Fastenal Company (NASDAQ:FAST) sells industrial and construction supplies in a wholesale and retail fashion. As of December 31, 2010, the Company had 2,490 store locations located in the United States, Puerto Rico, Canada, Mexico, Singapore, China, The Netherlands, United Kingdom, Hungary and Malaysia. During the year ended December 31, 2010, it operated 14 distribution centers in North America, from which it distributed products to its store and in-plant locations. Its stores are operated as a Fastenal store.
The company's product line includes fasteners, tools, hydraulics and pneumatics, janitorial supplies, welding supplies and metals. The product line, which is referred to as the fastener product line, consists of two categories: threaded fasteners, such as bolts, nuts, screws, studs, and related washers; and miscellaneous supplies, such as paints, various pins and machinery keys, concrete anchors, batteries, sealants, metal framing systems, wire rope and strut.
A 10-year summary of sales, Earnings Before Interest and Taxes (EBIT), earnings per share (NYSEARCA:EPS), yearly high and low stock price, corresponding high and low P/E (calculated by dividing the high and low price by the EPS for the year), and average P/E (average of high and low P/E) is shown below. Prices are adjusted for stock splits.
Key 10-year data for Fastenal
Year | Sales (in Millions) | EBIT (in Millions) | EPS | High Price | Low Price | High P/E | Low P/E | Average P/E |
2011 | 2,770 | 575.08 | 1.21 | 43.7 | 28.8 | 36.1 | 23.8 | 30.0 |
2010 | 2,270 | 430.64 | 0.9 | 30 | 20.7 | 33.3 | 23.0 | 28.2 |
2009 | 1,930 | 297.49 | 0.62 | 20.9 | 13.1 | 33.7 | 21.1 | 27.4 |
2008 | 2,340 | 451.17 | 0.94 | 26.8 | 15.9 | 28.5 | 16.9 | 22.7 |
2007 | 2,060 | 377.90 | 0.77 | 24.5 | 17.3 | 31.8 | 22.5 | 27.1 |
2006 | 1,810 | 321.03 | 0.66 | 23.7 | 16.6 | 35.9 | 25.2 | 30.5 |
2005 | 1,520 | 269.06 | 0.55 | 20.6 | 12.7 | 37.5 | 23.1 | 30.3 |
2004 | 1,240 | 208.34 | 0.43 | 15.8 | 11.1 | 36.7 | 25.8 | 31.3 |
2003 | 995 | 136.34 | 0.28 | 12.5 | 7.1 | 44.6 | 25.4 | 35.0 |
2002 | 905 | 121.21 | 0.25 | 10.7 | 7.4 | 42.8 | 29.6 | 36.2 |
From these data, we can plot Sales, EBIT, and EPS versus Year, as shown in the chart below.
Sales (in Millions), EBIT (in Millions), and EPS versus Year for Fastenal, 2002-2011
As evident from the chart above, Fastenal has demonstrated reasonably predictable sales and earnings over the past 10 years, allowing us to predict EPS in the near future, say in five years (i.e. Year 2016), using the linear regression equation for EPS = 0.0922 (2016) - 184.3 = 1.5752.
A conservative average P/E estimate for the stock can be obtained as follows:
Signature P/E: A well established stock has a signature P/E, an average P/E it commands in the market based on its business. We calculate this by averaging the Average P/E over the past 10 years, excluding any outliers (data points that fall significantly beyond the other data points). There are no significant outliers, so we average the Average P/Es from the past 10 years to arrive at a signature P/E of 29.9.
High P/E estimate: A conservative high P/E estimate can be calculated by averaging the five lowest High P/Es of the 10 High P/Es from the past 10 years. Averaging the 5 lowest High P/Es from the past 10 years gives 32.7.
Low P/E estimate: A conservative low P/E estimate can be calculated by averaging the five lowest Low P/Es of the 10 High P/Es from the past 10 years. Averaging the 5 lowest Low P/Es from the past 10 years gives 21.3.
Average P/E estimate: This takes the average of the High P/E estimate and the Low P/E estimate, as calculated above, to give a conservative estimate of an average P/E for the stock we can expect. Averaging 32.7 and 21.3 gives us 27.
Target Price
Multiplying our EPS projection for 5 years hence by the average P/E estimate gives us a projected average price for the stock: $1.5752 * 27 = $42.51, which represents an annual stock price return of (2.22)% from the current price = $46.50. When we add in the 1.46% dividend yield, the total return expected is an annualized (0.75)%, which means an investment in FAST today is expected to lose value in 5 years, which is bearish for the stock.
Given a beta = 0.97 for FAST, a risk-free rate = 2% (using the yield on 10-year Treasury bond as a benchmark), and estimated risk premium of about 5% for the general stock market, we have a discount rate = 2% + 0.97*(5%) = 6.85%. Applying this discount rate of 6.85%, our projected price of $42.51 in 5 years translates to a target price = $30 in today's dollars, which is 34% below the current price of $46.50 for the stock, suggesting the stock is overvalued right now. For a good margin of safety, investors are well advised to buy only if the current price is at least 20% below the target price, which means a buy price of $24.
