Toyota May Be Overpriced, But Not Overvalued (NYSE:TM)


Chicago Hosts Annual Auto Show

Scott Olson

Data and pricing in this model are accurate as at pre-market 6th July 2022. TM $154.67 at the time of writing.

I’ll preface this article by declaring I own 2 Toyota (NYSE:TM) vehicles, a 2020 CH-R and a 2009 RAV 4. I love them, they’re reliable, cheap, I will probably buy another soon (swapping the RAV 4 for a more modern version), and probably won’t look at any other make of vehicle until I’m ready to purchase something from a more premium brand (probably not for many years).

So I consider myself somewhat biased in favour of a car manufacturer whose product I enjoy and highly recommend.

With that being said, I worked as hard as I could to find a reason to justify and defend Toyota’s market capitalization, but I can’t find a solid argument to convince you that there is value in TM at its current valuation.

This article seeks to explore Toyota’s current financial health, uncover the issues facing the firm, examine briefly the macroeconomic trends surrounding the Automobile Manufacturers industry, give a score to the attractiveness of Toyota’s current valuation and attempt to provide a price target for Toyota.

For reference, we will be comparing Toyota to its peers in the Automobile Manufacturers Industry. All of my data including my peer analysis is available for download here.

Setting The Scene: Rating Toyota’s Financial Health

Starting with the base financials of Toyota, I want to assess a few key factors that determine any firm’s viability in my eyes. Those are the firm’s liquidity, solvency, operating efficiency and overall profitability.

I assess these factors individually for the firm and then rank each of the firm’s metrics against its peers, before giving an arbitrary overall score to the firm’s base financial health. (Each metric is scored between 0% & 100% inclusive, in 25% increments.

Scores of 0% are for metrics that I consider to be a critical risk to a business, with immediate and demonstrable impact on a firm’s current and future continuation. These metrics would need immediate action to resolve, else the business risk a heightened chance of being wound up.

Scores of 25% are for metrics that I consider to present an operational risk, meaning the firm’s continued operations are at risk if action is not taken quickly to improve the firm’s financials.

Scores of 50% present a downsizing risk, meaning the firm may need to consider selling assets in the short to medium term in order to continue operations with minimal risk.

Scores of 75% I consider a profitability risk to a firm, but not necessarily a risk to the continued operation of the business. These are generally areas for improvement, but not needing urgent immediate attention.

A score of 100% is noted as “no concern”, meaning I see no reason for this metric to worry investors or management of the firm.

I do not offer scores above 100%, as I use these scores to identify risk areas in a business and a general sense of overall risk. A score above 100% would “muddy the waters”.

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Toyota earns a passable 87.5% score for its base financial health, noting that the firm has a concerning “acid test” ratio, more formally known as the quick ratio. This ratio is typically used by investors to indicate how a firm could use its near-cash assets in order to cover its liabilities, without selling its inventory stock or obtaining finance.

This score is one of the lowest in the auto manufacturing industry, and I have scored it a 50% with this in mind, along with considering the likelihood of a recession this year (discussed further in this article).

We draw no concerns from Toyota’s margins, being higher than the majority of the industry, nor from its debt to equity, being a relatively normal, though slightly higher, level for auto manufacturers.

Next, we consider Toyota’s management of its balance sheet, by examining its obligations.

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I’m not a big fan of firms with significant short-term debt, especially when it is 35% of their total debt to equity. While not entirely threatening to the business’ continued operations, I need to mark Toyota down on this metric.

The covered ratio shows us that the debts are not significantly weighing down Toyota, so this receives a score of no concern. Though moving to the current ratio, we see that current liabilities are marginally covered by current assets and this paired with earlier metrics looking at the size of the debts pushes me to assign a minor penalty, further justified by the metric being very low for the industry.

Next is dividends, where we see a mixed picture, but not particularly concerning.

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Firstly, we need some context. Toyota’s financials show that the firm has a negative cash flow per share of -$0.06, however, using levered free cash flow we can obtain a levered FCF margin of 5.27%, which gives us a positive FCF number we can substitute for the CF coverage figure.

Whilst we note this is a substitution and not the official calculated FCF per share figure, this is still an accurate representation of Toyota’s financial health, though I will probably receive criticism thrown at this particular amending of Toyota’s financials.

Dividends are covered by levered cash flow, but a “normal” value for the Auto Manufacturing industry is considered a CF coverage between 5.44 and 12.18, so 2.28 is considered very low for the industry.

