With online competitors taking an ever-increasing marketshare, it's hard to see how Best Buy (NYSE:BBY) can reinvent itself to maintain its status as the global leader in consumer electronics. Still, just because a firm has had deteriorating fundamentals doesn't necessarily make it a bad stock (or mean it will be a terrible stock going forward).
For example, look at our track record as it relates to our fair value estimate on Best Buy. You'll see our fair value in the center column and the price of the stock at the time that our fair value was issued. For the past two years, we've been pounding the table on Best Buy's undervaluation! Best Buy is now trading at nearly $40 per share!
We think it's pretty amazing how a disciplined systematic process like the our Value Rating that is focused on cash flow helps investors see clearly when stocks are undervalued and overvalued. This is why we think having an objective and independent view based on financial analysis is really the only way that investors can find the best stocks at the most opportune time. We'll leave the sales pitches to others. Some can sell ice to eskimos. To us, the financials tell the story. And we at Valuentum then tell this story to investors. Let's dig into our report on Best Buy.
- Best Buy earns a ValueCreationTM rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 39.3% during the past three years.
- Best Buy is the global leader in consumer electronics as far as big box retailers go. We think the company must reinvent itself to survive competitive pressures from the likes of online powerhouse Amazon.
- Best Buy's cash flow generation and financial leverage aren't much to speak of. The firm's free cash flow margin has averaged about 2% during the past three years, lower than the mid-single-digit range we'd expect for cash cows. However, the firm's cash flow should be sufficient to handle its low financial leverage.
- 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.
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. Best Buy's 3-year historical return on invested capital (without goodwill) is 39.3%, which is above the estimate of its cost of capital of 10.5%. As such, we assign the firm a ValueCreationTM rating of EXCELLENT. In the chart to the right, 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 Best Buy is worth $36 per share. Our discounted cash flow model indicates that Best Buy's shares are worth between $23-$49 each. Why do we use a prudent margin of safety? Click here. The margin of safety around our fair value estimate is driven by the firm's HIGH ValueRiskTM rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $36 per share represents an implied EV/EBITDA multiple of about 5.3 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of -3.3% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 3.3%. Our model reflects a 5- year projected average operating margin of 3.4%, which is below Best Buy's trailing 3- year average. For Best Buy, we use a 10.5% 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 $36 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 above, we show this probable range of fair values for Best Buy. We think the firm is attractive below $23 per share (the green line), but quite expensive above $49 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 Best Buy's fair value at this point in time to be about $36 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 Best Buy'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 $48 per share in Year 3 represents our existing fair value per share of $36 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.