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Family Dollar Stores, Inc (FDO) operates a chain of more than 7,000 general merchandise retail discount stores in 44 states, providing primarily consumers with a selection of merchandise in neighborhood stores. Family Dollar Stores is a dividend aristocrat, having raised its dividend for 35 consecutive years.

A 10-year summary of Sales, Earnings Before Interest and Tax (EBIT), Earnings per share (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.

Key 10-year data for Family Dollar Stores

Year

Sales (in Millions)

EBIT (in Millions)

EPS

High Price

Low Price

High P/E

Low P/E

Average P/E

2011

8550

617.16

3.12

59.1

41.5

18.9

13.3

16.1

2010

7870

563.86

2.62

51.1

27.8

19.5

10.6

15.1

2009

7400

450.93

2.07

34.4

24.7

16.6

11.9

14.3

2008

6980

361.76

1.66

28

15.9

16.9

9.6

13.2

2007

6830

381.9

1.62

35.1

17

21.7

10.5

16.1

2006

6390

311.14

1.26

30

21.7

23.8

17.2

20.5

2005

5820

342.8

1.3

34.8

19.7

26.8

15.2

21.0

2004

5280

406.66

1.5

38.6

25.6

25.7

17.1

21.4

2003

4750

383.14

1.4

43.7

28.1

31.2

20.1

25.6

2002

4160

335.07

1.22

36.2

25.5

29.7

20.9

25.3

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 Family Dollar Stores, 2002-2011

As evident from the chart above, FDO 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 = 0.1814 (2016) - 362.19 = 3.5124.

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). The P/Es from 2003 and 2002 are significantly higher than the rest, so we average the Average P/Es from the past 8 years to arrive at a signature P/E of 17.2.

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 18.7.

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 11.2.

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 18.7 and 11.2 gives us 14.95.

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: $3.5124 * 14.95 = $52.52, which represents an annual stock price return of -1.9% from the current price = $56.60. When we add in the 1.5% dividend yield, the total return expected is -0.4% per year, which means an investment in FDO today is expected to stay essentially flat after 5 years.

Given a beta = 0.27 for FDO, 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% + 0.27*(5%) = 3.35%. Applying this discount rate of 3.35%, our projected price of $52.52 in 5 years translates to a target price = $44.54 in today's dollars, which is 21% below the current price of $56.60 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 $35.

Market Expectation

What is the market's expectation of FDO's growth rate given its current market price = $56.60? 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 = $56.60, dividend rate = $0.84, and discount rate = 3.35%, we get growth rate = 1.8%. This seems low, given that FDO has grown its revenue by 6% annually over the past 5 years, with earnings and dividend growth rates in the double digits. While growth is supposed to slow down as a company matures, a 1.8% expected growth rate appears low and suggests the stock is undervalued. The caveat, of course, is that the discount rate of 3.35% used is rather low due to the current low interest rates. As interest rates go up, the discount rate would increase accordingly.

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 = 3.23, giving us a current P/E = 17.5. This is about the same as the stock's signature P/E of 17.2, which suggests the stock is fairly valued 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 $44.

Family Dollar Stores' P/E Compared with Competitors' P/Es

It is helpful also to compare Family Dollar Stores' valuations with those of its competitors and peers in the discount variety stores industry. Normalized P/E, Current P/E and Forward P/E are tabulated below for the company and its competitors/peers. Normalized P/E is calculated using average earnings over the past ten fiscal years. Current P/E uses earnings during the last fiscal year. Forward P/E uses projected earnings in the next year based on analysts' consensus.

Stock

Normalized P/E

Current P/E

Forward P/E

Family Dollar Stores (NYSE:FDO)

31.88

17.57

13.51

Dollar General (NYSE:DG)

57.54

21.15

15.69

Dollar Tree (NASDAQ:DLTR)

62.41

23.06

17.96

Wal-Mart Stores (NYSE:WMT)

23.55

14.02

12.62

Big Lots (NYSE:BIG)

37.37

15.52

12.42

Mean

42.55

18.26

14.44

Median

37.37

17.57

13.51

Compared to its peers, Family Dollar Stores appears undervalued based on normalized P/E, and fairly valued based on current P/E and forward P/E. Dollar General and Dollar Tree are significantly overvalued on all three measures. Big Lots is undervalued based on current P/E and forward P/E, and fairly valued based on normalized P/E. Wal-Mart Stores is undervalued on all three measures and is probably the best bet among these five stocks.

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 FDO, the forecast low EPS is equal to 2.218, so the Forecast Low Price = 11.2 * 2.218 = $24.80.

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 FDO, this equals 18.7 * 3.5124 = $65.75.

Thus, the Risk Index = ($56.60 - $24.80) / ($65.75 - $24.80) = 78%. Since this is significantly greater than 20%, the stock has an unfavorable reward to risk ratio at the current price. A pullback to $33 would give a risk index less than 20%.

Conclusion

Family Dollar Stores, Inc., currently selling around $56.60, has a target price = $44, suggesting the stock is overvalued. Moreover, the stock is expected to offer zero total return in five years, and downside risk significantly outweighs upside potential. Nevertheless, the stock appears to be fairly or slightly undervalued compared to its peers, it is selling around its historic P/E, and its market expectations are low. Therefore, I rate the stock a HOLD at the current price. A pullback to around $35 would provide conservative investors adequate margin of safety to buy as a long term investment.

Use this information as a starting point for your own due diligence, before buying any stock. If you do buy, be sure to read any annual reports (10-K) and quarterly reports (10-Q) to ensure that the fundamentals remain good and the stock is on target to reach its projected price. After holding for five years, repeat the analysis detailed in the article to decide whether to continue to hold, add, or reduce your position.

Source: Family Dollar Stores Stock Analysis