We can see through that earnings coverage is considered exactly “average”, so there is no real concern to be had there.

It’s worth noting that Seeking Alpha’s Quant system has flagged Toyota as at risk of cutting its dividend and rates Toyota’s Dividend Safety as an F, predominantly as it has calculated Toyota’s Cash Dividend Payout Ratio (TTM) at 297.70%. I’m unsure, and doubtful, that this is reflective of the true underlying safety of the dividend, given I’m unsure how Toyota could sustain a 5Y average dividend of 981.07% as quoted by Seeking Alpha.

Finally, we come to the firm’s future outlook.

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Immediately eyeballing the data, you’ll be drawn to the implied 3Y net margin improvement.

This is a calculated metric, which we get by; EPS 3Y / Revenue 3Y = Implied Net Margin Improvement.

This stat indicates to us, that with a tiny 1.26% revenue improvement (considered low for the industry), there is a 10X improvement in margins. This could indicate to us just how significantly impacted Toyota’s margins have been through supply chain challenges.

We already know that Toyota has had multiple cuts to production output expectations this year due to COVID, so these outlook figures give us a further into how the bottom line is being impacted.

The only other noteworthy item here is the tiny revenue improvement, which is low for the industry (though a score of -3% is still within the realms of normal for the industry’s future expectations).

Finally, we take a holistic view of Toyota’s financial health.

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I’ve weighted its base financial health and obligation structure at an equal 35%, as I believe these factors will be important facing headwinds in a changing industry (shift to autonomous vehicles, electrification, a potential recession). Toyota’s balance sheet is healthy enough that it should be able to withstand a recession, though the underweight quick ratio presents the biggest risk should things begin to turn dire.

Dividend affordability only gets a 10% weighting, as all firms have the ability to make significant changes to dividends in order to maintain financial sustainability, but it’s still important to consider the effect it has on the business.

And lastly, the firm’s future gets a 20% weighting – less than base financial health or obligation structure, because these are based on estimates, and so we need to maintain a level of conservative optimism about outlooks.

Toyota scores an overall 86.90%, very passable, but I note there are some areas with significant enough risks to warrant some concern.

Those areas of risk are the firm’s liquidity (quick ratio 0.76), obligations structure (short term debt / long term debt 0.35), short-term obligations structure (current ratio 1.09), and low cash flow coverage of dividends (CF coverage 2.28). Low 3Y FWD revenue growth is also a factor of note, but not a front-of-mind concern.

It’s worth noting that one of the limitations of my summaries is that scores are initially averaged, with averages naturally weighted upwards. A bad metric score can be “covered over” by surrounding good metric scores, so it’s important to consider each metric on its individual merits.

Toyota’s Valuation Is Unappealing, But Not Necessarily Wrong

Next, we will consider Toyota’s valuation relative to it’s peers.

Note that we are not yet attempting to provide a price for Toyota, but consider how attractive its valuation is compared with the whole industry.

Measuring valuation attractiveness is similar to measuring financial health: rank the metric compared to peers, where instead scores are simply calculated as the reverse of the percentile rank (=1-”Percentile Rank”) as this is a peer analysis. We then assign weights to each metric.

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Note Price to FCF margin calculation: take the price and divide it by the free cash flow margin to ascertain the price investors are paying for each 1% increase of FCF margin.

Here we see a firm that seems to be trading at a relatively fair price compared to it’s sales and earnings metrics, but when we get to book value and free cash flow, things start to look a little different.

Because Toyota carries quite a bit of debt, we can see how this is affecting the firm’s book value, as the total assets are weighed down by total liabilities (noting that total debt at $221.08B is ranked at the 93rd percentile for the industry), and the firm’s debt to equity ratio is 99%, vs a median average of 0.58. So we can begin to see how Toyota is expensive by this metric.

Furthermore, Toyota’s price to cash flow is also above average, but price to free cash flow margin is among the most expensive in the industry.

So Toyota performs poorly across these metrics, earning a very shallow 28% overall score, and a weight-adjusted 23%.

Noteworthy

It’s also noteworthy that Toyota’s asset turnover of 0.48 is considered low, and falls only just inside the realm of “normal” for the industry (median 0.51).

Toyota’s dividend is in the 92nd percentile at 4.30 however, but the dividend yield is exactly average at 2.78%, while the price to dividend yield (55.63) is considered more expensive than normal (85th percentile).