Market Expectation
What is the market's expectation of FAST's growth rate given its current market price = $46.50? Since stock price = dividend * (1 + growth rate) / (discount rate - growth rate), we have growth rate = ((stock price) * (discount rate) - dividend) / (stock price + dividend). Plugging in stock price = $46.50, dividend rate = $0.68, and discount rate = 6.85%, we get growth rate = 5.3%. This seems reasonable, given that Fastenal has grown its revenue by 9%, its earnings by 12%, and its dividend by 27% annually over the past 5 years. The growth rate is limited by the sales growth rate (which is the slowest historic growth rate in this case), and is supposed to slow down a bit as a company matures, and as interest rates go up, so will the discount rate and market expected growth rate.
While many investors are impressed by the company's huge dividend growth rate over the past 10 years, it must be kept in mind that the company only paid a pittance 10 years ago, and with the dividend rate increases in recent years, so have the payout ratios, as shown by the table below.
Year | EPS | Dividend | Payout Ratio |
2011 | 1.21 | 0.65 | 0.54 |
2010 | 0.9 | 0.62 | 0.69 |
2009 | 0.62 | 0.37 | 0.60 |
2008 | 0.94 | 0.4 | 0.43 |
2007 | 0.77 | 0.23 | 0.30 |
2006 | 0.66 | 0.2 | 0.30 |
2005 | 0.55 | 0.16 | 0.29 |
2004 | 0.43 | 0.1 | 0.23 |
2003 | 0.28 | 0.06 | 0.21 |
2002 | 0.25 | 0.01 | 0.04 |
The payout ratios have become unsustainably high in the past 3 years, close to or exceeding 60 percent of earnings. Dividend must come from earnings, and earnings must come from sales. Dividend growth is unsustainable without a corresponding growth in earnings and sales, and Fastenal's dividend growth has far outpaced its earnings or sales growth. In general, conservative investors should look for payout ratio under 40 percent, especially given the cyclical nature of Fastenal's business. It appears that the stock price and dividend rate have risen too far ahead of earnings and sales recently, and a pullback is due.
Current P/E Compared with Signature P/E
We should also determine how the stock's current P/E compares with its signature P/E, since established stocks tend to revert back to their respective signature P/Es over the long term. The current EPS = 1.21, giving us a current P/E = 38. This is about 129% of the stock's signature P/E of 30, which again suggests the stock is overvalued right now. To provide some margin for error, we should look to buy when the current P/E is 80% or less of the stock's signature P/E, which means a buy price around $29.
Fastenal's P/E Compared with Competitors' P/Es
It is helpful also to compare Fastenal's valuations with those of its peers/competitors in the general building materials industry. Current P/E and forward P/E are tabulated below for the company and its competitors.
Stock | Current P/E | Forward P/E |
Fastenal (FAST) | 38.54 | 26.8 |
MSC Industrial Direct Co. (NYSE:MSM) | 20.85 | 16.56 |
W.W. Grainger (NYSE:GWW) | 21.44 | 16.18 |
Anixter International (NYSE:AXE) | 12.59 | 10.87 |
Mean | 23.355 | 17.6025 |
Median | 21.145 | 16.37 |
Fastenal appears significantly overvalued compared to its peers as measured by both current P/E and forward P/E. MSC Industrial Direct and W. W. Grainger appear fairly valued on both measures. Anixter International appears undervalued on both measures.
Risk Index
Lastly, we calculate the Risk Index, calculated as (Current Price - Forecast Low Price) / (Potential High Price - Forecast Low Price) to give an estimate of the risk: reward ratio. Risk index less than 20% is desired, which gives us +200% potential returns for every risk of 50% loss we assume.
The Forecast Low Price is calculated by multiplying the Low P/E estimate by the Forecast Low EPS, to give a conservative estimate of low price for the stock in 5 years, assuming zero EPS growth and low valuation. Forecast Low EPS is estimated by averaging the EPS over the past 5 years. For growth stocks with predictable earnings growth, EPS in 5 years should not be any lower than this conservative estimate. For FAST, the forecast low EPS is equal to 0.888, so the Forecast Low Price = 21.3 * 0.888 = $18.93.
The Potential High Price is calculated by multiplying the High P/E estimate by the projected EPS in 5 years, giving us a price target in 5 years should the stock command a high P/E. For FAST, this equals 32.7 * 1.5752 = $51.44.
Thus, the Risk Index = ($46.50 - $18.93) / ($51.44 - $18.93) = 85%. Since this is significantly greater than 20%, the stock has an unfavorable reward to risk ratio at the current price. A pullback to $25 would give a risk index less than 20%.
Conclusion
Fastenal Company, currently selling around $46.50, has a target price = $30, suggesting the stock is overvalued. The stock is projected to have a negative total return in five years at the current price. Downside risk appears to outweigh upside potential significantly. The stock's current P/E of 38 is significantly higher than its historic P/E of 30. Moreover, Fastenal appears significantly overvalued on a relative basis compared to its peers.
The stock's strong recent dividend growth appears to have outpaced its earnings and sales growth, suggesting the stock may be a case of a dividend bubble. As a cyclical stock, the stock appears near its high in a business cycle, and is bound for a correction in the next recession, which is right around the corner. Therefore, I rate the stock a sell at the current price. A pullback to $24 would provide conservative investors adequate margin of safety to buy as a long term investment.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Disclaimer: Use this information as a starting point for your own due diligence, before buying or selling any stock. By recommending a sell, I advise taking profits if you own this stock and have long term gains. Shorting the stock, however, should be reserved for the rare investor with prodigious amount of capital and a strong stomach, because the stock has strong price momentum, which can propel the stock price higher still for another 6 months up to a year.