**Buffalo Wild Wings** (NASDAQ:BWLD) is a restaurant owner, operator, and franchisor operating primarily in the United States, with a few locations in Canada as well. There are currently over 840 locations in operation, which includes a mix of both company owned and franchised restaurants. The company has experienced phenomenal earnings growth over the past 10 years, and based on their growth strategy I am confident that this will continue for at least the next five years, despite the rising cost of chicken wings which has forced the company to recently increase menu prices to protect margins.

They have plans to have a total of 1,000 stores in operation by the end of 2013, and over 1,500 stores within five to seven years time. The company has a great track record of increasing same store sales, even during periods while the overall market for casual dining was declining. Sounds like an interesting investment opportunity, but at a current (08/23/2012) share price of $74.77 is now a good time to initiate a position? Let's find out.

The **Deep Discount Strategy** is a value investing approach to buying select stocks at a price *below* their fair value. The basis of the strategy is as follows:

*Quality*: Choose only the highest quality companies with a stellar record of consistently high growth across a number of metrics.*Value*: Determine the fair value of the company based on anticipated future growth and a minimum desired compound annual return of 15%.*Target*: Buy and hold the company only when the share price is below a margin of safety, set significantly lower that the fair value price.*Enhance*: Purchase additional shares if the stock price moves lower, assuming the fair value remains the same.

In this article, we will apply the Deep Discount Strategy to Buffalo Wild Wings to develop a valuation and target purchase price. Numbers used in this analysis are sourced primarily from MSN Money.

## Quality

In the context of the Deep Discount Strategy, quality is defined by the company's ability to meet a number of criteria with respect to consistent growth and return on capital. Specifically, we look at the following metrics:

- Return on Invested Capital [ROIC] > 10%
- Earnings per Share [EPS] growth > 10% annually
- Sales growth > 10% annually
- Equity growth > 10% annually
- Long term Debt < 3 years of current earnings

Companies that are able to meet these criteria consistently over a long period of time are likely to be more predictable, and this is key to us being able to develop a proper valuation of the company with a strong degree of confidence. Let's see how Buffalo Wild Wings measures up.

*ROIC* for last year was 14.5% and the average over the past five years was 14.1%. These both surpass our minimum requirement of 10%. ROIC is an important number because it tells us how well the company's management is putting money to work.

*EPS Growth* over the past several years is shown in the following table:

Year | EPS ($) | EPS Growth (%) |

2002 | .27 | - |

2003 | .28 | 3.70 |

2004 | .42 | 50.0 |

2005 | .51 | 21.4 |

2006 | .92 | 80.4 |

2007 | 1.10 | 19.6 |

2008 | 1.36 | 23.6 |

2009 | 1.69 | 24.3 |

2010 | 2.10 | 24.3 |

2011 | 2.73 | 30.0 |

EPS growth has surpassed our minimum requirement of 10% per year by a huge margin for every year since 2004. Average EPS growth over the past five years is 24.4% and is an average of 30.8% over the past 10 years.

*Sales growth* over the past several years is shown in the following table:

Year | Sales (millions) | Growth (%) |

2002 | 96.11 | - |

2003 | 126.50 | 31.6 |

2004 | 171.05 | 35.2 |

2005 | 209.70 | 22.6 |

2006 | 278.18 | 32.7 |

2007 | 329.65 | 18.5 |

2008 | 422.42 | 28.1 |

2009 | 538.92 | 27.6 |

2010 | 613.26 | 13.8 |

2011 | 784.48 | 27.9 |

Sales are growing at a rate that exceeds our minimum requirement of 10% per year for the past several years. Average sales growth over the past five years is 23.2% and is an average of 26.5% over the past 10 years. This is excellent from the point of view that sales are growing very consistently, and at a high rate.

*Equity Growth* over the past several years is shown in the following table:

Year | BVPS ($) | Growth (%) |

2002 | 4.01 | - |

2003 | 4.70 | 17.2 |

2004 | 5.09 | 8.30 |

2005 | 5.70 | 12.0 |

2006 | 6.73 | 18.1 |

2007 | 8.02 | 19.2 |

2008 | 9.59 | 19.6 |

2009 | 11.62 | 21.2 |

2010 | 14.10 | 21.4 |

2011 | 17.30 | 22.7 |

Equity is growing at a rate that exceeds our minimum requirement of 10% per year for the past several years. Average growth over the past five years is 20.8% and is an average of 17.8% over the past 10 years. Again, excellent and very consistent year after year.

*Long-term debt* as of the most recent annual report stood at $23.05 million. Based on annual earnings of $50.43 million, it would take 0.46 years to pay off the entire debt if all earnings were allocated as such. This is well within our criteria that debt be capable of being paid off with 3 years of current earnings.

*Summary*: Buffalo Wild Wings meets all of our criteria for a high-quality company that will allow us to calculate a valuation in a predictable manner. EPS, sales, and equity are all growing year after year at a rate that exceeds our minimum requirements. This is a result of management putting capital to good use, as evidenced by the high ROIC. Finally, the company is able to achieve this without relying heavily on external financing (low debt).

## Company Valuation

The value of Buffalo Wild Wings for our purposes is determined by the expected future EPS growth for the next five years, an estimated future P/E ratio, and finally a minimum acceptable rate of return (MARR) that we desire to achieve. Also required is the trailing twelve months EPS number to use as a starting point. We use these numbers to calculate the future value (NASDAQ:FV) and subsequently the present fair value of the company.

*Future EPS Growth*: Analyst consensus is that EPS for Buffalo Wild Wings will grow at a rate of 20.1% over the next five years. Does this make sense? EPS growth over the past five years averaged 24.4% and grew 30% last year. Sales and equity grew at average rates of 23.2% and 20.8% respectively over the past five years. Based on the company's growth strategy, I am comfortable that the analyst consensus of a 20.1% EPS growth rate over the next 5 years is reasonable. We will use it for our calculations to follow.

