This Auto Stock Is Ridiculously Cheap

Adrian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

In this market, it's becoming harder and harder to find truly great investment opportunities that offer an asymmetric risk/reward ratio. Behind a great investment, there is always a great business. However, that's just one of the conditions a company needs to satisfy to have its stock considered a great investment.

Price also matters, and therefore a great investment also involves a highly undervalued business. It's hard to find a company that has both a great business and a low valuation. But Ford (NYSE: F) may be the perfect example: its free cash flow generation has improved significantly over the past years, yet the stock price remains unbelievably low, even after the 82% one-year rally!

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Consistent increase in sales

Ford has consistently increased its sales in the past two years, which is admirable considering the bad macroeconomic atmosphere in Europe the company faced last year. It's U.S. sales were up 13.4% last month (trucks were up 19.9%), making it the best June Ford has experienced since 2006. Part of this success is due to macroeconomic reasons: the seasonally adjusted annualized selling rate (SAAR), according to Automotive News, was nearly 16.0 million, the highest in the industry since November 2007. The recent increase in interest rates may have caused expectations of future interest rates to go up, and many people may have decided to buy a car now, before interest rates go even higher.

So far, it seems that Americans are becoming interested in owning Ford cars again. But that's just the beginning of the story, because Ford also has a still small yet highly attractive (in terms of growth rate) share of the promising Chinese auto market. Sales in China went up 44% from a year earlier. Just in the month of June, Ford sold 75,254 vehicles in China. General Motors (NYSE: GM) has also been doing well in China, with a 10.6% increase in its sales over the prior year. But Ford's success is not comparable!

Attractive dividend 

Everybody loves dividends, and Ford shareholders are no exception. Luckily for them, Ford's current yield is above the S&P 500 average (roughly 2%), offering a 2.3% annual payout with a payout ratio of 16.3%. The return on assets, equity and investment are 3.1%, 33.9% and 3.5%, respectively.

Ford's dividend is quite admirable if you compare it with General Motors. The latter recently announced a quarterly dividend of slightly less than $0.60 per share, but only applicable to its Series B mandatory convertible junior preferred stock. But considering that GM's $49.5 billion bailout still has not been paid back, it may be too soon for GM to start paying dividends. Check The Fool's premium GM research service to understand more about the real risks facing GM and the possibility of seeing a dividend by the end of the year.

Interesting partnerships in the making

In April, Ford and General Motors announced they will work together to develop a new 10-speed automatic transmission, a very unusual alliance to say the least. They set aside the historical rivalry and will cooperate to produce a new gearbox as they try to achieve the 54.5 mile-per-gallon mandate, which takes effect in 2025. This can help both companies to save millions of dollars in R&D.

Ford is also working with Toyota Motor (ADR) (NYSE: TM) to develop a new gas-electric hybrid fuel system for trucks and SUVs. The new hybrid powertrain will bring more fuel efficiency and will also allow both companies to develop new technology faster and cheaper. Toyota has more experience in the hybrid field, as it launched its first mass-produced gasoline-electric hybrid in 1997, selling more than 3.3 million hybrid vehicles so far. Therefore, Ford is expected to win a lot of technological know-how from this alliance. 

But Ford's strategy involves something more than alliances: it is working to build more models on common platforms, and this shall improve economies of scale. The company expects 80% of its total global production to come from five global platforms by 2016, a change that could save billions of dollars in development costs.

Thus, by forgetting about historic rivalries and implementing long-term reforms aimed at improving efficiency, Ford looks strongly focused on the only thing that matters in the long run: making better cars.

Low market valuation

Most analysts agree with the fact that Ford is undervalued. To begin with, despite the latest improvements in fundamentals, Ford's P/E ratio remains low at 11.3. Ford has a fair value estimate of $21 per share, according to Morningstar. Seeking Alpha contributor Markos Kaminis has averaged the analysts' estimates for 2013 and 2014, and obtained an EPS estimate of $1.55. The current stock price suggests only a 11X multiple on EPS, which is another signal this stock is cheap. Goldman Sachs, on the other hand, has a $20 price target, suggesting a 20% upside.

Toyota is pricey

Notice that General Motors' P/E ratio is 12.6. Toyota Motors, on the other hand, seems too pricey, with a P/E of approximately 21.6. In the Tokyo Stock Market, Toyota's stock price experienced almost a 120% price increase in the past 12 months, and this suggests that although its business may be strong the stock is too expensive for it to be considered a great investment opportunity at the moment.

Toyota's performance is due to a weaker yen, as Toyota's stock activity and yen depreciation are positively correlated, and also because of Toyota's expertise in manufacturing vehicles under its kaizen philosophy, which is so efficient that once Ford CEO Alan Mulally cited Toyota as a model of how Ford should operate. 

Regardless of the current share price, Toyota is a well respected brand among car buyers and has reported a massive increase in operating income for this year ($13.7 billion from $3.8 billion last year). This is partly because of a more favorable exchange rate and partly because of its intrinsic brand popularity and global efforts to reduce its cost base. Therefore, Toyota is worth watching closely. It may be too expensive now, but a correction could be seen as a buying opportunity in the next months.

The bottom line

I believe Ford is a clear example of a stock that remains well undervalued after the financial crisis, despite having improved its fundamentals consistently. In the short run, the latest earnings calls show us that Ford is selling more both in America and in the emerging markets.

In the long run, Ford is committed to the only thing that matters: making better cars. Add to this the low current P/E ratio, an attractive dividend (unlike General Motors) and a strong brand in China (where Toyota Motors finds it hard to sell cars), and you have a great investment opportunity to consider.

China is already the world's largest auto market -- and it's set to grow even bigger in coming years. A recent Motley Fool report, "2 Automakers to Buy for a Surging Chinese Market," names two global giants poised to reap big gains that could drive big rewards for investors. You can read this report right now for free -- just click here for instant access.

Adrian Campos has no position in any stocks mentioned. The Motley Fool recommends Ford and General Motors. The Motley Fool owns shares of Ford. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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