Macro: Recession Fears, Shared Vehicles, Electrification, Autonomous Driving

Looking outside of Toyota itself, the automotive industry is undergoing significant wholesale changes to the design (EVs vs ICEs), use (shared vehicles) and end-user (autonomous driving) for their products. These huge changes come as the US faces a potential recession, as demonstrated by the below US yield curve.

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High Charts

Automakers need to try to withstand a significant downturn in spending on new vehicles. Fortunately, TM should be capable of this with its carefully maintained balance sheet and overall good financial health.

Recessions are hard for auto manufacturers, with a 45% correlation between the depth of a recession and reduced manufacturing output according to Deloitte Insights. This means automakers will need a balance sheet capable of withstanding a significant downturn in spending on new vehicles. Toyota should be reasonably capable of this, but carefully consider the quick ratio.

Car sharing (ride-sharing services or car-share) is predicted to continue to grow, with a McKinsey & Co wrote a report that suggested that a slowdown in spending on new cars will be partially caused by car sharing, but not responsible for a reversal of spending.

A shift to EVs and autonomous driving tech development is already underway within the industry and discussed at length already in other Seeking Alpha articles, so I will only note that Toyota has been slow on the uptake, and even at odds with shareholders over the issue of EVs.

Already mentioned above is the effect of supply chain issues on Toyota’s financial performance, but some further reading is also available that looks at a halt on orders of vehicles in Japan and order times are now being reported as “stretching out to years”.

Pricing Toyota

Pricing Toyota is tricky. Toyota is the second-largest auto manufacturer in the world by revenue (behind Volkswagen), so it deserves to be priced at a premium to the industry.

Looking at the below, we start to see what size premium investors have paid for Toyota, but we need to determine what metrics in particular investors are seeing as worthy of paying a premium for.

As noted in our valuation attractiveness analysis, Toyota’s premium presents a challenge for finding further value and reasons for upside price risk.

We know that Toyota’s gross, operating and net margins are above average for the industry, and this, along with revenue growth, supports a price between $127 and $148 (marginally lower than the current price), with strong correlations to price to sales (P/S supports the current price of Toyota at its exact current price).

But beyond these metrics, things look bleak.

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Despite strong margins, we know that Toyota’s unlevered free cash flow margin is exactly the median for the industry. This gives us our first sign that in a recession, Toyota’s free cash flow could be impacted which is priced at an extreme premium currently, but not nearly as much as the price to free cash flow margin.

A little less extreme is the EV / EBITDA, which allows us to view debt on the balance sheet in a positive light, which suggests only a 30% over-pricing of Toyota.

The most reasonable guiding metric for pricing I feel though is net income margin. Given a very strong correlation of 99.5%, and that Toyota is a leader in the industry for margins, this metric suggests investors are marginally overpaying for Toyota’s net income margin by 18%.

Let’s try taking out the “noisy” metrics based on metric variation.

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This leaves us with several metrics with an average implied value of $90.67 (downside risk of 41%). Applying weights to these metrics based on variation and correlation gives us the following:

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$95.15 presents us with a downside risk of 38%, a target market cap of $132.4 billion, taking Toyota down from the second-largest firm for market capitalization (behind Tesla at $706.6B), down to third behind BYD Company Limited (OTCPK:BYDDY) at $134.89B.

It’s worth noting that a peer analysis relies heavily on the market’s attitudes towards the industry overall, with the industry median P/E sitting at 4.23 vs the S&P P/E Median of 14.89, suggesting that the market overall is bearish on the industry vs the wider market. No surprises there given a looming recession, supply chain issues and significant changes in electrification and automation.

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multipl.com

Explaining The Mispricing Of Toyota

Given Toyota is a market leader in revenue and profitability, it’s no surprise that investors see it deserving of a premium.

I certainly feel that Toyota would be deserving of a large premium if economic outlooks were bullish, however with a looming potential recession and significant challenges regarding the running of the business (supply chains), plus an overall market avoidance of the industry (comparing S&P P/Es to Auto Manufacturing P/Es), then I see Toyota’s overall price at risk. Particularly if cash flows slowed and margins were squeezed, we might see some additional debt, and therefore risk, onboarded to maintain operations.

Further, I would imagine that a significant and prolonged recession could see weaknesses in Toyota’s financial health become more painful and prominent, which could add additional risk premiums in the eyes of investors.

However, I could be overly pessimistic, and Toyota’s premium is well deserved if not modest to the extreme when you consider the premium being afforded to Tesla (TSLA).

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.



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