*Future P/E Ratio*: The future P/E ratio is most easily estimated by looking at historical values and trends. The following table summarizes the average P/E ratio for each of the past several years:

Year | Avg. P/E Ratio |

2003 | 41.3 |

2004 | 34.5 |

2005 | 32 |

2006 | 21.8 |

2007 | 30.7 |

2008 | 20.7 |

2009 | 21.4 |

2010 | 21.1 |

2011 | 21.5 |

Current (08/23/2012) | 25.4 |

The average P/E ratio over the past nine years is 27.2 which is slightly higher than the current P/E (as of today) of 25.4. This seems like a reasonable value to use for our calculations.

*Future/Present Value*: To calculate the future value, we also need to determine the EPS for the trailing twelve months and our MARR. Buffalo Wild Wings earned $2.94 per share over the past year so we will use this number as the starting point in projecting future earnings. We will use a MARR of 15% as this is the compounded return we aim to achieve using the Deep Discount Strategy. A 15% annual return doubles the original investment in five years time.

Our inputs to the value calculations are then as follows:

- EPS [ttm]: $2.94
- Future EPS growth rate: 20.1% / yr
- Future PE ratio: 27.2
- MARR: 15%

Plugging the EPS numbers into a future value equation predicts an EPS of $7.35 in five years' time. Assuming our future PE ratio of 27.2, this results in a predicted future share price of $199.82 in 2017.

The final step is to calculate the present value of the stock. To achieve our MARR of 15%, we must purchase the stock at a price of $99.34 per share or lower. This was determined using a present value calculation with the future share price determined above as the input at a 15% interest rate.

In summary, we have determined that the current fair value of Buffalo Wild Wings is $99.34 per share. If purchased at this price, we predict that we will achieve a compounded annual rate of return of 15% over the next five years.

## Entry Price Target

In the preceding section we determined that Buffalo Wild Wings is currently valued at $99.34 per share. Our goal using the Deep Discount Strategy is to purchase equities at far less than their fair value. This does two things for us. First, it provides a margin of safety, as the future EPS and future P/E ratios used in the valuation calculations are an educated guess. Purchasing stock for a lower price reduces the risk that we were not accurate in the estimate of these numbers. Second, buying at a discount has the possibility of magnifying our returns greatly, resulting in a compounded rate of return significantly higher than our 15% stated minimum.

Very conservative investors may want to purchase at a discount of as much as 50% to fair value. This provides a very large margin of safety if our predictions are wrong, and has the possibility of increasing our returns exponentially. The downside is that for high-quality companies, it may be a very long time (or perhaps never) for the share price to reach this low level. Therefore, we will also accept a discount of as little as 25% to fair value at the investor's discretion. *This results in an initial price target of $49.67 to $74.51 for an initial entry into this stock.*

The following table summarizes target purchase prices for Buffalo Wild Wings based on the range of acceptable discounts, and also calculates the overall (simple) return based on a future value of $1,968.87 per share.

Discount (%) | Purchase Price ($/share) |

0 | 99.34 |

25 | 74.51 |

30 | 69.54 |

35 | 64.57 |

40 | 59.61 |

45 | 54.64 |

50 | 49.67 |

I am going to choose an entry target corresponding to the 35% discount level. Based on a current share price (08/23/2012) of $74.77 we would look to initiate a position at an initial entry price of $64.57, which represents a 35% discount to the fair value we calculated previously, and is 14.9% below today's price.

## Position Management

Let's assume we have $100,000 in capital that we wish to invest in this company. For an initial entry, I typically allocate 25% of total capital, or in this case $25,000 for the acquisition. This would allow for the purchase of approximately 400 shares at a price of $64.57. Entry through the sale of put options is a viable strategy here, but I will not go into detail here for the sake of simplicity.

If share price drops, it's important to remember that the share price is not the same thing as share value. We calculated the present fair value above, and notice that the current price of the stock was not even considered in the calculation. The price of a stock is affected by a whole multitude of factors including fear/greed, macroeconomic events, news, and of course the performance of the company itself. As long as we are confident that the *value* of the stock has not changed, we should be perfectly comfortable increasing our position size as the share price drops.

Every 30 days we will re-evaluate our position. I will allocate an additional 25% in capital at that time as long as the price remains at or below the chosen discount level of 35%. I may increase position size earlier if there is a significant drop in share price and I am still confident that the intrinsic value of the company has not decreased.

Let's assume that share price drops 2% each month for three months after the initial entry. Following the entry strategy above, I will have purchased a total of 1,600 shares at an average cost of $62.66 and will have invested a total of $100,259.

A common source of confusion with any strategy is when to exit the position and take profits (or a loss). There are just two situations that will trigger us to exit all or part of our position in this company:

- We exit 50% of our position when the share price increases to fair value. In this case, assuming no change in company valuation we will plan to sell when the price reaches $99.34 per share.
- We sell our entire position when the share price increases to a level 20% above fair value. Again, assuming no change in company valuation, we will close out our entire position when the price reaches $119.21 per share.

Note that although we used a predicted future stock price in five years time as part of our calculation to determine today's value, we don't actually intend to hold the stock for five years if we reach fair value before then. Once the stock is fairly valued we begin to take profits and look for other discounted stocks to invest our capital.

We will realize a loss with this strategy if conditions change within the company that cause our calculated fair value to drop below our average cost per share.

If we exit using the strategy outlined above, we will achieve a profit of $74,586 or a 74% simple return. Of course there is a chance we may not get into the position at all, if price does not reach our desired discount level.

Comments()