Why Ford and GM Are Still Excellent Undervalued Investments

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

Although Ford and GM have taken off over the last three months from better-than-expected results, they are still considerably undervalued against Japanese peer Toyota. I recommend swallowing the risk and aggressively buying stakes in these two producers, particularly Ford, due to its leading free cash flow yield. As the economy picks up, I believe the market will come to a realization that their market caps should be much larger. With Facebook just worth around $5 billion more than GM and Ford, there is room for considerable change. Below, I explain why Ford and GM are great investments.

Buy Ford (NYSE: F) As It Continues To Deliver

The last three quarters have been terrific for Ford. In 1Q 2012, it came out 11.4% ahead of consensus; in 2Q 2012, 7.1%; and in 3Q 2012, 33.3%. And though shareholder value has recovered 28.7% from the late July low, it still has gone up only 5% for the year to date--underperforming the S&P 500 by more than 800 bps. Perhaps most importantly, sales rose an impressive 48% year over year in China, and it will build off of this momentum by releasing 2 new SUV models soon. And in the fast-growing hybrid market, the company has done better than the supposedly invincible Toyota (NYSE: TM). The C-Max outsold the Prius, 3,182 to 2,769.

I further recommend buying Ford because of its overall cheapness. At only 7.8x forward earnings and with strong free cash flow generation, this brand name company merits a buyout. Though it offers a 1.8%, the company still has a payout ratio of just 2.2%--it is putting a lot of cash flow into future growth initiatives. Free cash flow has averaged $5.4 billion through all the ups and downs of the last 5 years. That comes out to more than a 12.5% yield against the market capitalization, which means it is relatively safe from a financial perspective. Remember, this is the company that went without a bailout from the government--something that has yet to be appreciated by the market.

Going forward, I see the company gaining share against Toyota. The Japanese auto producer saw strong demand in Japan for the second quarter, but the country's territory dispute with China represents a substantial headwind that Ford does not face. Moreover, Toyota itself has given a weaker outlook on production than its competitors have off of this political environment.

Solid Fundamentals At General Motors (NYSE: GM)

And what about GM? The Street is currently bullish on the stock and rates it a 1.9 out of 5, where "1" is a "buy." The company now trades at a respective 9.6x and 6.8x past and forward earnings, versus 10x forward earnings for Toyota. With the stock trading below book value and holding $15.3 billion in cash, it can easily drive EPS accretion to make up for any hiccups in growth. Fortunately, the company is forecasted for 10.8% annual EPS growth over the next half decade.

Assuming GM merely meets expectations, 2016 EPS will come out to $5.11. At a multiple of 12x, this translates to a future stock value of $61.32. Discounting backwards by 10% yields a present value of $38.07. Needless to say, this is considerably more than the current market assessment of $25.57. Though the stock is up 36.6% from its 52-week low, it is still a decent 7%+ below its 52-week high achieved months ago. I expect the company driving strong returns after momentum continues in China off of a 14.3% year over year growth in October. The introduction of a hatchback in India will take away market share from competitors Suzuki, Hyundai, and Ford. Emerging market penetration will also help to offset domestic uncertainty. Over the last three quarters, GM's performance has been much better than expected--EPS in the third quarter was 52.5% ahead of consensus.

I would still recommend buying Ford over GM. Not only has Ford been able to survive without the government's aid, it has been able to gain market share in a tough market. By contrast, GM's free cash flow generation has only averaged $801 million since it went public, and it hasn't trended nearly as well as its competitor's has. At a market cap of $40 billion, the free cash flow yield comes out quite low, especially to Ford. Yet over the last six months, GM has gained 14.4%--outperforming Ford by nearly 900 bps. While I still find GM undervalued, I expect it to underperform Ford over the near-term and next few years.

Know What You Own

Ford has been performing incredibly well as a company over the past few years -- it's making good vehicles, is consistently profitable, recently reinstated its dividend, and has done a remarkable job paying down its debt. But Ford’s stock seems stuck in neutral. Does this create an incredible buying opportunity, or are there hidden risks with the stock that investors need to know about? To answer that, one of The Motley Fool’s top equity analysts has compiled a premium research report with in-depth analysis on whether Ford is a buy right now, and why. Simply click here to get instant access to this premium report.


TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Ford. Motley Fool newsletter services recommend Ford and General Motors Company. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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