Valuation Of Ford Motor Company

| About: Ford Motor (F)
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Summary

Ford Motor Company is a Fortune 500 corporation that is a major player within the $102 billion United States automobile manufacturing industry.

Ford has competitive advantage within the industry because of its broad/mass market cost leadership strategy.

A risk for Ford is that the company is at the whim of the economy. If the economy collapses, consumers will first start cutting on large purchases such as cars.

Operational and Key Risk Factors

Ford Motor Company’s (F) operational and key risk factors can be found by analyzing the composition of the financial statements. On the balance sheet, financial services finance receivable both current and noncurrent make up the largest portion of net assets followed by net properties. In the footnotes, financial services finance receivable is explained as part of Ford’s financial services segment and largely provides loans to consumers to purchase vehicles and non consumers, such as dealerships, to finance the purchase of their inventory which is split roughly 2:1. Because it makes up a large portion of Ford’s net assets, this accounts for the credit risk that Ford and other manufactures must take. As a result of vehicles being a relatively high priced good, Ford must take credit risk into consideration as a large proportion of their sales will have credit extended. Net property also composes a large part of net assets which captures operational risks as Ford is largely invested in fixed assets. As most of the firm’s fixed assets are in machinery and other production equipment, I can see how Ford is especially at risk to economic downturns as swings in demand could result in large losses due to their leverage. Finally, Ford and in its competitors operate on a fairly slim net margin of less than 5%. Due to the high cost of production, changes in the supply chain or even swings in commodity prices could snowball into material cost variations at the end of production. As a result of the already narrow margins, Ford does not leave a ton of flexibility for inefficiencies or unexpected changes in their supply chain.

Balance Sheet Presentation

Looking at the balance sheet, there are several accounts that are subject to misrepresentation that can affect the health of the firm related to future performance capabilities. First, as mentioned prior, the single largest asset account is the combination of short term and long term financial services finance receivable. However, as stated in their footnotes, this account balance is offset by a relatively small valuation allowance of 484 out of 96,160 to account for the financing that will ultimately be uncollectible. As a result, this balance is subject to overstatement as the valuation allowance not only is highly subjective based off internal models, but also easy to manipulate to benefit the appropriate financial ratios such as the quick ratio. At first glance, the 484 allowance seems fairly low relative to the total balance of the account but more information is needed to be certain and suggest a numerical adjustment. Related to this, trade and other receivables, although lacks a footnote, also contains comparable allowance balances. Similarly to the financial services finance receivable allowance, more information is needed to determine the accuracy of the valuation allowance.

Additionally, inventory is also an account that is subject to misrepresentation as Ford follows a LIFO treatment of their U.S. inventory which in turn ultimately reduces the net inventory account value by nearly 10% and increases the cost of goods sold. While inventory has some flexibility in its costing system, it seems that LIFO is the least representative as Ford boasts a high, adjusted inventory turnover of 13.7. This emphasizes the later, often higher inventory costs that end up reducing inventory balances, increasing COGS, and reducing retained earnings. Although this allows Ford to match revenues and costs incurred during a period, it does not match the appropriate costs utilized to generate the revenue and Ford should switch to a FIFO or average cost system which could increase the inventory balance by up to 10%.

Finally, deferred revenue, specifically dealer and dealers’ customer allowance for claims, is a large account that is at risk of misrepresentation due to its subjective nature and sizeable impact on the financial statements. Dealer and dealers’ customer allowance for claims comprises over 20% of deferred revenue and is also a highly subjective balance that is determined through internal models with many assumptions. As a result, this account can easily be manipulated to decrease the liability and increase net income. However, in this case, Ford seems to be continuing its trend of conservative accounting and doing the opposite as the balance of the allowance has been rising over the last four years. Although more data is needed, it appears that Ford has a relatively high allowance which is reducing its net income and consequently retained earnings.

