As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Family Dollar's (NYSE:FDO) case, we think the firm is fairly valued at $53 per share, with the stock trading slightly higher than these levels.
For some background, 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 (click here for more info on our methodology), which ranks stocks on a scale from 1 to 10, with 10 being the best. If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Family Dollar scores a very respectable 7 on our scale (reflecting its attractive value on a relative basis and its healthy technicals).
Our Report on Family Dollar
Family Dollar earns a ValueCreation 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. We expect the firm's return on invested capital (excluding goodwill) to expand to 31.3% from 30.5% during the next two years.
The firm is trading at attractive valuation mulitples relative to peers, but our DCF process indicates a less compelling opportunity. We'd wait for a clearer signal
on valuation before jumping into the firm's shares.
Family Dollar 's cash flow generation and financial leverage aren't much to speak of. The firm's free cash flow margin has averaged about 4% 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.
The firm experienced a revenue CAGR of about 7% during the past 3 years. We expect its revenue growth to be better than its peer median during the next five years.
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. Family Dollar 's 3-year historical return on invested capital (without goodwill) is 30%, which is above the estimate of its cost of capital of 10.3%. 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. Family Dollar 's free cash flow margin has averaged about 4% during the past 3 years. As such, we think the firm's cash flow generation is MEDIUM on our scale. 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, which we use in deriving our fair value estimate for the company. At Family Dollar, cash flow from operations was about flat from levels registered two years ago, while capital expenditures expanded about 122% over the same time period.
Our fair value estimate is $53 per share, which represents a price-to-earnings (P/E) ratio of about 17 times last year's earnings and an implied EV/EBITDA multiple of about 8.3 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 7% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 7%. Our model reflects a 5-year projected average operating margin of 7.8%, which is above Family Dollar 's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.4% for the next 15 years and 3% in perpetuity. For Family Dollar, our model uses a 10.3% 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 $53 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 Family Dollar. We think the firm is attractive below $40 per share (the green line), but quite expensive above $66 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 Family Dollar 's fair value at this point in time to be about $53 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 Family Dollar '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 $70 per share in Year 3 represents our existing fair value per share of $53 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.