over next 10 years)32333
Sum of PV96891
Debt99689
Cash48604
Value of equity45806
Number of shares4058
Estimated value /share11.29
Price9.17
Price as % of value0.83
Source: Why Ford Is Undervalued