Comparison to Competitors

Ford is extremely similar to GM (GM) and Chrysler (FCAU) in terms of its business model and strategy. All of these companies have the strongest growth from the sales of trucks, as major makers offer better fuel economy with each model and continue to invest heavily in combined fuel efficiency and performance improvements. Chrysler has multiple brands including Maserati and Alfa Romeo, while Ford has limited brands as it wants to keep the brand focus on Ford itself to keep its market share. The divergent international strategies of GM and Ford major players is most interesting. GM is tapping into the growth in China and global sales increased by 11% for the car maker. Ford’s global market share fell 10 basis points in 2016 but is expected to have global growth in 2017. The main differentiation between these two companies is that GM has began to invest billions into R&D towards electric cars, high growth self-driving car, and ride sharing markets a year prior to Ford’s decision to invest into these future markets which makes Ford behind and in a position to catch up to be fairly positioned in the market.

Ford already has the following initiatives well underway to compete against this innovative market:

  • The mass production of self-driving cars by 2021 plans to sell cars to ride-hailing services like Uber and Lyft.
  • The production of advanced drivetrains specifically designed for electric vehicles.
  • A smart-mobility subsidiary which GM has also started earlier into automotive connectivity, autonomous driving, and data analytics.
  • Ford operates less brands than GM opting in order to build a stronger brand name

Forecast

My forecast horizon for Ford is 5 years. The automotive industry is saturated with big brand name competitors especially in mature markets. For example, in the U.S., Ford only has a 14% market share despite being one of the world’s largest car companies. This competition causes margins in the industry are relatively low between 5-10%. Combining competition with negative industry growth outlook in mature markets of -1% annually leads us to believe that even excess sales growth for Ford will be low and short lived. However; I believe that Ford has some distinct competitive advantages over traditional competitors that will facilitate excess sales growth like its initiatives into self driving cars, strong brand, marketing channels, and business in emerging and developing markets. The developing and emerging markets is ultimately where I believe where excess sales growth will come from since automotive demand is growing there. Ultimately though, cars are more or less substitutable goods and eventually Ford’s competitive advantages and sales growth rates will revert to the industry average relatively quickly. I believe the long term growth rate in sales will settle down to the long-run population growth rate in the world population around 5 years from now as automotive competitors quickly adjust to enter the new markets.

According to the residual income model shown below, Ford’s implied stock price is $10.39. In addition to the residual income model, I also calculated Ford’s implied stock price using multiples of its competitors as well as using the Dividend Discount Model. My Dividend Discount Model (shown below) gave us an extremely low stock price of $4.03. There is a low valuation for two reasons. One is the extremely high cost of equity. This comes from how the cost of equity is calculated and how the index used. The annual return of 12% for the market risk premium is extremely high. However; from the CAPM theory, the market return should be a holistic view of the market and should include the returns of all the stocks. The Wilshire 5000 index does exactly this. I believe that it gives us the true measure of the market return as opposed to another index like the S&P 500. A high cost of equity will always provide a lower valuation as the discount rate will be higher. Additionally, Ford is quite conservative in the sales growth rate of 2% for excessive returns in the forecast horizon and 1% terminal growth rate. This low growth rate of sales I believe is realistic, but nonetheless is small compared to most other industries. This will lead to lower dividends in the Dividend Discount Model. Lastly, the Comparables Table below shows an implied stock price using the multiples method. According to P/B, Ford is close to its fair value by using comparables or the industry average. However; using P/E, Ford gets a valuation ranging from $8.57 to $24.92 with an industry average target of $15.73.

Residual Income Model

Table made by John O'Connor

Dividend Discount Model

Table made by John O'Connor

Comparables

Table made by John O'Connor

Recommendation

My recommendation is to sell Ford stock based off of the residual income model as well as the dividend discount model, which both gave an estimated stock price below the current market price of $12.01. The residual income model gave an estimated price of $10.39, which is 10% below the current market price. The dividend discount model gave an even bigger discrepancy between the implied share price and market price. The implied price for dividend discount model is $4.03. Based off of these calculations, I believe you should sell Ford stock and wait for it to approach a more reasonable share price.

Disclosure: I/we 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.

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