Michael J Mauboussin wrote in "Measuring the Moat (pdf)" more than a decade ago that competitive advantage analysis is vital to assessing a company. Fastenal has significant competitive advantages but what about its valuation? As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Fastenal's (FAST) case, we think the firm is overvalued. We think it is fairly valued at $38 per share, approximately 30% below where it is currently trading.
We think a comprehensive analysis of a firm's discounted cash-flow valuation and relative valuation versus industry peers is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index (click here for an in-depth presentation about our methodology), which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors (we like firms that fall in the center of the diagram below). Valuentum followers understand that more interest = more buying = a higher stock price.
If a company is undervalued both on a DCF and on a relative valuation basis, it scores high on our scale. Fastenal posts a VBI score of 4 on our scale, reflecting our 'overvalued' DCF assessment of the firm, its unattractive relative valuation versus peers, but bullish technicals. We compare Fastenal to peers Anixter (AXE), MSC Industrial (MSM), and WESCO (WCC). In the spirit of transparency, we show how our performance has been since inception:
Our Report on Fastenal
• Fastenal's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively.
• Each of Fastenal's 2,600+ stores is a local, one-stop shop for a variety of OEM, MRO and construction supplies. The firm's value proposition to customers centers on working within a decentralized environment to deliver local product to local people.
• Fastenal has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 11% in coming years, and the firm had no debt as of last quarter.
• Fastenal's motto is 'Growth through Customer Service.' The firm believes it can grow market share by providing the greatest value to the customer. Fastenal's ability to grow is amplified if it can service the customer at the closest economic point of contact. Execution remains critical.
• As it relates to operations, Fastenal is our favorite distributor. The firm's local storefront model provides a unique method of expanding availability and providing cost savings to customers. Its platform can't be easily replicated by peers.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Fastenal's 3-year historical return on invested capital (without goodwill) is 25.3%, which is above the estimate of its cost of capital of 10.8%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Fastenal's free cash flow margin has averaged about 8.6% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Fastenal, cash flow from operations decreased about 12% from levels registered two years ago, while capital expenditures expanded about 128% over the same time period.
Our discounted cash flow model indicates that Fastenal's shares are worth between $30.00 - $46.00 each. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $38 per share represents a price-to earnings (P/E) ratio of about 31.4 times last year's earnings and an implied EV/EBITDA multiple of about 18 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 12.4% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 5.7%. Our model reflects a 5-year projected average operating margin of 24.5%, which is above Fastenal's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 8.1% for the next 15 years and 3% in perpetuity. For Fastenal, we use a 10.8% weighted average cost of capital to discount future free cash flows.
(click to enlarge)
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $38 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Fastenal. We think the firm is attractive below $30 per share (the green line), but quite expensive above $46 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Fastenal's fair value at this point in time to be about $38 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Fastenal's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $49 per share in Year 3 represents our existing fair value per share of $38 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements