It's September and college students have packed up and moved into their new dorms across the county. For Bed Bath & Beyond (BBBY), this is the most wonderful time of the year. With great name recognition and strong market performance, it's easy to see why Valuentum believes Bed Bath & Beyond is trading so close to its fair value.
At Valuentum, we think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators 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, which ranks stocks on a scale from 1 to 10, with 10 being the best.
If a firm is undervalued both on a discounted cash-flow and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. As you can see in our analysis, Bed Bath & Beyond only scores a 6 on our scale, making it fairly valued but not in line with our ideal 9 or 10 scores for stocks that we'd consider adding to our Best Ideas portfolio.
Our Report on Bed Bath & Beyond
- Bed Bath & Beyond's business quality (an evaluation of our ValueCreationTM and ValueRiskTM 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.
- Bed Bath & Beyond offers domestic merchandise and home furnishings. Though the firm's goal to offer quality merchandise at everyday low prices is admirable, such a strategy is not new or unique.
- Bed Bath & Beyond 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 9.1% in coming years, and the firm had no debt as of last quarter.
- Although we think there may be a better time to dabble in the firm's shares based on our DCF process, the firm's stock has outperformed the market benchmark during the past quarter, indicating increased investor interest in the company.
- Bed Bath & Beyond has grown from just a few dozen stores in fiscal 1992 to over 1,400 today. We expect the company's expansion plans to continue.
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 (WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Bed Bath & Beyond's 3-year historical return on invested capital (without goodwill) is 48.5%, which is above the estimate of its cost of capital of 10.8%. As such, we assign the firm a ValueCreationTM 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.
We think Bed, Bath & Beyond's shares are worth $73 each, which represents a price-to-earnings (P/E) ratio of about 14.6 times last year's earnings and an implied EV/EBITDA multiple of about 8.5 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 5% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 7.6%. Our model reflects a 5-year projected average operating margin of 14.5%, which is below Bed Bath & Beyond's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 0.9% for the next 15 years and 3% in perpetuity. For Bed Bath & Beyond, we use a 10.8% weighted average cost of capital to discount future free cash flows.
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 $73 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 ValueRiskTM 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 Bed Bath & Beyond. We think the firm is attractive below $58 per share (the green line), but quite expensive above $88 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 Bed Bath & Beyond's fair value at this point in time to be about $73 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart to the right compares the firm's current share price with the path of Bed Bath & Beyond'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 $99 per share in Year 3 represents our existing fair value per share of $73 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