- Domino's franchise business model has allowed it to carve out a nice Economic Castle.
- But despite its strong economic returns, the market has caught on to its fantastic ability to deliver value to shareholders (ROIC less WACC).
- The company's shares are overpriced, and we continue to prefer opportunities in the Best Ideas portfolio.
As part of our process at Valuentum, we perform a rigorous discounted cash-flow methodology that evaluates the intrinsic value of a company on the basis of its future free cash flows and the strength of its balance sheet (its net cash position). Let's walk through our cash-flow-derived fair value estimate of Domino's Pizza (NYSE:DPZ) and run shares through the Valuentum process. We'll also highlight why we think Domino's boasts an Economic Castle and why this view is independent of, albeit related to, the price-to-fair value assessment.
For those that may not be familiar with our boutique research firm, 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. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest buying interest by investors. The firms we like are valued attractively and are just starting to see their value recognized by the market via strong pricing performance.
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At the methodology's core, if a company is undervalued both on a discounted cash-flow basis and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Domino's Pizza posts a Valuentum Buying Index score of 4, reflecting our "overvalued" DCF assessment of the firm, its unattractive relative valuation versus peers, and bullish technicals. Since the Valuentum Buying Index puts a large emphasis on valuation as the primary consideration and Domino's shares are cheap, the firm registers a below-average rating on our scale. We tend to add firms that score a 9 or 10 on the scale (a "we'd consider buying" rating) and hold these firms in the portfolio until they register a 1 or 2 on the scale (a "we'd consider selling" rating). With that said, let's dig into Domino's report.
Domino's Pizza's Investment Considerations
• Domino's Pizza'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. We think Domino's Pizza has one of the strongest Economic Castles in our coverage universe on the basis of its immediate forward forecasted 5-year ROIC-less-WACC spread, which has consistently been several hundred points above its cost of capital.
• Domino's Pizza is the number one pizza delivery company in the US, based on reported consumer spending. The firm also has a leading international presence and ranks as the second largest pizza company in the world, based on number of units and sales.
• The firm's highly-profitable master franchise model, which is a large factor behind its strong Economic Castle due to minimal capital requirements, continues to generate sustainable returns for franchisees ($50k-$75k in annual EBITDA), revealing healthy internals. Its international operations are entirely franchised, while its domestic operations are mostly franchised. Where a moat assessment may overlook Domino's as a strong business, an Economic Castle assessment identifies the strength of its business model as clear as day.
• Domino's is targeting a long range outlook of 4%-6% net unit growth, domestic same store sales growth of 1%-3%, international same store sales growth of 4%-6%, and global retail sales growth of 6%-10%. Our forecasts are calling for mid-single-annual expansion.
• Domino's scores a 4 on the Valuentum Buying Index. We generally prefer firms in the portfolio of the Best Ideas Newsletter, a collection of companies that have registered the highest rankings on our system.
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 with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Domino's Pizza's 3-year historical return on invested capital (without goodwill) is 273.2%, which is above the estimate of its cost of capital of 9.3%. 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. Domino's Pizza's free cash flow margin has averaged about 8.4% 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 Domino's Pizza, cash flow from operations increased about 27% from levels registered two years ago, while capital expenditures expanded about 66% over the same time period.
Our discounted cash flow model indicates that Domino's Pizza's shares are worth between $45-$67 each. Domino's shares are currently trading north of $70, above the high end of the estimated fair value range, which is derived on the basis of Domino's future free cash flows and net balance sheet. We think Domino's represents a good example of how a firm can have a strong Economic Castle but still be overpriced from a valuation standpoint. The Economic Castle rating is based on its ROIC-less-WACC spread, while a company's valuation is based on how the market values that spread. 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 $56 per share represents a price-to-earnings (P/E) ratio of about 22.6 times last year's earnings and an implied EV/EBITDA multiple of about 13.4 times last year's EBITDA. We think these valuation multiples are reasonable given the strength of Domino's franchise business model and the pace of its future free cash flow expansion, which is quite robust.
Our valuation model reflects a compound annual revenue growth rate of 5.1% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 4.7%. The revenue forecast is consistent with management's expectations of mid-to-high- single-digit revenue expansion, but modestly below the 6%-10% global retail sales guidance on the basis of its 3-year average (which is also below that target). Our valuation model reflects a 5-year projected average operating margin of 20.6%, which is above Domino's Pizza's trailing 3-year average. We think ongoing international franchise growth will have a positive impact on the company's profitability.
Beyond year 5, we assume free cash flow will grow at an annual rate of 2.9% for the next 15 years and 3% in perpetuity. For Domino's Pizza, we use a 9.3% weighted average cost of capital to discount future free cash flows. We think the long-term growth rate and discount rate are reasonable forecasts that fit the theoretical underpinnings of the DCF process.
Our discounted cash-flow process allows us to arrive at an absolute view of the firm's intrinsic value. However, we also understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money-managers -- those that drive stock prices -- pay attention to a company's price-to-earnings ratio and price-earning-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash-flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. We compare Domino's Pizza to peers Starbucks (NASDAQ:SBUX), Yum! Brands (NYSE:YUM), and McDonald's (NYSE:MCD), among others. Domino's valuation metrics are greater than both its peer and industry medians, not only over the near-term, but also based on normalized EV/EBITDA and PEG assessments. Shares are not cheap.
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 $56 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 Domino's Pizza. We think the firm is attractive below $45 per share (the green line), but quite expensive above $67 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 Domino's Pizza's fair value at this point in time to be about $56 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 Domino's Pizza'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 $74 per share in Year 3 represents our existing fair value per share of $56 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
In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.