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As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Dollar General's (NYSE:DG) case, we think the firm is fairly valued at $48 per share, slightly lower than where it is currently trading. We're expecting a pull back in the shares.

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, which ranks stocks on a scale from 1 to 10, with 10 being the best.

In the spirit of transparency, we show how the performance of our VBI has stacked up per underlying score (click here for more info on our methodology):

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. Dollar General posts a VBI score of 5 on our scale, reflecting our 'fairly valued' DCF assessment, unattractive relative valuation versus peers, and neutral technicals. We use Family Dollar (NYSE:FDO), Big Lots (NYSE:BIG), Dollar Tree (NASDAQ:DLTR), and Fred's Inc (NASDAQ:FRED) for our peer group analysis.

Our Report on Dollar General

click to enlarge images

Investment Considerations

Investment Highlights

Dollar General'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.

The company looks fairly valued at this time. We expect the firm to trade within our fair value estimate range for the time being. If the firm's share price fell below $38, we'd take a closer look at adding it to the market-beating portfolio of our Best Ideas Newsletter.

Dollar General's cash flow generation and financial leverage are at decent levels, in our opinion. The firm's free cash flow margin and debt-to-EBITDA metrics are about what we'd expect from an average firm in our coverage universe.

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.

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 (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Dollar General's 3-year historical return on invested capital (without goodwill) is 25.2%, which is above the estimate of its cost of capital of 9.9%. 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. Dollar General's free cash flow margin has averaged about 3.3% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM. 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. At Dollar General, cash flow from operations increased about 48% from levels registered two years ago, while capital expenditures expanded about 105% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Dollar General's shares are worth between $38.00 - $58.00 each. 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 $48 per share represents a price-to-earnings (P/E) ratio of about 21.6 times last year's earnings and an implied EV/EBITDA multiple of about 10.8 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 8% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 12.3%. Our model reflects a 5-year projected average operating margin of 11.5%, which is above Dollar General's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3.2% for the next 15 years and 3% in perpetuity. For Dollar General, we use a 9.9% 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 $48 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 Dollar General. We think the firm is attractive below $38 per share (the green line), but quite expensive above $58 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 Dollar General's fair value at this point in time to be about $48 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 Dollar General'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 $65 per share in Year 3 represents our existing fair value per share of $48 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

Source: Why We Think Dollar General Is Due For A Pullback