Ford (NYSE:F) currently has a lot of debt on its balance sheet. Ford's debt/equity ratio of 3.8 seems extremely high compared to the industry average of 0.9. The short-term outlook for Ford looks good enough, as the company has been generating healthy cash flow from its operations. To make a sound investment in Ford, which could yield a lot of profit over an investment horizon of 3-4 years, an analyst needs to be certain of the probability of only two things: That the company will continue to maintain its present trend in generating cash flow from operations, and that some of it will be used to bring down the debt equity ratio.
There was plenty of good news in Ford's last quarterly results. The net profit margin was at an all-time high of 12% in North America. This is important because Ford generates 70% of its profits in North America. According to the EPS estimates of most analysts, the prospects for automobile sales in North America are considered healthy in the short term.
Many other financial numbers relating to Ford also look quite healthy. The average asset turnover ratio (Sales/Assets) has improved over the 2007 to 2012 period from 0.58 to 0.79. The EBT margin has also improved significantly over the period 2007 to 2012, from -2.17% to 6.37%.
The cash yield from Ford has also been encouraging over the last five years. The ratio of average cash flow to average market capitalization (over the last 5 years) is 14.68%. Using another metric to measure the same (calculated as a ratio of average cash flow from operations to the sum of average fixed capital and average working capital), the cash yield from the business is 10.43%. The average cash flow from operations exceeds average Capital Expenditure over the 2007-2012 periods by $10.903 billion. Such numbers show that Ford has been generating a healthy amount of cash from its businesses.
Plenty of analysis has been done in the last couple of months on the apparent undervaluation of Ford stock. Morningstar reports that the stock is trading at a P/E ratio of 2.5, when the industry average P/E is 7.5. The Price to Sales ratio (0.3) is also less than the industry average (0.4), and the dividend yield on the stock is 1.83%, which is more than the industry average of 1.1%. Such simple metrics indicate an undervalued stock, when one takes into account the positive aspects of the company mentioned in the last few sections.
One unhealthy financial metric for Ford is the high Debt to Equity ratio (3.8). The current amount of debt on the balance sheet is approximately four times the market capitalization. Yet the company has generated enough cash in the last five years to just about service this debt. The average cash flow from operations over this period was $10,844 million, while the maximum interest the company had to pay was $10,437 million. Thus, the conservative interest coverage ratio of Average Cash flow/Maximum interest paid in last five years was unity. Ideally, this number should be higher, to give a margin of safety in servicing the debt.
After Ford announced its quarterly earnings on October 30, the stock appreciated from a price of $10.36 to a peak price of $11.25 (the peak price for the last 12 months was $12.79 in February).
But why is the stock so depressed? One plausible explanation is the uncertainty regarding the European economy: News about the European operations of Ford continues to be negative. Ford's losses in European operations in the last quarter were $468 million (53% more than losses in the same period last year). Management has already announced that three of Ford's European manufacturing plants will be shut down, although such closures are not exactly a sign of Ford's retreat from the European market. Management has announced turnaround plans for the company's European operations, which are not expected to become profitable within the next 3-4 years.
What Does the Future Hold?
One of the positive triggers or catalysts for a price rally might be the reduction in the debt on the balance sheet - think of debt and equity as claims in the value of business. If debt is reduced over a period of time, the value of equity claims should automatically go up. Chances look good that Ford will generate enough cash over the next 3-4 years to gradually reduce its debt.
Make or Break For Investors
To arrive at a valuation estimate for Ford, we took the premise that Ford will continue to generate enough cash in the coming years to just about service its debt (based on the positive qualitative and quantitative factors highlighted earlier in this article). If the premise holds true, then the value of the equity component cannot be less than the debt capacity that Ford can comfortably service (a conservative valuation rule from Benjamin Graham School of value investing).
To understand the rationale behind the rule, think of stock as a part ownership in a piece of business. If the business has some ability to generate cash, you can go the bank and get a loan. The business should be worth at least the amount of the loan you can get, otherwise someone else could buy the business from you at a lower price, take a loan from the bank, and make an easy arbitrage profit. In fact, the valuation rule says that the business is worth at least 1.75 times the debt capacity, plus any surplus cash on its balance sheet.
So, if Ford continues to generate an average CFO of $10,844 million and gradually reduces its debt until that debt on the balance sheet reaches a figure of $72 billion and its interest coverage ratio reaches an average figure of 4, the value of the company (1.75 debt capacity + surplus cash) could be as much as $175 billion (we have made an assumption here that Ford will be paying 5% interest on its debt if the coverage ratio is 4). Thus, the market value of the equity component would be $100 billion, which is almost 2.5 times the current capitalization. In other words, we can expect a 150% increase in the stock price of Ford over a period of approximately three years.
A discounted earnings plus equity model, developed by Efsinvestment and applied to Ford, suggest that these days the company is trading at a considerable discount. EFS's fair stock price valuation indicates that currently, extremely undervalued Ford stock has at least 240% upside potential to reach its fair value.
Investors should eagerly look out for any signs that Ford management is taking steps to reduce the debt on the balance sheet. It could be a good time to load up this stock in your portfolio.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.