I was surprised to find that Ford Motor Co. (NYSE: F ) is one of the hot topics around the Motley Fool CAPSwater cooler. Granted, its one-star rating shows no love, but there were more bulls than bears weighing in. Looking through the pitches, it seems the bulls are banking on a turnaround, or at least the idea that the stock price reflects all the bad news. Bears, by contrast, think a turnaround will be a tall order.
The woes are well known. Total U.S. auto-industry sales have been pretty much stagnant for the last five years. Meanwhile, Ford is losing market share. Once trailing only General Motors (NYSE: GM ) in the United States, Ford now trails Toyota (NYSE: TM ) as well.
But well-known woes should either be reflected in the stock price (if you believe in efficient markets) or so commonly held that they must be wrong (if you are a contrarian). Since I'm a contrary sort of fellow, I had to figure out whether the bulls were on to something.
I have to say, I'm with the bears on this one. To start with, a market cap of $13.2 billion against a $159 billion enterprise value demonstrates that Ford is leveraged to the gills. While it's true that much of that debt is tied to the company's financing business, that isn't much comfort to me in the midst of a credit crisis. If people are turning in the keys to their houses, it's a safe bet they'll turn in their car keys, too.
So how about that idea of the problems being already priced in? Fair enough -- but that's something that can be pretty easily worked out. No matter which model an investor favors, pretty much everyone agrees that a company is worth its future cash flows (measured as earnings, dividends, or free cash flow) discounted to the present value using an appropriate rate of return.
The most popular cash flow to discount is earnings, so I'd like to start there. Unfortunately, Ford doesn't have any earnings. In fact, if you add up all of Ford's net income for the last 10 years, it amounts to around $17 billion -- an average of $0.86 per share per year using its recent share count. The problem is, $22 billion of that total was earned in 1998. The subsequent nine years have resulted in cumulative losses of $5 billion.
Dividends are also out, as the company stopped paying those in 2006.
So that leaves free cash flow, which happens to be my favorite valuation method. Free cash flow can be measured two ways, depending upon whether the entire company or just the equity is being valued. And if one takes the latest free cash flow to equity holders, the valuation doesn't look all that bad.
Cash flow from operating activity was $17.1 billion in 2007. Subtracting capital expenditures ($6.0 billion) and the net investment in new financing receivables ($9.5 billion) leaves $1.6 billion in free cash flow.
As for a discount rate, I'd want to use one that is fairly high. Ford's bonds maturing in 2018 are currently yielding 12.5%. Since the bonds have a higher claim on company assets if something goes wrong, as an equity holder I want to earn at least as high a return on the stock. I'll be generous in this case, and say that the 12.5% is sufficient since equity returns receive more favorable tax treatment.
Using a 12.5% annual return requirement, the current free cash flow justifies an equity value of $12.8 billion, which is about in line with the current value.
However, as we have seen from the Bear Stearns (NYSE: BSC ) example, when there is a lot of leverage, equity valuations are ... shall we say ... prone to error. So, I think it makes more sense to look at the value of the entire company. In this case, the free cash flow is $8.7 billion, since I add back the $7.1 billion in after-tax interest expense. I also use an 8.5% weighted average cost of capital based on the after-tax cost of debt and the aforementioned 12.5% cost of equity.
In this case, I come up with an enterprise value of $102 billion. After subtracting the net debt, equity investors have a $43 billion hole to crawl out of.
We can also use this information to figure out what the market has already priced into the stock. In order to justify its current value, Ford will either have to start growing around the GDP growth rate (compared to the shrinking it has done over the last five years) or find a whopping $5 billion in annual cost savings.
That would be a tall order for any turnaround plan. If anything, it seems to me like all the good news is priced in, not the other way around.