- The discounted cash flow model is a lens into market expectations of a company.
- If shares are trading at the fair value estimate, the firm must achieve forward financial projections to justify its stock price.
- We think CarMax is priced to perfection. Strong revenue and earnings growth, and a low discount rate drive our fair value estimate of $52 per share.
CarMax's no-haggle pricing strategy has made it one of the most successful used-car dealers in the US. Fiscal 2014 was a banner year for the company. But will the strength continue? And if so, what does this mean with respect to the company's intrinsic valuation? Let's take a look at CarMax's (NYSE:KMX) investment potential and run shares through the Valuentum style of investing.
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. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. 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.
Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.
We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.
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. CarMax posts a Valuentum Buying Index score of 3, reflecting our "fairly valued" DCF assessment of the firm, its unattractive relative valuation versus peers, and bearish technicals. A 3 is not a very attractive score, which means that we're not rushing to add shares to the Best Ideas portfolio. However, CarMax doesn't register a 1 or a 2 either, meaning that we wouldn't be looking to remove it from the portfolio if we did hold it. With that said, let's dig deeper into the used-car retailer's fundamentals. You can read more about how we use the Valuentum Buying Index in the Best Ideas portfolio here (pdf).
CarMax's Investment Considerations
- CarMax's business quality 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. On an unlevered basis, excluding non-recourse debt, its ROIC is comfortably in the teens.
- CarMax is the largest retailer of used cars in the US, and one of the largest vehicle auction operators. The firm differentiates itself through no-haggle pricing and a customer-friendly sales process in ~140 stores. The used-car market (~80% of its sales), however, is highly competitive.
- Fiscal 2014 was a banner year for CarMax. Revenue advanced ~15%, as it sold more than 877k vehicles, including ~535k retail vehicles and 342k+ wholesale vehicles at auctions. Its comparable-store used unit sales growth of 12% was the best since fiscal 2002. CarMax Auto Finance showed nice earnings expansion as well.
- We think CarMax has compelling growth prospects. Its stores currently reach less than 60% of the population, and in current CarMax markets, the company only has 5% share in vehicles aged 0-10. We're looking for expansion and share gains to drive most of its future sales growth. Investors should expect 10-15 annual store openings through fiscal 2017.
- A little-known fact is that CarMax was once under the ownership of the now-defunct Circuit City. It wasn't until 2002 that the CarMax business was separated from Circuit City to become a publicly traded company. The company has never looked back.
- We're expecting continued strong performance at CarMax, but we think the market is largely factoring in such strong expected performance into the share price. As is often the case in very bullish markets, great companies are often bid up to fair value or more. We prefer ideas that are significant undervalued and are just starting to go up (Valuentum stocks).
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. CarMax's 3-year historical return on invested capital (without goodwill) is 19.2%, which is above the estimate of its cost of capital of 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.
Our discounted cash flow model indicates that CarMax's shares are worth between $42-$62 each. Shares are trading at the mid-point of this range, at present. 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 $52 per share represents a price-to-earnings (P/E) ratio of about 24 times last year's earnings and an implied EV/EBITDA multiple of about 19.8 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 10.1% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 7.9%. Our model reflects a 5-year projected average operating margin of 7%, which is above CarMax's trailing 3-year average.
Readers should understand that these forecasts reflect fairly strong revenue and earnings growth, and even so, our valuation is only at the company's share price. Said differently, if CarMax comes up short of our financial projections, a fair value at the lower end of the fair value range may turn out to be more accurate. Remember: because value is based on the future (and the future is unpredictable), valuation is a range of probable fair value outcomes, with the fair value estimate being the most likely outcome at the present point in time.
Beyond year 5, we assume free cash flow will grow at an annual rate of 5.8% for the next 15 years, and 3% in perpetuity. For CarMax, we use an 8% weighted average cost of capital to discount future free cash flows. The intermediate-term forecast and discount rate are also somewhat aggressive (high for revenue, low for discount rate). To be buyers up here, investors in CarMax are expecting the firm to do incredibly well.
We 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-earnings-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. For relative valuation purposes, we compare CarMax to a number of peers, including AutoNation (NYSE:AN).
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 $52 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 CarMax. We think the firm is attractive below $42 per share (the green line), but quite expensive above $62 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 CarMax's fair value at this point in time to be about $52 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 CarMax'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 $71 per share in Year 3 represents our existing fair value per share of $52 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.